The Lehman Experience and the Birth of Bail-in
Credit Suisse's Wilson Ervin explains how his Lehman experience led to the creation of bail-in, and describes some of the innovations by the Swiss regulators.
No one who was there will forget it. All those present in the offices of the Federal Reserve Bank of New York during the infamous weekend in September 2008, when Lehman Brothers went bankrupt, will find it hard to shake the memory, as policy makers and Wall Street's most senior bankers tried, ultimately unsuccessfully, to avoid a devastating collapse. One man found it harder to forget than others though. Wilson Ervin, at the time Credit Suisse's chief risk officer (he is now vice chairman in the bank's executive office) was determined to prevent another such crash. He was adamant there had to be something better than a destructive collapse or another taxpayer bail-out. Along with other executives at Credit Suisse, he went about trying to crack the problem, and invented a new approach called bail-in. It has evolved from a novel suggestion into a global policy initiative driven by the G20 and touted as a key solution to handling future systemic crises.
In an interview with the International Financial Law Review, Wilson Ervin spoke about the genesis of the idea, the challenges he and his colleagues faced in launching it, and Switzerland's progressive regulatory response.
Bail-in is obviously a hugely important aspect of post-crisis reforms, and it's your brainchild. Could you talk about the early days of the idea?
Wilson Ervin: Back in 2009, as the crisis was ebbing and the discussion turned to reform, a number of us at Credit Suisse were debating the ideas. At that time, there were so many reforms in the air – from legislators, from academics, from media people – but it seemed like most of them missed the central issue of the crisis. Policy makers didn't have a credible approach to handle the failure of a large bank and once the market saw that first-hand with Lehman, we entered into a level of panic that we hadn't seen since the 1930s. That was a gigantic hole at the center of the crisis for both the financial system and the real economy.
We kept thinking about our own recent experiences from the crisis, and the twists and turns we had to navigate. We had been around the table during Lehman Brothers weekend (in 2008) and tried to figure out what could have been different. It was something that haunted me, personally. It kept chewing at me – both because of its importance, and because it's a remarkable puzzle. Why was the collapse so devastating, both for markets generally, and for creditors? The bankruptcy mechanisms worked well enough in legal terms, but it was a disaster in economic terms. Within the Lehman puzzle, the ex ante losses were probably around $25 billion, but the ex post liquidation losses were more than $100 billion bigger. Where did all that money go? It's a giant sum even by the standards of the crisis.
The Lehman outcome haunted me, personally. It was a puzzle that kept chewing at me.
To me, that was a really important problem. If you don't know where that $100 billion went, you have some real challenges getting the credit markets to work. You need to have a mechanism that doesn't destroy enormous value – that doesn't start a downward spiral. One insight that helped us was the work we do every day with troubled corporate borrowers. In the US, you have restructuring tools like Chapter 11, and can often find a way to keep the good parts of the business going while you fix the capital structure. I remember going from one of those meetings to a policy reform discussion and thinking about the parallels.Why does recapitalisation work for corporates but seem impossible for a bank?
So we started to think about what you would have to do to adapt this technique from a corporation to a bank. What needs to change? Could you really make this work? We had thought about some really primitive versions of this on Lehman weekend. But things were moving too quickly, and there were no legal preparations in place. We didn't see any way we could figure out the legal impediments in 48 hours. We would probably have needed a consensual solution with thousands of creditors, which struck us as a little far-fetched for a weekend.
It seemed like a bail-in of creditors could have a strong answer to the so-called Lehman problem.
So a consensual restructuring was off the table for Lehman weekend, but we kept coming back to that idea. The bones of the concept just seemed to make sense. And the key issues started to unravel pretty nicely as we worked through different elements. With a bit of preparation – and a lot of legal and regulatory work – it seemed like a bail-in of creditors could have a strong answer to the so-called Lehman problem. It could have saved everybody a lot of money, and also kept the system from spiraling out of control.
How was the concept initially received by colleagues, peers and ultimately regulators?
There were a lot of sceptics initially. If you'd said five years ago that this would now be a global policy initiative, you would have been laughed out of the room! At first, we had to think through a lot of legal and economic issues. It's sort of the mother of all corporate finance projects. Our general counsel in the US, Neil Radey, gathered a small team to work through some initial legal issues. We made enough progress to decide it was a realistic idea and that it could make a contribution. The Economist was kind enough to publish it as an Op Ed that I co-authored with the late Paul Calello (then the head of Credit Suisse's investment bank), and that's where it started getting some traction.
That is due to the leadership of a few people on the regulatory side. People like Paul Tucker at the Bank of England and Jim Wigand at the Federal Deposit Insurance Corporation (FDIC) got interested early, worked on the key issues, and ultimately breathed life into the idea. Mark Carney was very important in his role as Financial Stability Board (FSB) chair. Lawyers like Randy Guynn at Davis Polk and Simon Gleeson at Clifford Chance were also critical in the early days. In projects like this, you run into a lot of naysayers. But there are also people who are more interested in solutions than settling for a bad status quo – and they're a lot more fun to work with. They helped turn this from an intriguing notion into a builtout policy with an implementation plan.
What are your concerns, if any, for the ultimate success of bail-in?
I think we've crossed the Rubicon in the US. I agree with Paul Tucker that you have both the will and the tools to do this today if any of the big US banks ran into trouble. Europe is more complicated, but it's moving very quickly to a solution now that the Bank Recovery and Resolution Directive (BRRD) is in place and getting implemented.
What are the challenges from here? A key element is to ensure continuity of functions for customers, and prevent a tripwire termination of business. The International Swaps and Derivatives Association (Isda) protocol is perhaps the most important market there. The FSB helped coordinate a major agreement there last year. There are some other markets to tackle, but that was the critical one.
Europe is more complicated, but it's moving very quickly to a solution.
The final step is making sure that banks are set up to make resolution possible, and that they're prepared for a high-speed restructuring if they hit the rocks. Lehman happened to have a structure that worked well for bailin. They had a holding company with a lot of unsecured debt that could have been swapped into equity. But banks around the world are funded in lots of different ways, and you need to make sure there is a resource to make bail-in work. That's why the FSB has launched a big initiative around total loss-absorbing capital (TLAC) – to ensure that all banks have a financial structure that works for bail-in in an emergency. For example, both of the large Swiss banks are changing their corporate structures to make bail-in work under Swiss law. It will be a big effort across Europe, but it's well underway.
Mark Carney spelt out measures in November last year to guard against contagion with TLAC, including curbs on banks' ability to count debt they sell to one another as TLAC. Will that be sufficient to prevent the problem?
I think so. In the crisis, there were lots of questions about contagion caused by direct linkages, and these measures should ensure we don't run into that. A related issue is something people call correlation – that is contagion through a concern about a lookalike firm. For instance, when a retailer fails, people automatically look around for the most similar firm to worry about next. When Lehman failed, investors immediately wondered what bank was the most similar, and might be next to fail. But I think we can handle that issue as long as we have a system that is well defined, and prepared for that challenge.
Some people say that people will run from TLAC the first time it is bailed in. But TLAC is a term instrument – you can't run. And if bail-in can preserve value – and avoid those huge additional losses that hit Lehman, the pressure to sell won't be nearly as bad. In 2008, the incentive to panic was clear. I'm sure there will be stress and some price pressure in the market, but bail-in will change the calculations from last time and should be much more stable.
So continuity and TLAC are the two things that are getting solved now and will help to make this reform durable. There are also two longer-term issues to watch: cross-border cooperation and central bank liquidity. Those are harder to follow, because they're behind the regulatory curtain, but both are important
How is cooperation being addressed?
Within the EU you have a fair amount of coordination and legal super structure to enforce that. The more challenging elements come in when you move across other borders – for example between the US and the EU or when an emerging market is involved. Crisis management groups are putting regulators together and walking through these scenarios. That's important progress already. Some would go much further and aim for a United Nations Commission on International Trade Law (UNCITRAL) change, or a treaty to ensure people work together better. I support that, although many in the legal world would tell you not hold your breath for those.
In the medium term, I think the best approach is to set up incentives for so-called home and host regulators to work together. If you can see that the best outcome is a cooperative solution, you reduce the pressure to take adverse action. That's one of the subtle things in the new TLAC proposal. For the first time, the FSB is starting to talk about the internal structure of banks, with an eye on incentivising home and host regulators to work together.
We live in a pretty interconnected world. If you just frame your actions to protect local conditions, you may end up causing problems elsewhere.
The FSB has put a framework on the table to get the discussion started. There are some good parts, but also some parts that need work to improve the incentives for cooperation. For example, the internal TLAC requirements are very focused on pre-positioning capital into specific host countries. That should provide comfort to host regulators, but comes with the cost of restricting flexibility. More flexibility might help avoid other problems, like capital being stuck in one place when you need it in another country. A broader approach might help avoid that drawback. Another element that might help is for countries to have a duty to consider broader financial stability issues – not just the stability in their own jurisdiction when they are executing a resolution. We live in a pretty interconnected world. If you just frame your actions to protect local conditions, you may end up causing problems elsewhere. In today's world, that cannot only cause problems elsewhere, but can ricochet back to your home market. It would help if supervisors could take a broader view from the outset.
And where do you stand on the risks that these TLAC measures might now pose for asset managers investing in this sort of debt?
It will create some challenges for asset managers – but also some opportunities for people who do their homework. The size of the TLAC market is estimated at around $4 trillion. Investors won't be able to assume that they will be bailed out next time – but they are also getting paid better for taking credit risks than pre-crisis. I'm sure there are some who would like to keep the extra spread, but not the extra risk of getting bailed in. But that's not how real capitalism is supposed to work, and I don't think governments or taxpayers have the stomach for more bail-outs. Smart investors will adapt to this. As long as we're transparent about how this process works, and we focus on preserving value in resolution, I think markets will adapt.
Switzerland has obviously taken a proactive and more conservative approach to post-crisis regulation than the EU. As a senior figure within a Swiss bank, how do you feel Finma has performed?
Switzerland was an early adopter of reform. And for a small country to move first takes some courage. Switzerland had an expert commission that proposed a contractual bail-in system, built on so-called CoCo bonds. A number of people were sceptical at the time as to whether you could really raise serious money from CoCos, but Switzerland had confidence in their principles and their ability to design a workable, investible regime. They were right. Switzerland has established a contractual bail-in system that already provides a large amount of loss absorbency. And while it's not the cheapest system, it was the first one that was possible. I think you have to give the official sector a lot of points for doing the intellectual preparations and having the determination to implement that into an early solution.
Both Credit Suisse and UBS have already created a lot of TLAC via this system. There will be more to do when the final rules come in, but Switzerland has gone a long way to launching an early version of TLAC concept before it was even called that.