Viv Davies: Hello and welcome to Vox Talks, a series of audio interviews with leading economists from around the world. I’m Viv Davies from the Centre for Economic Policy Research. It’s 6 September 2012 and I’m speaking to Xavier Freixas, a professor of economics at the Universidad Pompeu Fabra in Barcelona about his recent paper on bank resolution in Europe. I began the interview by suggesting that cross-border or systemic bank resolution was once the Cinderella of regulatory reform but that it has now become centre stage.

Xavier Freixas: Yes, definitely. The perspective on banks’ bankruptcy has changed completely, and for once I think that the theory goes in the direction of the changes that have been proposed to regulatory regimes, mainly in Europe.

VD: In your new Vox column titled “Towards a new framework for bank resolution”, you argue that the recent introductions to the regulatory framework in Europe, particularly with regard to bank resolution such as the European Crisis Management Directive, for example, are crucial in order to improve the efficiency of the banking system. Could you explain?

XF: For a long time the theory of banking has justified banking regulation because of contagion, because of the high social cost of a bank’s failure. The next idea was that having a bank failing should be avoided, therefore we needed on the one hand deposit insurance to limit the impact of a bank failure, and on the other hand capital requirements to limit the probability of the bank failing. What was not done yet was to minimise the cost of contagion at the very point where it is created – at the point of bankruptcy. The US had these rules that were consequence of the savings and loan crisis; these were the Prompt Corrective Action rules that allow the regulatory authorities to intervene at the right time, when capital was depleted, and to introduce measures to limit the strategies of a bank that would be detrimental to the deposit insurance fund and maybe to taxpayers if the deposit insurance fund is insufficient. Now Europe is taking the same road and I think this is really a great step forward.

VD: In your paper you also describe the tension between ex-ante incentives and ex-post efficiency, in classic bankruptcy and in banking scenarios, and suggest that the best way to analyse a bank resolution situation is to think of it as a bargaining game between the bank’s shareholders and the treasury. Could you elaborate on this a little for us?

XF: Why do firms have debt? There are two explanations from a theoretical perspective. One is because interest on debt is tax-deductible, so that’s one explanation. The other one, more interestingly, is that it provides the right incentives for managers because if they don’t behave in the right way then they go bankrupt. This is the ex-ante incentive. From that perspective what we want is for debt to be non-renegotiable. The alternative is to say, “Well, there is a cost of bankruptcy, so once bankruptcy occurs we would like to limit the cost, the inefficiency of bankruptcy – to limit the number of lawyers, to put it bluntly. And for that we want ex-post bankruptcy to be renegotiated to introduce debt-equity swaps, or the like, that will improve the situation of the firm.

This is slightly different for banks: why? Because the social cost of a bank’s bankruptcy is considered much higher than the social cost of a standard firm’s bankruptcy. There will be costs of a standard firm’s bankruptcy, but there is not such a social cost and in particular there is no contagion. Therefore, having the right bankruptcy rules is critical, and it’s even more important when we consider what happened. Take the case of Fortis, for instance. On the one hand we had the regulator who wanted to solve the problem in the quickest way. Time was of the essence for the regulator.

On the other hand, bargaining with the regulator we had the shareholders, who prefer to litigate, and therefore the objective is completely different. They’re not in any hurry, they want to maximise the value of their shares, they want to help dilution of their shares. So the bargaining position of the treasury is usually very weak, because the treasury and the regulatory authorities are in a hurry; they usually want to minimise the threat to financial stability. The shareholders want to litigate and to get the maximum amount out of their shares. This is the bargaining game. The solution to the bargaining game is to work out an agreement. If there is no agreement there is bankruptcy. As we didn’t have a specific bank resolution regime in Europe, this meant that a bankruptcy could go on for five years or something like that, maybe I’m exaggerating. But there was a common bankruptcy procedure that was in place for non-financial firms but not for banks.

So the threat from bankruptcy was often not credible, and the standard procedure was to bail out banks. Before the crisis the standard view of regulators was that too-big-to-fail banks (SIFUs or systemically important financial institutions) would be bailed out, but non-systemic ones would be liquidated. This turned out not to be entirely true, and Northern Rock was the first non-systemic bank to be nationalised as a form of bailout. What we have now is a different view: that is that if we have the right legal and regulatory instruments, as is the case with the proposal of the European Commission in June, then the bankruptcy threat is quite credible. There is no threat of contagion; it’s simply saying, “Well, shareholders will get zero, and that’s that.” These are the so-called ‘Berlin’ schemes that minimise the cost to taxpayers while at the same time limiting contagion, because if what shareholders value is wiped out then there is no contagion. Contagion comes from the payment system.

VD: Can bank resolution be a one-size-fits-all approach, or is each country a special case? In a recent Vox column, for example, Daniel Gros and Dirk Schoenmaker describe how in Greece it’s the insolvency of the government that has sunk the banks, yet in Spain it’s the banks that are sinking the government. What are your thoughts on the challenges of national differences in banking regulation?

XF: The great news is that we now have resolution mechanisms, so all over Europe since 2010 we have damage schemes for the winding-up of banks. That is great. Last Friday we had the Spanish government put forward regulation legislation to create the European Memorandum of Understanding; things are now going exactly in this direction. What this means is that we now have the instruments to solve the crisis. Now it becomes somewhat complicated for the following reasons: on the one hand we would like to have sufficient flexibility at the level of the countries. So if all countries somehow face a different crisis – some countries have very large banks, some countries do not – we wouldn’t like to have this one-size-fits-all approach. On the other hand, there is a political economy approach that will tell us, that if you leave it to the government, the government will maximise its objective function; that is, to stay in government for a longer period of time. And this is not exactly minimising taxpayer cost of a bank resolution, it’s not exactly improving the long-term efficiency of the banking system. I’m thinking of Bankia in Spain, a very large bank, and quite possibly the Spanish government will decide not to liquidate it, and this will be very costly for taxpayers, but the government has already injected money into Bankia, and has already committed to keeping Bankia going. So because the government has already put some money in it, deciding now to liquidate it would mean that it was wrong in the first place. And politically this has a strong cost, which means that the political dimension is there and from the political perspective it would be better to have strict rules that the objective function which is to minimise the cost to taxpayers, and at the same time to increase the long-term efficiency of the banking system.

VD: So finally, Xavier, what would you say are the most important elements of an effective bank resolution framework?

XF: Clearly what we want from a theoretical perspective is that the managers know they will be analysed if they take too much risk. This was not the case prior to the crisis. The banks were running a huge maturity mismatch and were collectively illiquid, but each of them individually was okay because they were facing liquid markets. And then suddenly the interbank market collapsed, and there was this liquidity crisis. So having a real threat of bankruptcy defined in terms of shares not being diluted but of the shareholders getting zero, they will be completely wiped out, this is something the managers will take very seriously and therefore will consider the real risks of the investments they are making rather than herding with the other banks in going into subprime investments in the US, or going into mortgage investments in Spain.

VD: Xavier Freixas, thank you very much for taking the time to talk to us today.