Friday, October 9, 2009

Sheila Bair has strong words for secured creditors

Posted in FT Alphaville by

On Monday, FDIC chair Sheila Bair proposed forcing the secured creditors of any failed US banks to take a 20 per cent haircut on their exposure to said institution. According to a Reuters report, Bair believes having secured creditors take a hit when a financial institution fails “could help rein in excessive risk-taking and strengthen the financial system”.

From Reuters:

Bair told a group of international bankers on Sunday that officials might want to consider “the very strong medicine” of limiting secured claims to 80 percent, although she said such a proposal would need to be carefully weighed.

She said curbing claims would encourage secured creditors, who are protected from losses when a bank fails, to more closely monitor the risks a bank is taking and could speed up the process when an institution needs to be wound down.

“This could involve limiting their claims to no more than say 80 percent of their secured credits. This would ensure that market participants always have ’skin in the game’,” Bair told a meeting of the Institute of International Finance here.

In a note on Wednesday, analysts at BNP Paribas argued the proposal, if implemented, “could have important implications for banks’ funding costs, creditors’ recovery rates and general lenders’ credit risk assessment”.

And, as they explained, the ramifications could be trans-Atlantic:

Since secured exposures include repo transactions, European banks with material repo exposure to US banks could also be impacted. That said, US banks currently at risk of being taken over by the FDIC are small in size, and European lenders` repos with them - if indeed there are any in place - should be small.

Bair’s idea also greatly exercised Joseph Mason, a professor of finance at Louisiana State University at former economist at the Office of the Comptroller of the Currency. Dr Mason, in a piece for RGE Monitor, said Bair’s comments were “really, really important”. Emphasis FT Alphaville’s:

The FDIC has to deal with its own ramifications of [The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005] and the contracts the law incentivized. Just as the mortgages that contributed to the credit crisis were not your parents’ mortgages, the repos Bair discussed are not the traditional products you think of in repo markets. These repos were market funding products that resulted in the manifestation of “cliff risk,” where the entire financial market seemed to suddenly blow up in 2007 and 2008. Of course, had we known where to look we could have seen the pressures mounting…While those of us who have been inundated in investigations of the phenomenon - whether for legal case work, regulatory rulemaking, or academic research - now understand the dynamics, the popular reactions to Ms. Bair’s remarks shows that many market observers and policymakers are still in the dark. Worse yet, policymakers are relying on more margining as a fix for systemic risk from OTC derivatives, threatening more - not less - sudden failures like we saw at the peak of the panic.

Mason’s piece is worth reading in full.

Felix Salmon also defended the proposal, arguing:

I like this idea, if only because secured funding at banks is invidious, especially from the point of view of someone like Bair, who exists to protect deposits. Depositors are senior to unsecured creditors, so lenders love to jump the queue, as it were, and become secured creditors instead, thereby becoming senior even to depositors. It’s an easy way of being lazy, and not feeling the need to underwrite billions of dollars in loans.

At this point, Bair’s suggestion remains just that. Whether her words are subsequently turned into policy will be something watch.

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