Governments dished out $1 trillion in taxpayer money to bail out banks during the financial crisis that erupted in 2008. Their voters were furious. Since then, regulators came to a broad agreement on a better approach: Instead of bailing out a faltering bank, force the creditors to bail-in — or share the burden of losses. The idea is to sell debt to investors with the understanding that in the event of a failure the earmarked bonds might quickly lose their value or be swapped for equity. Few people would argue with the principle that investors in banks should lose money when the bets they make go belly-up. Yet in practice, bailing-in has proven politically tricky, as regulators must make tough choices about which creditors are wiped out and which are saved. Plus loopholes abound.
Recent bank failures in Europe have sparked debate about whether bail-ins are working as designed. The theory appeared to work when Spain’s fourth-biggest lender, Banco Popular Espanol SA, was forcibly sold to a bigger competitor in June 2017, wiping out shareholders and about 2 billion euros ($2.3 billion) owed to bondholders. It was heralded as a victory for European Union regulators, since no taxpayer funds were used. But investors are suing, saying the deal was arbitrary and could have been avoided. By contrast, Italy is using public funds to prop up its oldest bank, Banca Monte dei Paschi di Siena SpA. It’s spending up to 20 billion euros and rescuing most — though not all — bondholders of that institution and two failed regional banks. Because those bailouts happened in one of Europe's most indebted countries and spared ordinary citizens who owned the bank’s debt, they rekindled fears that weak banks and poor countries would get caught in a vicious debt spiral. Some policy-watchers brushed off the controversy as a transition problem, since many banks have yet to build up enough of the “loss-absorbing” debt they're now required to sell to make bail-ins easier. More than $500 billion of such securities have been sold in the U.S. and Europe in the last two years.
Sick banks pose a dilemma for policy makers: Lean back and a collapse can snowball into economic disaster, pushing an entire country to the brink. Mount a rescue and public debt soars and recklessness gets rewarded. The fundamental idea behind a bail-in is to pre-package and accelerate the insolvency process so that it can take place over a weekend to prevent financial shocks. By Monday morning, a wobbly bank can again be a viable institution, now owned by former creditors. ATMs should be well stocked, with plenty of funds available to satisfy counterparties. The bail-in process protects depositors whenever possible and identifies ahead of time which investors will lose money in the process. Equity is wiped out first to mop up losses. Junior debt and some senior claims are next in line to be written down or converted into new equity. Credit Suisse Group AG executives coined the term bail-in in 2010, and it’s now enshrined in banking laws around the world. It's since been used to cover wider cases of creditor loss-sharing for troubled banks.
Regulators say bail-ins are an increasingly accepted way to manage troubled banks, part of a post-crisis arsenal of tools that defuse the problem of lenders that are “too big to fail.” They create an incentive for creditors to keep an eye on banks’ risk management. They could also help gradually dissolve the chummy bonds between national governments and their banks by removing the implicit guarantee that the bail-out practice provides. Critics say the cases in Italy show there are too many ways to skirt the rules, and that the option to bail-in creditors won’t stop governments from tapping the public purse again. Republicans in the U.S. Congress are trying to repeal the new bail-in provisions in the U.S. banking law because they say the rules don’t do enough to prevent regulators from using taxpayer money. Some policy makers argue that the only way to prevent bailouts is to require banks to hold much larger capital buffers. The true test of the bail-in idea, they say, won’t come until a large global bank goes under and politicians don’t blink.
The Reference Shelf
- Bloomberg News article on how Italy's bank rescues tested European Union rules, and a QuickTake Q&A on Monte Paschi.
- An International Monetary Fund report titled "From Bail-out to Bail-in," and an article from the Bank for International Settlements.
- The original Economist guest article where the term bail-in was applied to bank resolution.
- Euromoney magazine looked at whether the EU resolution rules were doing more harm than good.
- European Central Bank working paper on bail-in.
- A QuickTake backgrounder on the "Too Big to Fail" debate.
First published Nov. 7, 2017
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Leah Harrison at firstname.lastname@example.org