Depositor Liquidity and Loss Sharing in Bank Failure Resolutions

I. INTRODUCTION Bank failures give rise to a number of widespread fears. Among these is the fear of depositors that, if uninsured, they may suffer losses in the current value of their deposits and that, whether insured or not, they may not have full and immediate access to the current value of their accounts so that their deposits are effectively frozen. That is, depositors may suffer a loss in credit value (credit risk) and/or a loss in liquidity (liquidity risk). Both conditions represent a loss in depositor wealth. The potential loss in credit value occurs if the market value of the banks' assets at the date of resolution (failure) is less than that of their deposits and if additional losses are incurred during the resolution process. The potential loss in liquidity occurs if depositors at the failed bank may not access the full current value of their funds after failure until the proceeds from the sale of the bank or its assets are distributed. This loss may be divided into a time or present value loss of receiving a future rather than an immediate payment of the same amount and, if an efficient secondary market for depositor receivership claims does not exist, an additional illiquidity loss. (1) The reasons for the loss in credit value and ways of minimizing such losses through both enhanced monitoring and disciplining by at-risk depositors and other bank creditors and efficient closure rules by regulators have received considerable attention in the recent literature (e.g., Benston and Kaufman, 1997, 1998). The potential loss in liquidity has received substantially less attention, however, particularly in the United States, where liquidity risk has not been a major problem in recent years. From the introduction of federal deposit insurance in 1934 until after the enactment of the Federal Deposit Insurance Corporation (FDIC) Improvement Act (FDICIA) in 1991, effectively all depositors were fully and immediately protected at all failed banks. In the few instances in which they were not, uninsured depositors were often provided, until very recently, with immediate liquidity of the estimated recovery value of their deposits (Kaufman, 2002). Liquidity risk in bank resolutions, however, remains a serious problem in most other countries. Indeed, in these countries, loss of liquidity is often perceived as a more frightening consequence of bank failures than the loss of value. For example, a European bank analyst has recently argued, The issue is not so much the fear of a domino effect where the failure of a large bank would create the failure of many smaller ones; strict analysis of counterparty exposures has reduced substantially the risk of a domino effect. The fear is rather that the need to close a bank for several months to value its illiquid assets would freeze a large part of deposits and savings, causing a significant negative effect on national consumption. --(Dermine, 1996, p. 680) Likewise, the Swedish central bank has observed that freezing a company's assets and suspending its payments from the time the bankruptcy order is issued could have serious implications if applied to banks. A bank's liabilities do after all form an active part of its business operations, and its borrowing and interbank funding activities reflect among other things the banks' central role in the payment system. Suddenly freezing the repayment of liabilities at one or more big banks could have immeasurable consequences for the banking system as a whole. --(Viotti, 2000, p. 55) In effect, short-term liquid deposits (money supply) are suddenly involuntarily transformed into longer-term, illiquid deposits (bonds). (2) Recently, Anari et al. (2002) have found evidence that delays in recovering the value of assets of failed banks in the 1930s and in reimbursing the depositors had strong and lasting effects on the persistence of the Great Depression in the United States. …