Bail-in at a Glance

Motivation

The functioning of financial institutions is important for the performance of the real economy. To avert severe disruptions for the latter due to bank failures, governments had to support distressed financial institutions and bailed them out during the recent financial crisis. Bank bail-outs, however, are suboptimal and typically tend to exhibit adverse side effects.

First, public bail-outs foster banks’ moral hazard and undermine market discipline. Bailing out banks acknowledges that they are too-big-to-fail and can thus enjoy the government’s implicit guarantee in times of distress. Due to this guarantee large banks pay relatively lower funding costs than other banks. This further provides incentives for larger banks to take excessive risk. As a result, risk and leverage in the financial system accumulate, posing a threat to financial stability.

Second, as seen during the European sovereign debt crisis, public finances can dramatically worsen due to bank bail-outs. If public debt increases too much, concerns regarding the government’s ability to service its debt arise and sovereign bonds may be downgraded. This puts further pressure on bank balance sheets, since banks tend to heavily invest in sovereign debt. Due to this “vicious cycle between bail-outs and public finances” a bank bail-out may reinforce troubles in the banking sector.

Third, a private takeover of a troubled bank by one or more financial institutions, facilitated by the government due to a bail-out, likely leads to further consolidation in the financial sector, aggravating the too-big-to-fail problem.

Fourth, bailing out banks with an improper resolution toolkit or by applying general corporate governance proceedings appears deficient. This can be seen when considering the repercussions stemming from the failure of Lehman Brothers, the firm’s filing for bankruptcy protection and its consecutive disorderly liquidation. The freezing of financial markets following the failure of Lehman Brothers shows how interconnected financial institutions and markets are and how contagious local asset value deterioration can be. In particular, the resolution of systemically important financial institutions has to be addressed with a unique toolkit, tailored to their specific characteristics.

Since the financial crisis, regulators have been working on the development of a toolkit to ensure an orderly resolution of failing financial institutions with limited negative spillover effects. At the very heart of the new resolution frameworks - both in Europe and oversea – lies the bail-in tool. Particularly, a bank’s debt holders, who are the beneficiaries of an institution’s success in good times, should recapitalize the bank during times of distress under the new regulatory framework. This bail-in of debt holders in times of bank distress should address the aforementioned problems and (1) restore market discipline, (2) limit the financial risk of taxpayers due to bail-outs, (3) reduce the too-big-to-fail problem due to further consolidation in the financial sector and (4) ensure that an effective regulatory framework for resolving and recapitalizing banks during times of distress exists.

Although the bail-in in theory partly (or even fully) succeeds in achieving these goals, its implementation may still bear some unintended undesirable consequences

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