There seems to be a good proposal on how to split a potentially insolvent bank into a good bank/bad bank.
It looks good, but there seems to be a real flaw in the proposal. What Woodward and Hall propose is a de facto way of creating deposit insurance out of thin air. Why? This is because the splitting up of the bank (Citi, in their example) is such as to fully protect the depositors, which is not the case in the usual insolvency proceeding. Depositors are also creditors of Citi, and if uninsured, they stand in line, along with other creditors, although of course, they are ahead of shareholders. With the good bank, the depositors are protected, benefitting de facto from a quasi deposit insurance.
The key question is this: why would the bondholders voluntarily agree to “take the hit” disproportionately with Citi’s depositors? It is easy to see why we would want to protect the depositors, but there is a zero-sum game here, where protection for depositors has to come from “unprotecting” another group, i.e. the bondholders. If the hit is involuntary, the lawyers would have a field day invoking the due process and equal protection clauses on behalf of bondholders.
A similar situation applies to the question of how to separate out the bondholders as between those holding claims against the bad bank (the bulk persumably) and those against the good bank, in which case, the latter would be on the same footing as “fully-protected” depositors, given that the good bank is set up to limit the risk of insolvency to zero. A perusal of the tabular data in the example given by Woodhard and Hall would easily show this. They have a small amount of $118 billion of bonds held as liabilities of the good bank. How did they arrive at this figure? They could have set a figure of zero, in which case the equity of the good bank would have been $545 billion, a figure that seems unrealistically high.