24 December 2013

Poor performance of Royal Courts Undermine Rights

This month I have seen two significant decisions issued by Royal courts well up the rationalised hierarchical judicial structure that should be of concern to investors and business people. These decisions have a majority of the judges supporting erroneous positions that both upset the stability of the law and imperil property and contractual rights in disturbing and unexpected ways. The minority of judges appear to have much more sensible and stronger arguments but failed to prevail.

On 4th Dec 2013 the High Court of Australia upheld the purported power of the liquidator of the landlord company (Willmott Forests Limited (in receivership and liquidation)) to disclaim the leases granted by the company and that the result was to extinguish tenant's estate in the land. This meant that the liquidator of the lessor company could sell the land, including the forests planted and owned by the tenant, free of the estate of the tenant in the land and the trees, and leaving the tenants with an unsecured claim on the insolvent company for the losses resulting.

Yesterday (23rd Dec 2013), the Supreme Court of New Zealand ruled in BFSL 2007 Ltd v Steingrad [2013] NZSC 156, that insureds and insurers could not pay defence costs covered under liability indemnity insurance contracts safely and securely because the insurer could become liable to pay these amounts additionally and on top of the total liability limit of the policy of insurance.

The decision in Willmott means that tenants have no security of tenure in Australia whatsoever, their estates and interests in the land they have leased can be extinguished as a matter of routine on the insolvency of the corporate landlord for the commercial advantage of other parties. This means any lease with a rent that is below market rent could be disclaimed, leaving the tenant to increase the rent to market rent. The insolvent landlord can thereby effectively confiscate any improvements made by the tenant, make the tenant pay again for future use of the land it has already paid for and/or use the threat of eviction to jack the rent up or otherwise renegotiate the bargain to whatever the tenant can be made to pay using this form of unconscionable leverage.

If there is a case where a tenant could lose its estate in the land with more inequitable consequences, it would be hard to imagine. The tenants had paid for 25 year leases entirely up front, and had paid for the land to be planted with trees, in the understanding that their leasehold interests in the land and the trees would be legally protected and that practically nothing could deprive them of the right to the benefits of the harvested trees when they were ready to harvest within the life time of their lease of the land. The liquidator has now disposed of the land on the basis that the leases are extinguished, leaving the buyers with the rights to harvest the tenant's trees without paying the tenants who planted the trees anything whatsoever. The proceeds of the sale of the land and the trees go into the general corporate estate for the payment of creditors according to their security interests, with the tenants entitled to compensation as unsecured creditors of the insolvent landlord (i.e. fat chance of recovering anything).

The decision in BFSL 2007 Ltd v Steingrad [2013] NZSC 156 is likely to have fairly modest impact because the insurance market has responded to the confusion this case has generated by redrafting insurance contracts to operate as they had always intended them to operate, however that such actions have become necessary is of concern. I briefly explain and analyse the issue below.

The Law Reform Act 1936 provides a statutory charge over 'all insurance moneys that are or may become payable in respect of that liability' in favour of the person the insured is liable to pay damages or compensation and that the insurer indemnifies the insured for.

Somehow, the majority of judges of the Supreme Court of New Zealand do not understand the nature of a charge or security interest in the modern parlance. A security interest is a claim over property to use it or its proceeds to pay a liability. Necessarily the security interest is separate from the property it attaches to. If the property the security attaches to realises less than the security, the property and its new owner is not then liable for any shortfall, rather the new owner takes the property free of the security interest that was realised.

In this case the property the security interest attaches to is the  'all insurance moneys that are or may become payable in respect of that liability' (emphasis added). This necessarily excludes all insurance moneys under the insurance contract that are paid or payable in respect of other benefits under the policy such as defence costs. So whatever is paid out or payable out of the policy that is for the insured's liability for damages or compensation to the judgement or settlement agreement creditor is the property the security interest attaches to. This money can then go safely from the insurer to the insured's judgement or settlement agreement creditor: to the extent it becomes part of the insured's estate, the judgment or settlement agreement creditor can still get this ahead of the insured's other creditors since this security interest ranks ahead of all others.

However the majority of judges of the Supreme Court of New Zealand think that the security interest attaches to  'all insurance moneys that are or may become payable in respect of that liability policy' (emphasis added), meaning that the other benefits payable under the policy, bargained between the insured and the insurer for whatever other or associated reasons or persons go to the third party creditor of the insured instead.

They are also very confused about the effect of security interests. They seem to think that if person A's claim on person B is security for A's liability to person C, that person C could potentially recover more from person B than person B owed person A. For example, suppose person A owes person C $1 million, and person B owes person A $100,000. Suppose that C has a legal right to realise the security interest by making B liable to C. Although the security interest secures a debt of $1 million, the security can only realise the value of the property that the security attaches to, namely the debt of $100,000. Payment of $100,000 from B to C exhausts the property the security interest attaches to, and B's liability to C is fully discharged.

Even though Sec 9 (4) allows the secured party to proceed and recover against the insurer directly, the realisation of security interests over debts can never realise or recover from the debtor's debtor more than the other debtor owes the debtor under the debts that the security interest attaches to. Neither can the secured party recover more than the amount secured. Sec 9 (4) only refers to the secured amount as a limit, but in reality both limits go without saying! Somehow the majority of the judges of the Supreme Court of New Zealand think the subsection reads:

Every such charge as aforesaid shall [The liability of the insured may] be enforceable by way of an action against the insurer in the same way and in the same court as if the action were an action to recover damages or compensation from the insured; and in respect of any such action and of the judgment given therein the parties shall, to the extent of the charge, have the same rights and liabilities, and the court shall have the same powers, as if the action were against the insured

Somehow they think that the subsection does something other than realise a security interest limited to the realisable amount of the collateral the security interest attaches to, they think it makes the insurer fully liable for the liability of the insured (note that the 'extent of the charge' is the 'amount of his [the insured's] liability' refer subsection (1)).

Subsection (7) is also apparently redundant, although the majority of judges on the Supreme Court of New Zealand appear to think it vitally necessary to limit the liability they think is being imposed on the insurer by subsection (4).

The intention and effect of section 9 is that the compensation and damages payments of insurance contracts can be protected and can be beneficially enjoyed by the persons the insured is liable to pay compensation or damages to. This was ever and is only ever relevant when the solvency of the insured is in doubt, and the other creditors of the insured could otherwise take security over the compensation or damages payments or share in them. There is no requirement to hold sufficient liability cover to pay all liabilities in full, nor is there anything restricting limits or other benefits or payments from insurance policies that also indemnify the insured against liabilities to pay damages or compensation.

There is really only one situation where the section would have the effect of restricting the payments under the insurance policy and that is where there are multiple compensation or damages claims that the insurer has notice of pursuant to subsection (6), and the ones that have the earlier dates of cause of action are yet to be determined, or where multiple compensation or damages claims have the same date of cause of action and any of them are not yet determined, all because of the ranking rules of subsection (3). All other benefits, including defence costs claims, can be administered and paid safely by the insurer. At least they could until yesterday: unless your insurance contract has been restructured or updated to get around this needless issue you better hope there are no claims to defend and no other benefits to pay.

Why complain about the performance of the Royal courts? There is a better alternative: rather than a rational hierarchy of royal courts with compulsory jurisdiction and avoidance of overlapping jurisdiction, which is an instrument of imposition of Royal power on subjects, we can have free choice of tribunals and competition, a society where dispute resolution does not have a single source of authoritative answers. Such a tribunal market implies a customary law system, where custom rather than binding precedents or legislation provides the definition and content of our laws. Such a legal system can produce much better dispute resolution services and much better legal security so that our institutions can't be turned upside down by a panel of people deciding that damages and compensation creditors can suddenly jump ahead of others because they need a boost. These decisions also show that the rule of law is indeed a myth.

04 April 2013

Bitcoin Speculation and Demise

If you haven't heard of bitcoin yet you haven't been paying attention to monetary theorists, modern Austrian school economists, offshore financial service, anarchist, libertarian or fringe and speculative financial circles in the last year or two.

A summary of the bitcoin currency:

  • It is a purely electronic currency
  • The rules and institutions of the currency that recognise the validity of its issue and transfer (with or without subdivision and/or combination) are customary (a kind of customary law of the opt-in variety)
  • Currency value is held in and transferable between and divisible between public keys which represent the 'accounts' in the system, by way of transfer messages signed by the private key of the public key of the account from where it came, nominating the payee(s) and amounts.
  • Transfers are published and approved to form a block-chain, to so all users can track the balance held in each account (to confirm where the value came from) and where it has gone (to control the double-spend problem)
  • The community accepts the longest block-chain as being valid, which means that the community accepts all the previously recorded and published transactions in the block chain
  • Extending the block-chain requires computing resources to solve arbitrary mathematical problems. Whoever can find these solutions can extend the block chain and issue a pre-determined quantity of new currency as their reward for processing the new transactions and thereby cementing acceptance of the older transactions. The community only accepts block chain extensions that transfer value with the proper signatures from the originating accounts. 
  • The identities and ownership and control of keys may be kept private or anonymous (i.e. the money is public (to control the double-spend problem) but the accounts where the money are held are not)
This system provides a basis for the currency to be secure and have a market value without having a central authority.

Because the currency is not issued in exchange for funds received by the issuer or owing by the issuer, and because the holder of the currency does not have any rights to redeem the currency against the issuer or to participate in any profits or assets of the issuer, the currency itself is not a debt security, nor an equity security, nor a bank note nor a negotiable instrument. Neither is it legally a form of currency or legal tender. It is a form of intangible personal property like ... like I'm not sure quite what. These features mean that it is typically not subject to any securities or banking laws, nor any AML laws. And even if it were to be within the definition of such laws, the ability of those laws to restrict or take legal action against the issuer or holder is rather moot: identifying and finding the issuer or holder is difficult and doing so will not stop others accepting or using it or mining more, and effecting confiscation may be difficult or impossible (e.g. with secret sharing as an antidote to the odious official key theft laws such as sec 130 of our very own Search and Surveillance 'law').

However, the lack of any issuance in exchange for assets and redemption in the form of assets means that its market value is determined by the combination of the quantity on issue (which is arbitrarily pre-determined by consensus in the community) and the demand to hold such currency. This can provide a determinate market value, but that value can be highly sensitive to the strength of the demand to hold the currency at any particular time. The actual market value has been highly volatile, and could now be driven largely by speculative fever, as suggested by this well written article:

I’m Raising My Bitcoin Price Target To $400

This article examines in some detail the potential for speculative mania in bitcoins.

The purpose of this post is to look further into the future as to what will replace bitcoin and how.

Firstly, note the consequence of price volatility in a currency: users of the currency will be hesitant to use it as a store of wealth, and will only use it as a speculative assets or for mediating actual trades. The vast wealth that now appears to exist in the form of bitcoins at the current market price will seek to migrate to other forms of wealth. Those other forms of wealth will not be denominated in bitcoins, either. Unlike gold and modern fiat currencies, credit markets in bitcoins will not emerge with any depth or liquidity or ubiquity.

Secondly, bitcoin users who are seeking alternative forms of wealth storage will expand markets for offshore financial services and for privacy enhanced (and confiscation resistant) wealth services. This expansion will be fueled by innovative offshore financial service providers who integrate their services with bitcoin.

Thirdly, the development and popularisation of bitcoin will put more pressure on AML laws and the FATF that will ultimately lead to acceptance or toleration of strong financial privacy, financial anonymity and asset protection. This is likely to be fueled by (and/or will fuel) a change in the tax mix from income tax to consumption taxes, and from progressive residence based income tax to flat rate source based income taxes, which reduces or eliminates the tax enforcement interest in personal and corporate offshore financial wealth holdings. This development will emerge through jurisdictional arbitrage and jurisdictional competition, and the breakdown of the FATF/OECD tax information cartel.

At the technical level, the bitcoin linking of 'mining' with approving transactions will be decoupled within bitcoin or by other similar currencies. The value-base of alternative currencies will move from mining economics to issue and redemption in exchange for commodities or financial assets. Commodities such as gold and silver provide the traditional market value anchor for currencies, and these could be restored in new digital currencies. The digital currencies will move back to being financial liabilities of issuers who will hold commodities and/or financial assets to be available to be used to redeem these liabilities. For this to happen, the current strangle-hold of restrictive securities laws and banking laws will have to be relaxed, and the AML laws will have to be scaled back to allow better financial privacy protections and to allow customer anonymity. These legal developments will only happen under considerable commercial pressure and by the re-emergence of more open jurisdictional arbitrage and jurisdictional competition (or alternatively the collapse of the state in a significant population area or areas).

31 March 2013

Oram on Bank Failure Dynamics with OBR

Today's article by Rod Oram raises some valid points about how banking sector stress and failure could play out in New Zealand with the Reserve Bank's OBR policy being effected. The key concern:
[The] Reserve Bank has devised a rescue system that encourages depositors will flee their banks and try to head for the one it and the Government have saved.
This will happen for three obvious reasons under the Open Bank Resolution process due to take effect in June:
[1.] Depositors will be frightened by the Reserve Bank taking a proportion of a failed bank's deposits to recapitalise the institution. [2.] Failure is likely to be systemic and contagious in the event of, say, a collapse in the housing market or a drying up of international credit.
This means people will worry their banks and deposits will be next in line for treatment.
[3.] The Reserve Bank pledges it will make only a one-off "haircut" on deposits in the failed bank. It won't return for a second bite if the bank's problems deepen. This means new deposits in the rescued bank will retain their full value.
Oram also makes the point that bank customers and depositors are normally unsecured, while some wholesale creditors have security over high quality bank assets:
 Thanks to the Global Financial Crisis, commercial creditors are becoming more sophisticated in the collateral they are securing from banks.
An example here is covered bonds that are secured by ring-fenced high quality housing loans. BNZ introduced them in 2010 and other banks have followed with alacrity. While this security has lowered banks' funding costs, it's a moot point whether this has resulted in higher profits for the banks or lower borrowing costs for customers.
There are plenty of other ways New Zealand banks are ring-fencing assets to the benefit of their secured creditors, as David Tripe and Geoff Bertram analysed in an article in the November 2012 edition of the Policy Quarterly journal of Victoria University's Institute for Governance and Policy Studies.
Their analysis, available at http://bit.ly/10c3750, shows how secured creditors are gaining more protection for themselves should a bank collapse. This is leaving unsecured creditors bearing a growing share of the losses.
If you have deposited money in a bank, you are one of its unsecured creditors.
The result of these policies and practices together is that in the event of stress in the banking sector to the point of failure of one of more major banks is that market funding for surviving banks could become insufficient.

Counter-acting these concerns, during banking sector stress, the market price of funding for bank customers and borrowers can become significantly higher. This has two effects: it can make bank assets worth less, and it can rebuild or widen bank profit margins. This change in market price represents the transfer of some of the financial stress from the banks to the non-bank creditors: banks are, after all, credit intermediaries. Of course this natural and beneficial market pricing mechanism is the subject of much hand-wringing in a financial crisis: politicians and commentators want strong banks that continue to lend freely during periods of financial stress, but these two goals are in some conflict during periods of financial stress.

Another counter-acting force from this dynamic is the differences in bank strength in the financial system during periods of stress and failure. A bank does not fail by itself, it fails because bank customers and investors become sufficiently concerned about its health to cut off its funding. In doing this they will put their funds elsewhere, significantly including in other banks that are seen as stronger and less adversely affected by  the sources of losses revealed by the stress.

Finally, even in the event of the funds fleeing stronger banks for their weaker peers who have already failed and been restructured and now benefit from a government guarantee on their post-restructuring deposits, this does not mean the policy has not worked.  If the failed bank has converted enough of its debt into equity (or quasi-equity), the government guarantee would be needless and the bank would be able to attract funding even without the government guarantee, as happened in Australia in the 1890s. Further bank failures and restructurings progressively remedy the insolvency of such banks and does not imply that solvent banks will also fail, as can be seen from how that crisis played out:

The governments of Victoria and New South Wales passed controversial company laws that were designed to allow failed banks and other companies to more easily restructure their debts. After the failure of about 41 'land and building institutions' (think finance companies) in Sydney and Melbourne, the Federal Bank failed and the Commercial Bank of Australia was unable to attract or retain funding and suspended payment on 4th April 1893 and restructured its debts into preferred shares (30%) and long term deposits (70%) in a process that took around 8 weeks. Both banks had been lending to the failed land and building institutions. Even before the reconstruction took effect, the Commercial was able to attract funds from other banks by the financial innovation of providing trust-accounts-as-bank-accounts (of course in those days most payments to and from bank accounts were effected by cheques, which are made out to bearer or a named payee rather than a bank account number, so could be deposited anywhere):
A curious feature of the reconstruction, and one that was later copied by the other suspended banks, was the opening up by the Commercial, four days after it suspended, of trust accounts which enabled deposits and withdrawals to be made without involving any of the funds of the bank's 'old' business. These accounts undermined the banks that remained open, and there 'ensured the spectacle of depositors in bank still open, hastily withdrawing their funds to escape the threat of reconstruction and promptly depositing in a trust account in the Commercial' (Butlin 1961:300)
Quoted from Laissez faire banking, Free banking in Australia, K Dowd, p 134

The reconstruction, once effected was sufficiently successful to enable it to spread:
Every surviving bank had thrust before it the great advantages of 'reconstruction': permanent accession of capital; immediate elimination of the mounting tide of withdrawals; and miraculous restoration of confidence. Harassed and worried bankers ... followed the lead of the Commercial. (Butlin 1961: 300, as quoted in Dowd 1993: 134)
However, not all banks failed, suspended payment or went through reconstruction, in particular, the Bank of New South Wales (now Westpac), the Union Bank of Australia (now ANZ) and the Australasia (now also ANZ), even to the point of flouting government 'bank holidays' as a show of their strength.

The OBR IT pre-positioning enables New Zealand banks to effect similar reconstructions by the start of the next business day after failure, and with significantly less disruption than in the 1890s.

Mr Oram's concerns could be addressed by the following changes:

Firstly, the capital requirements for banks could be higher, and met by larger amounts of subordinated debt. This type of funding is good for absorbing losses in a restructuring or OBR situation ahead of ordinary depositors and bank customers. Subordinated debt is still a kind of debt finance (for tax and financial reporting purposes), so it is not a limit on leverage. However, it is a kind of funding that exposes the bank to close market discipline and losses can be applied to it without any political or popular concerns. Ideally, it should be convertible to ordinary share capital in a stress situation to assist raising further ordinary share capital. Higher total capital requirements would make bank failures rarer, and reduce the emphasis on liquidity regulation. There could also be a capital surcharge for secured borrowings to compensate unsecured creditors for their subordination.

Secondly, the core funding requirement should be reduced in quantity but increased in quality. Presently it is 75% of the bank net loans and advances, however, it can be made up from super-senior (secured) wholesale funding (such as covered bonds), as well as call funding and funding that matures in the short term (so called 'non-market funding' of less than $5m/customer (or is it per facility?)). So, in the event the bank is subject to stress, the super-senior funding such as covered bonds is not available to absorb any losses in a restructuring, and the call funding will run off (notwithstanding it is supposed to be 'sticky' retail funding), leaving the remaining depositors to absorb any losses in a restructuring after shareholders and subordinated creditors. One of the lessons from the Global Financial Crisis is that retail bank runs still happen notwithstanding deposit insurance (e.g. Northern Rock), but the RBNZ boffins think that without deposit insurance retail customers are going to leave their life savings at call with a stressed bank. The true core funding is funding that is subordinated to or ranks equal with ordinary depositors, and that does not mature in the short term (6-12 months). So this should only include share capital, subordinated debt, and unsecured funding that does not mature for 6-12 months or more.  If this definition was made more strict, the quantity required should also be substantially reduced, e.g. to 40-50%. If the bank is going to fail anyway, the call funding will run off and the term funding will mature over time leading to default. At the time of default, if the bank still has a partial remainder of true core funding, and a larger extent of subordinated debt, the losses to be shared by the depositors at the time of failure will be significantly lower.

Thirdly, the OBR procedures should be designed to be feasible and effective even without a government guarantee for the post-haircut balances, for example if the government is insolvent at the time the bank failed.  

27 March 2013

Politics of Modern Bank Failures

The Cyprus bank failures and restructurings gives some insights into the fraught politics of bail-outs and bail-ins. Five features are notable from the way this saga was handled:

1. Risk is being moved from the government to investors. Governments, national and supra-national, have their own solvency concerns, and wish to push back risks and losses to bank investors. The public, political and bureaucratic appetite for governments to carry the losses are now weak.  This includes both for insolvent banks and for insolvent governments within the Eurozone and EU.

"What we've done last night is what I call pushing back the risks," Dutch Finance Minister Jeroen Dijsselbloem, who heads the Eurogroup of euro zone finance ministers, told Reuters and the Financial Times on Monday, hours after the deal was struck.
"If there is a risk in a bank, our first question should be 'Okay, what are you in the bank going to do about that? What can you do to recapitalize yourself?'. If the bank can't do it, then we'll talk to the shareholders and the bondholders, we'll ask them to contribute in recapitalizing the bank, and if necessary the uninsured deposit holders," he said.

2. Bank resolution and restructuring powers held by governments and government agencies are being used as a way to overcome political legislative difficulties. These powers are extensive and involve discretion, and may have unpredictable results, but they are being used.

The legislation needed to complete the restructuring of the Cypriot banking system is already in place, German Finance Minister Wolfgang Schaeuble said in the early hours of Monday morning.
Speaking after euro-zone finance ministers approved a new bailout deal for Cyprus, Mr. Schaeuble said "the necessary laws have already been enacted."
He said a banking levy--as was agreed under a now-discarded agreement made just eight days ago--would have required the Cypriot parliament to pass fresh legislation.

3. Taxes on deposits are politically unpalatable. The substance may be desirable, but the form is not. Bank restructuring, closures and resolutions are more appropriate and are doable notwithstanding political difficulties.

The Cypriot parliament rejected a planned levy on bank deposits on Tuesday, throwing a European bailout plan for the tiny economy into disarray.
The vote was overwhelming, 36 with against and 19 abstentions, and brings Cyprus to the brink of financial collapse.

4. Large depositors and creditors of banks get screwed to save 'mum and dad' savers.

Cyprus's finance minister said Tuesday that large deposit holders at Cyprus Popular Bank PCL (CPB.CP), the island's second biggest lender, could face losses of as much as 80% on their deposits as the government moves to wind down its operations.
Speaking in a television interview with state broadcaster RIC, Michalis Sarris indicated that it could also take years before those depositors see any of their money returned.
"Realistically, very little will be returned," Mr. Sarris said.
Asked if, like in other bank closures, it could take six to seven years before depositors get back there money, he said: "maybe yes. And the amount [returned], could be 20%. Certainly, for depositors above 100,000 euros it could be a very significant blow."
His remarks come just hours after Cyprus's central bank governor estimated that the losses facing large depositors at rival Bank of Cyprus PCL (BOCY.CP), could reach as much as 40%.

Wholesale investors beware. Banks cannot rely on wholesale funding in times of stress, and wholesale funding costs must include an additional risk premium based on the prospect of losing up to 100% of the investment should the bank fail. The losses to be faced by large depositors are as a result of saving small depositors from taking any losses at all:
After 12 hours of talks with the EU and IMF, Cyprus agreed to shut down its second largest bank, with insured deposits - those below 100,000 euros - moved to the Bank of Cyprus, the country's largest lender. Uninsured deposits, those accounts with more than 100,000 euros, face losses of 4.2 billion euros.
Uninsured depositors in the Bank of Cyprus will have their accounts frozen while the bank is restructured and recapitalized. Any capital that is needed to strengthen the bank will be drawn from accounts above 100,000 euros.

5. Capital controls may be introduced even though they are pointless and unnecessary. They signal that the banks have not been restructured into a viable form and that the funding provided in the resolution transaction is inadequate, even though this is probably not really the case.

24 March 2013

Five lessons from Cyprus


While the Cyprus sovereign and bank insolvencies fester unresolved a week later, the twists and turns along the way provides some lessons for resolving bank and sovereign insolvencies:

  1. Uncertainty matters. Bank customers all over the Eurozone now have little confidence about what would or could happen in the event of bank failure and where the losses will be be visited. This uncertainty must be addressed by clear, binding rules and institutions that are feasible regardless of whether the state and any deposit insurance schemes are insolvent at the same time. On the other hand it also means that bank creditors need to monitor the financial condition of the banks and the states where they operate from.
  2. Institutional investors and large depositors are vulnerable. When the losses are allocated politically, 'mum and dad' savers have more clout per dollar exposure to the bank than large corporations and rich foreigners who can't vote. (Recent news is that those with under Euro 100k will be spared 6.7% haircuts and haircuts for those with bigger deposits is being put up from 9.9% to 25%.) The misnamed and unnecessary 'de minimis' facility in New Zealand's OBR pre-positioning spec is a political licence to screw institutional investors to spare everyone else, and thereby cut off wholesale funding to NZ banks at their time of stress. The absolute priority and pari passu rules must be protected to avoid this kind of problem. 
  3. Time is of the essence. As days turn into weeks, the disruption to bank customers mounts and these costs cannot be undone at a later stage. Bank resolution institutions needs to be ready in advance and feasible to effect within a few days and without long decision making delays. 
  4. When the government in insolvent, nothing is safe, but some assets and interests are more vulnerable than others. Governments can tax anything and at any rate, but some kinds of assets are more closely connected to the state and/or more easily within reach of the state. With Cyprus reportedly nationalising state pensions, this is a good example of the kind of assets that are most exposed. Pension and state mandated or tax-favoured retirement savings are examples of vulnerable assets (e.g. Kiwisaver funds). By contrast, real estate and private share portfolios are administratively and practically more difficult to seize or tax. 
  5. European political conditions and style prioritizes sharing of losses not only with tax payers but also investors and nations. Bail-outs at all costs are no longer in vogue. European politics has now caught up with economic reality that short term 'stability' measures are likely to be catastrophic long term. Investors, politicians, regulators and citizens now have to adapt to a world and a Europe where sovereign and bank debt is risky, and where failed banks and insolvent states get restructured at the expense (or partial expense) of their creditors. 

17 March 2013

A Quasi-Open Bank Resolution in Cyprus


The news that Cyprus bank depositors are taking a haircut in the restructuring and refinancing of the Cyprus banks is a step closer to seeing the New Zealand Open Bank Resolution plan becoming a feasible option for bank failures around the world. The fact that this kind of option is being sought out and effected in a nation-wide financial and banking crisis is also remarkable, although thankfully to be more expected when both the state and the banks are insolvent at the same time. Ironically, the Cyprus banks are reported to be insolvent because they took heavy losses from lending to the Greek government.

Another remarkable point is that the bank depositors are getting bank equity in exchange for the haircut portion of their deposits: this is a real recapitalisation rather than a selective default (which is the position for the New Zealand OBR scheme). Whether they get equity in their own bank or in the Cyprus banks as a whole is not clear from the new story I linked to earlier.

Effecting bank creditor recapitalisations on a bank by bank basis as or if required should also be seen as a preferable option, as creditors of viable and solvent banks are spared the haircuts, and the banking system as a whole continues to operate without interruption even if the state and many of the banks in the financial system fail. Credit risk in this way become more institution specific, and avoids being nationalised.

Customers of offshore banking centers have suffered several times in the recent financial crisis, including in Cyprus and Iceland. Where a jurisdiction has a large offshore banking sector in relation to its domestic economy, the state may be unable or unwilling to rescue its banks should they become insolvent. Ironically, the Cyprus bank restructuring is also a good reason for using offshore banks: Cypriot customers banking with Cyprus banks have suffered haircuts simply because they banked within their own country (although foreigners banking with Cyprus banks also suffered in the same way). Offshore banking customers, as with their domestic counterparts, need to consider the financial risks they face both from insolvent banks and from insolvent states. Offshore accounts held with strong banks and fiscally strong states such as Singapore and Hong Kong are safer than those held with weaker banks with weaker states such as Belize.