Not all failing financial institutions are eligible for a rescue operation where all assets maintain their value and creditors, depositors and investors preserve their full outstanding worth. As a consequence, a total or partial write down of assets is customary. Therefore, all creditors are advised to closely monitor the regulatory resolution strategies and domestic legal proceedings. These are meant to protect the public interest and maintain confidence in the financial system. The latter is in particular important for individual creditors who wish to minimize their potential losses and maximize repayment during the bank resolution and liquidation procedures.
Financial institutions generally fail for two reasons. Most failures characterize by insufficient readily available capital to meet obligations to depositors and other investors. Less common but still impactful is the situation where regulatory violations and international sanctions have the potential to trigger a run on the bank. Although third party intervention serves a purpose, creditors are often left in the dark and enter an uncertain and unpredictable era.
Staged Asset Recovery and Bullet Payments
The early days of bank resolution require a close examination of the different possibilities of orderly dissolution of the enterprise. Sometimes parts of the bank or specific business units contain sufficient value to justify a sale or transfer to another financial institution. In other circumstances, the bank is fully dismantled and creditors receive repayments subject to the applicable creditor hierarchy.
A novel bank bail-in and traditional bail-out enables a continuation of activities whilst creditors participate in the losses and write-down of the banks assets. In the event that the solutions for continuation are little, and the financial institution is not considered too big to fail, local insolvency rules decide on the winding up of the entity.
The winding up procedures of a financial institution are characterized by several isolated and predefined moments. Staged recovery is therefore for most creditors a necessity for maximum repayment. Prior to the approval of a bank liquidation by a local court, several administrative arrangements may be made. For individual creditors, debt and credit can be offset when local rules and contractual agreements allow for such transactions. The remaining balance will then be left for further recovery.
During the initial stages of the resolution procedures, the supervisory authority must decide on the most appropriate way to resolve the situation. These early moments often provide creditors with little access to their account balance, sometimes replenished by capital controls. To maintain confidence in the financial system, the resolution authority must provide swift access to the domestic deposit protection scheme to regain creditor access to a predefined and capped insured account balance. Bullet payments are connected to the outstanding account balance of a depositor but mostly covered by a DGS or liquidation payment, that often take place in periodic tranches depending on the accessibility of liquid assets available for distribution.
Depositor Protection and Further Recovery
Following the limitation on deposit accounts in matters of bank resolution, depositor protection seeks to safeguard bank deposit up to the insured amount. In the EU this amount is capped at 100.000 Euro, in the UK it is 80.000 GBP and the USA maximizes deposit insurance up to 250.000 USD. The insured amount exclusively covers the deposit and departs from (penalty) interest and other charges due to the account limitations. Academic theory asserts that excessive risk taking should be a matter of choice by contract parties. To avoid moral hazard and emphasize on the sovereign contractual relationship between the bank and its customer, market forces and public indignation should penalize wrongdoing by the bank.
Bank Liquidation Procedures
Financial institutions distinguish systemic parties that are too big to fail and other smaller banks that mainly serve a local purpose or engage in specialized services. As such, resolution may differ when it comes to size and importance of the failing financial institution. Local company, insolvency, and bankruptcy laws therefore often determine the bank liquidation procedures. Assets are then collected and realized and creditors are paid from the common pool available for distribution. It may happen that some assets are liquidated faster than others and thus repayment may take place in tranches.
Conclusion: Bullet Payments in Bank Liquidation…
Depending on the size of a deposit, account holders and other creditors can receive total indemnification in three stages of bank liquidation. The pre-liquidation stage allows for limitations on the account, friendly arrangements and civil action. Creditors with access funds, may be legible for stage 2: deposit protection which covers a maximum insured bank deposit. The bank liquidation procedure is considered the final stage whilst creditors who are forced to write down part of their outstanding deposit may impose legal action against those they blame for their losses.
The complexity of bank resolution combined with the amounts held with the failing financial institution make repayment in tranches at different moments in time realistic. Even though bullet payments take place, it is uncertain whether these payments are enough to cover the full claim of creditors. Therefore, creditors in bank failure or liquidation are urged to pay close attention to the resolution strategies initiated by the supervisory authority.