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Bank Insolvencies, Priority Claims and Systemic Risk

Part of the Lecture Notes in Economics and Mathematical Systems book series (LNE,volume 683)

Abstract

We review an extensive literature debating the merits of alternative priority structures for banking liabilities put forward by financial economists, legal scholars and policymakers. Up to now, this work has focused exclusively on the relative advantages of each group of creditors to monitor the activities of bankers. We argue that systemic risk is another dimension that this discussion must include. The main message of our work is that when bank failures are contagious then when regulators assign priority rights need also to take into account how the bankruptcy resolution of one institution might affect the survival of other institutions that have acted as its creditors. When the network structure is fixed the solution is straightforward. Other banks should have priority to minimize the risk of their downfall. However, if the choice of policy can affect the structure of the network, policy design becomes more complex.This is a fruitful avenue for future research.

Keywords

  • Banks
  • Priority rules
  • Systemic risk

JEL Classification Numbers:

  • G21
  • G28

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Notes

  1. 1.

    There is an extensive literature in financial economics that studies the optimal design of bankruptcy procedures; see von Thadden et al. (2010) for a recent review of the relevant literature.

  2. 2.

    See Walter (2004) for a description of the actual process of bankruptcy resolution followed in US during the financial crisis.

  3. 3.

    For a general analysis, see Shleifer and Vishny (1992). More recently, this work has been applied to banking to explain fire sales, market freezes, market spirals and related phenomena (see, for example, Acharya et al. 2011; Bebchuk and Goldstein 2011; Brunnermeier and Pedersen 2009; Caballero and Simsek 2013; Diamond and Rajan 2011) For a more thorough review of this literature, see Shleifer and Vishny (2010).

  4. 4.

    For reviews of the literature see Allen and Babus (2009) and Bougheas and Kirman (2015a).

  5. 5.

    See Regulation (EU) No 806/2014 of the European Parliament Council of July 2014. http://eur-lex.europa.eu/legal-content/EN/TXT/?uri=CELEX:32014R0806.

  6. 6.

    By tier structure we imply that the entries under subordinated debt are also ordered according to seniority.

  7. 7.

    Beyond their effects on the incentives to monitor, changes in priority rules can have other consequences. Such changes would affect the prices of those claims whose priority has been affected, potentially changing their ownership and thus the entities affected in the case of bankruptcy (see Danisewicz et al. 2015).

  8. 8.

    Their argument bears some similarity to the one used for supporting the seniority of bank claims on the balance sheets of other firms (see Longhofer and Santos 2000).

  9. 9.

    His work is an application to banking of earlier theoretical work on the role of seniority on corporate balance sheets (see, for example, Diamond 1993; Hart and Moore 1995).

  10. 10.

    See Evanoff (1993) and Herring (2004) for support of this view.

  11. 11.

    See Mantripragada (1992) for support of this view from a legal perspective.

  12. 12.

    There is a similarity between this argument and the theoretical argument put forward by Bolton and Oehmke (2015) related to the role of derivatives.

  13. 13.

    The 1993 Act placed international deposits very low on the priority ladder.

  14. 14.

    Our analysis might also be relevant for other sectors of the economy as interconnectedness is not an exclusive feature of the financial system. For example, Acemoglu et al. (2015b) study how interindustry input-output linkages can magnify small idiosyncratic shocks to produce macroeconomic tail risk. But this is attributed to the fact that they observe the emergence of a strongly skewed distribution of firm sizes. They argue as did Gabaix (2011) that a small shock to a large firm can produce major events. To do the same here would require considering also the size distribution of banks and their place in the network.

  15. 15.

    Actual capital requirement regulations imply that there will be regulatory intervention as soon as equity falls below a prespecified threshold.

  16. 16.

    The existence and uniqueness of the clearing vector is not violated when l < 1, see Acemoglu et al. (2015a).

  17. 17.

    This has also implications for the design of monetary policy. The Federal reserve in its attempt to provide liquidity to troubled institutions had to implement a number of non-traditional policies with unknown long-term consequences (Cecchetti 2008).

  18. 18.

    See Bougheas and Kirman (2015b) for some preliminary work in this direction.

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Bougheas, S., Kirman, A. (2016). Bank Insolvencies, Priority Claims and Systemic Risk. In: Commendatore, P., Matilla-García, M., Varela, L., Cánovas, J. (eds) Complex Networks and Dynamics. Lecture Notes in Economics and Mathematical Systems, vol 683. Springer, Cham. https://doi.org/10.1007/978-3-319-40803-3_8

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