Basel II and the Need for Bank Distress Resolution Procedures*

It is argued that without increased market discipline Basel II is not likely to resolve the regulatory problem caused by explicit and implicit guarantees of depositors and other creditors of banks. One way to enhance market discipline is to implement proposals for mandatory subordinated debt. For these proposals to achieve their objective, the non‐insurance of holders of subordinated debt must be credible. Increased credibility of non‐insurance of one or several groups of creditors could be enhanced if distress resolution procedures for banks were pre‐specified, and if they made possible bank failures without serious disruption of the financial system. The existence of rules for dealing with banks in distress not only enhances the credibility of non‐insurance of some creditors, it also allows for predictability of distress resolution costs for shareholders and management of banks. Such costs—if predictable—reduce the moral hazard incentives caused by deposit insurance schemes.