Bank Insolvency Procedures as a Foundation for Market Discipline

Predetermined, operational procedures for dealing with banks in distress are conspicuously absent across the world with very few exceptions. Instead governments and regulatory authorities intervene when banks approach failure. Bail-outs of important creditors, sometimes including shareholders, and blanket guarantees for creditors become the norm. We argue that efficient incentives of banks’ creditors, as well as of shareholders and managers, require redetermined rules for dealing with banks in distress, and a group of creditors that are credibly non-insured. Cross-border banking increases the need for pre-determined bank insolvency procedures that could enable banks to expand cross-border in branches. In the empirical part we show that credibility of non-insurance is maximized with a partial deposit insurance scheme, and
that the coverage can be decreased if effective rule-based distress resolution procedures are implemented.