Vol 2 (2005) - Issue 5

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Applying a Debt-Equity Swap Insolvency Model to Banks Would Increase Banking Sector Stability and Efficiency

Current bankruptcy system is inefficient

Both economists and lawyers are discussing the adequacy of existing bankruptcy procedures. Existing procedures are seen as costly, slow and inefficient. In existing procedures, assets and business operations of undertakings are closed or sold (often at low prices) when the liability structure becomes unsustainable. In undeveloped markets this is acceptable, since it is the only way to eliminate uncertainty and secure creditors.
But in developed markets, why should the response to balance sheet problems be a realization of debtor assets, endangering business operations, jobs, stability, competition and growth? In today’s developed market economies, the phenomenon of insolvency may be dealt with differently. Using a debt-equity swap, people in charge, i.e. shareholders, may be strained with the losses generated, without endangering the position of other stakeholders or limiting the possibilities to improve and develop the undertaking.

The ‘debt-equity swap’model

The leading alternative to existing bankruptcy procedures is the one introduced by the economists Aghion, Hart and Moore (‘The Economics of Bankruptcy Reform’, NBER Working Paper No. 4097). The basic idea of their bankruptcy model is a simple debt-equity swap. Shares of the insolvent company are annulled. Instead, debts of the bankrupt firm are converted into equity capital, and former creditors become shareholders.
Aghion, Hart and Moore argue convincingly that traditional bankruptcy procedures lead to the closure of many companies that would be more valuable if the operations were continued, whereas the system they propose would solve this problem. An undertaking would be closed if and only if the sales value of the assets is higher than the expected net present value of future surpluses. Needless to say, nothing would prevent new shareholders from selling their holdings to interested investors.
From the point of view of macroeconomic stability the ‘debt-equity swap’ model would be highly desirable. There would be no obligation or time limits to realize assets. Recessions would become less pronounced if the operations of bankrupt firms were not closed down as a routine matter. In practice, the debt-equity swap would be a fast internal arrangement between creditors and shareholders. The societal costs of the swap would be a fraction of today’s procedural expenses.

Applying the ‘debt-equity swap’model to banks

Though the ‘debt-equity swap’ model has gained attention, it has had no major impact in any jurisdiction. Still, in our opinion, the banking sector may represent the most fertile ground for the model. Applied to banks, the model would promote stability in the case of bank failures and hence save taxpayers’ money.
Also, the model would suit banks, since in this sector conditions for defining when insolvency is reached and the swap should be carried out are good. Insolvency could be linked either to existing capital adequacy levels or the net worth of the bank. Moreover, the banking supervisor could provide for the tracking mechanism needed, blowing the whistle when insolvency is reached.

Not all of the bank’s debts need to be converted

In principle, the ‘debt-equity swap’ model enables the transformation of all or a part of existing claims into equity. In practice, it would make little sense to convert all the debts of an insolvent bank into equity capital because the conversion of much less would be sufficient.