SIMULATING BAIL
‐
IN AND ITS IMPACT ON
WEALTH TRANSFERS AND ARBITRAGE
Jean Roy
Professor of finance, HEC-Montreal Moin El‐Herraoui
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
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.
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
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
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.
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
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
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
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.
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
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
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,
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)
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
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
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
Issue of Compensation
Objectives of the regulator
• Minimize any compensation paid by the regulator due to the execution of
Bail-in
• Maximize credit holders being better off under Bail-in scenario than under
liquidation scenario
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
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
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
