SIMULATING BAIL IN AND ITS IMPACT ON WEALTH TRANSFERS AND ARBITRAGE

Transcription

1 SIMULATING BAIL IN AND ITS IMPACT ON WEALTH TRANSFERS AND ARBITRAGE Jean Roy Professor of finance, HEC-Montreal Moin El Herraoui Director, Capital Markets Analytics and Modeling, CDIC

2 Content Introduction 1. The objectives for the bail-in simulator 2. The structure of the bail-in simulator 3. The issues of wealth transfer, compensation and arbitrage Conclusion

3 Introduction Following the large bailouts implemented during the 2008 financial crisis, Bail-in has become a major component of interventional reform and recommended as resolution tool as part of the FSB Key Attributes of Effective Resolution Regimes for Financial Institutions. Bail-in is defined as a process whereby some of the debt instruments of the troubled bank are converted to common shares, should its regulator deem the bank to be non-viable. Bail-in is new and complex resolution tool and there is a need to know how the Bail-in policy/regime can be well designed and implemented. Need to identify & understand the different factors affecting the Bail-in policy/regime. Need a Bail-in Simulator

4 1. Bail-in Simulator: Main objectives Assist in developing a Bail-in regime/policy based on detailed B/S data of different Systematically Important Banks (D-SIBs). Understand the effect of maintaining the relative credit hierarchy when applying Bail-in (respecting credit hierarchy as in KA 3.5) Understand the effect of the different parameters of Bail-in regime (e.g. conversion multiplier, liquidation cost) Understand the effect of Bail-in on control of the bank by the different stakeholders and the changes in their wealth. Compare Bail-in with Liquidation in terms of gain (loss) for various stakeholders

5 1. Bail-in Simulator: Main objectives (Contd.) Identify potential risks of the implementation of Bail-in and how to mitigate or minimize them (e.g. compensation risk & arbitrage risk) Understand the ability of Bail-in to successfully recapitalize a troubled bank under different failure scenarios

6 Bail-in Simulator: Key features The simulator assists in understanding the effects of the following paramers/options: Option to cancel common shares or not Option to operate a complete or partial conversion of the bail-inable debt Option to set the conversion price in various ways based on the market price of the shares or book value and to set a minimum conversion price Option to apply a credit hierarchy for Bail-in that is different from that of liquidation Option to use different conversion multipliers to convert the debt instruments. Option to apply different scenarios of failures/losses These degrees of freedom create significant complexity making it difficult to anticipate all the impacts combined.

7 Bail-in Simulator: Outcome of the simulator Examine implementation alternatives, Determine the ability to sucessfully recapitalize a troubled bank, Assess the implications for liability holders in terms of control and wealth, Evaluate the gain (or loss), if any, of a bail in over a liquidation for the various stakeholders, Identify and measure any wealth transfers that a bail-in may imply (between the different debt holders and common share holders).

8 2. The structure of bail-in simulator Input phase Detailed input of the liability and capital structure of a bank Assumptions relative to loss, post loss Risk Weighted Asset (RWA), liquidation loss Bail in parameters: Option to cancel shares or not Option to perform a complete or partial conversion of specific liabilities Use of a minimum conversion price Values of multiple used in conversion for the various classes of liabilities Anticipated price per share under stress

9 Processing phase: the bail in process Major steps of the simulation Agregate liabilities in bail in priority classes Apply operating loss to capital and compute target capital Use bailinable debt to absorb loss and replenish capital Compute the value of debt eligible for shares given the loss absorption hypotheses Compute conversion price for each priority class Attribute shares to converted debt classes using their conversion prices Compute the effects of the bail in on control and wealth Disagregate class results at the liability level

10 Formula for the number of shares granted Nb of shares = Eligible funds / Conversion price Eligible funds = Total converted funds or (Total converted funds Loss absorption) Conversion price = (Reference or minimum value) Multiple Reference value= Book or Market value Multiple = Reference NVCC multiple * Relative multiple Note: The multiple, greater than one, creates a discounted conversion price in favor of the provider of bailed in funds.

11 Processing phase: the liquidation process Agregate liabilities in liquidation priority classes Compute liquidation loss and total loss Compute value for each class under three liquidation scenarios L1 : Under bail in priority without liquidation cost (loss) L2 : Under liquidation priority without liquidation cost L3 : Under liquidation priority with liquidation cost Disagregate class results under the three scenarios at the liability level

12 The processing phase: Comparison of bail in vs liquidation For each liability, the net gain is computed as the difference between the value under the bail in restructuring (BIR) scenario and the liquidation under creditor hierarchy with liquidation costs, ie NG (Net Gain) = Value (BIR) Value (L3) NG = V(BIR) V(L3) A check is performed to make sure that all liability holders are better off under bail in.

13 Decomposition of the net gain The three sources of gain for each liability holder are obtained via the following decomposition: NG= (V(BIR)-V(L1)) + (V(L1)-V(L2)) + (V(L2)-V(L3)) NG= GRS + GRP + GALC 1. GRS is the Gain from the Redistribution of Shares caused by differences in the terms of conversion and the cancellation of shares or not, 2. GRP is the Gain from the Redistribution of Priorities between the bail in and the liquidation process, 3. GALC is the Gain from Avoiding Liquidation Costs.

14 Decomposition of the Net Gain from Bail in over Liquidation Wealth Transfers Gain from redistribution of shares (GRS) Gain from redistribution of priorities (GRP) Gain from avoidance of liquidation costs (GALC) Net Gain from Bail in over Liquidation (NG)

15 Multiple input processing The simulator also features two approaches to facilitate processing in a single run multiple input sets, namely: Sensitivity analysis Analysis of 9 input variables on 5 key output variables Scenario analysis Comparison of up to 5 scenarios

16 The output phase Shows if the target capital has been achieved or not, Displays how much each bail in priority class has contributed to the bail in, Presents the share of control of each priority class, Shows the value of each priority class after bail in, Displays the net gain obtained through bail in over liquidation at the liability level and check if all parties all better off, Presents the decomposition of the net gain into GRS, GRP and GALC at the liability level.

17 3. Wealth transfers Wealth transfers may be induced by the redistribution / cancelation of shares or the redistribution of priorities. High multiples tend to transfer wealth from old shareholders to new shareholders. On the other hand, the use of a minimum conversion price may transfer wealth from new shareholders to old shareholders. The size of the loss experienced by the troubled bank may affect both the size and the sign of wealth transfers Clearly, wealth transfers create winners and losers.

18 Issue of Compensation Objectives of the regulator Minimize any compensation paid by the regulator due to the execution of Bailin Maximize credit holders being better off under Bail-in scenario than under liquidation scenario Structure Bail in such that loss be smaller than liquidation loss

19 Compensation and wealth transfer Recall that for a stakeholder Net gain = Wealth transfers+gain from Avoidance of Liquidation Costs Thus, if a party suffers from a large enough wealth transfer its net gain may be negative leading to its prefering the liquidation and opposing the bail in or requiring compensation to accept the bail in. Our analysis shows that minimizing wealth transfers would minimize the need for compensation. But if compensation is requested, the negative net gain (i.e. net loss) would provide an approach to evaluate the amount.

20 Arbitrage and wealth transfer Wealth transfers may create incentives for arbitrage, such as short selling the common shares providing the wealth transfer and buying the bail-inable debt benefiting from the wealth transfer. Our analysis shows that the conversion multiplier is the major factor for arbitrage risk If high multiplier is used, arbitrage may drive down the price of common shares and lead to a process known as the «death spiral». Avoiding wealth transfers or at least keeping them small would minimize the opportunities for arbitrage and its negative impact.

21 Conclusion A bail in regime involves many parameters which have complex interactions. The simulator has allowed us to develop a better understanding of the process. Wealth transfers have emerged as a key issue in bail-in as they may lead to higher compensation and arbitrage risks. Regulators are thus faced with the challenge of balancing the benefits and costs related to wealth transfers in the bail in regime.