Bail-In

MoneyBestPal Team
By : personMoneyBestPal Team
March 05, 2024
A resolution scheme that requires the cancellation of debts owed to creditors and depositors of a financial institution on the brink of failure.
Image: Moneybestpal.com

Main Findings

  • Bail-in is a resolution tool that aims to resolve failing banks without using taxpayer money.
  • Bail-in involves canceling or reducing some or all of the bank's debt by imposing losses on shareholders, bondholders, and uninsured depositors.
  • Bail-in has some advantages over bail-out, such as reducing moral hazard, preserving market discipline, and enhancing fiscal sustainability.


A bail-in is a resolution scheme that requires the cancellation of debts owed to creditors and depositors of a financial institution on the brink of failure.


It is the opposite of a bailout, which involves the rescue of a financial institution by external parties, typically governments, using taxpayers’ money for funding. Bail-ins help to prevent creditors from taking on losses, while bailouts help to keep creditors from losses.



Why use a bail-in?

Bail-ins are used as an alternative to bailouts in situations where:

  • A financial institution's collapse is not likely to create a systemic problem and lacks "too big to fail" consequences.
  • The government does not possess the financial resources necessary for a bailout.
  • The resolution framework requires that a bail-in be used to mitigate the number of taxpayers’ funds allocated.


Bail-ins are especially useful when the debt is overwhelming in proportion to the government's ability to cover it, as was the case in Cyprus in 2013. Bail-ins can also reduce the moral hazard problem associated with bailouts, which may encourage excessive risk-taking by financial institutions.



Formula for a bail-in

There is no universal formula for a bail-in, as different jurisdictions may have different rules and procedures for implementing it.


However, a general approach is to follow these steps:

  1. Identify the amount of capital needed to restore the financial institution's solvency and viability.
  2. Determine the order of priority of creditors and depositors who will be subject to the bail-in, based on their seniority and contractual terms.
  3. Apply a haircut or write-down to the claims of the affected creditors and depositors, proportional to their share of the total liabilities.
  4. Convert some or all of the remaining claims into equity or other instruments that can absorb losses.
  5. Restructure the financial institution's operations and governance to address the root causes of its distress.



How to calculate a bail-in

To illustrate how to calculate a bail-in, let us consider a simplified example of a bank with the following balance sheet:


Assets: $100 billion

Liabilities: $90 billion

Equity: $10 billion


Suppose that due to a severe shock, the bank's assets lose 40% of their value, dropping to $60 billion. This means that the bank's equity is wiped out and its liabilities exceed its assets by $30 billion. The bank is insolvent and needs a capital injection of $30 billion to restore its solvency.


Assume that the bank's liabilities consist of:

  • $10 billion of secured debt, which has priority over other claims and is collateralized by some of the bank's assets.
  • $50 billion of unsecured debt, which ranks equally among creditors and has no collateral.
  • $30 billion of deposits, which are insured by the government up to $250,000 per account.


To implement a bail-in, the following steps are taken:

  1. The secured debt is unaffected by the bail-in, as it has priority and sufficient collateral.
  2. The unsecured debt is subject to a 40% haircut, meaning that $20 billion of its value is written off, and only $30 billion remains.
  3. The deposits are partially protected by government insurance, which covers $15 billion out of the $30 billion. The remaining $15 billion is subject to a 40% haircut, meaning that $6 billion is written off and only $9 billion remains.
  4. The total liabilities after the bail-in are $10 billion (secured debt) + $30 billion (unsecured debt) + $9 billion (deposits) = $49 billion, which matches the value of the assets after the shock ($60 billion - $10 billion collateral = $49 billion).
  5. The bank's equity is restored by converting some of the unsecured debt and deposits into new shares. For simplicity, assume that each dollar of debt or deposit is converted into one share. This means that the bank issues 39 billion new shares ($30 billion unsecured debt + $9 billion deposits) to its creditors and depositors, who become its new shareholders.



The bank's balance sheet after the bail-in looks like this:


Assets: $49 billion

Liabilities: $0

Equity: $49 billion (39 billion new shares)


The bank is now solvent and has a capital ratio of 100%. However, its original shareholders have lost their entire investment, and its creditors and depositors have suffered significant losses as well.



Examples of Bail-In

One of the most prominent examples of bail-in was the rescue deal for the biggest banks in Cyprus in 2013, which required shareholders and creditors to take on some of the costs. The Cyprus Experiment involved imposing a one-time levy of 6.75% on deposits below 100,000 euros and 9.9% on deposits above that threshold.


The bail-in also included a debt-for-equity swap for bondholders and shareholders of the two largest banks, Bank of Cyprus and Laiki Bank. The bail-in was part of a 10-billion-euro bailout package from the European Union and the International Monetary Fund.


Another example of bail-in was the resolution of Banco Popular, a Spanish bank that was acquired by Santander in 2017 for a symbolic price of one euro. The acquisition was preceded by a bail-in of Banco Popular's shareholders and subordinated bondholders, who suffered losses of around 3.3 billion euros.


The bail-in was carried out by the Single Resolution Board, a European agency responsible for resolving failing banks in the eurozone. The bail-in aimed to preserve financial stability and protect depositors and senior creditors.



Limitations of Bail-In

Bail-in is not a panacea for resolving bank failures. It has some limitations and challenges that need to be addressed. Some of these are:


Bail-in may not be sufficient to cover the losses of a large or systemic bank.

According to the Dodd-Frank Act, the bail-in would apply until at least 8% of total assets were lost, resulting in the likely liquidation of all shareholder and bondholder assets.


However, this may not be enough to restore solvency and confidence in the bank, especially if it has a high level of asset encumbrance or off-balance sheet liabilities. In such cases, additional public funds may be needed to recapitalize the bank or provide liquidity support.



Bail-in may trigger contagion effects and market panic.

By imposing losses on creditors and depositors, bail-in may undermine their trust in the banking system and prompt them to withdraw their funds from other banks that are perceived as risky or vulnerable.


This may create a bank run or a credit crunch that could worsen the financial crisis and harm the real economy. Moreover, bail-in may increase the cost of funding for banks, as creditors and depositors would demand higher interest rates or premiums to compensate for the risk of bail-in.



Bail-in may face legal and political obstacles.

Bail-in may violate contractual rights or property rights of creditors and depositors, who may challenge the bail-in decision in court or seek compensation for their losses. This may create legal uncertainty and delay the resolution process.


Bail-in may also face political resistance from stakeholders who may lobby against it or protest against it. Bail-in may be seen as unfair or unjust by those who bear the losses, especially if they are not responsible for the bank's failure or if they are not adequately informed or consulted about it.



Conclusion

Bail-in is a resolution tool that aims to resolve failing banks without using taxpayer money. It involves canceling or reducing some or all of the bank's debt by imposing losses on shareholders, bondholders, and uninsured depositors.


Bail-in has some advantages over bail-out, such as reducing moral hazard, preserving market discipline, and enhancing fiscal sustainability. However, bail-in also has some limitations and challenges, such as being insufficient to cover large losses, triggering contagion effects and market panic, and facing legal and political obstacles.



References


FAQ

A bail-in provides relief to a financial institution on the brink of failure by requiring the cancellation of debts owed to creditors and depositors. A bailout, on the other hand, involves the rescue of a financial institution by external parties, typically governments, using taxpayers’ money for funding.

A bail-in is typically instituted for one of three reasons: the financial institution’s collapse is not likely to create a systemic problem and lacks “too big to fail” consequences, the government does not possess the financial resources necessary for a bailout, or the resolution framework requires that a bail-in be used to mitigate the number of taxpayers’ funds allocated.

In the U.S., depositors are protected by the Federal Deposit Insurance Corporation (FDIC), which insures each bank account for up to $250,000. In a bail-in scenario, financial institutions would only use the amount of deposits that are in excess of a customer’s 250,000 balance.

Cyprus and European Union resolutions provide two examples of bail-ins in action.

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