Time may have come for bank “bail-in” scheme

September 20, 2010

The time for “bail-ins” may have come. The idea of rescuing banks with rapid, creditor-enabled restructurings has been overshadowed by a slew of other plans and some resistance. Regulators are now giving the scheme more attention. The practicalities would be fraught, but the concept ticks many boxes.

A non-financial company that runs into trouble often can invoke bankruptcy processes and restructure its balance sheet. Banks often don’t have any option other than liquidation. Even if they did, a run on deposits or credit can put them out of business in days, so months of restructuring negotiations won’t cut it. The idea of a bail-in is that a bank’s creditors agree in advance to have a restructuring imposed on them rapidly if the firm hits the skids, averting failure and any systemic fallout.

Take Lehman Brothers. In a hypothetical re-run of the firm’s final weekend two years ago, a conservative $25 billion of losses could have been taken on the asset side. Then $25 billion of equity would have been written off, with shareholders getting warrants worth something only if the firm recovered. Some $25 billion of preferred and subordinated debt would also be converted into equity, as would another nearly $20 billion of senior unsecured debt, or 15 percent of the total. The other 85 percent of senior unsecured debt, and all secured debt, would remain in place.

Come the Monday morning, Lehman would have a smaller balance sheet coupled with a newly plumped cushion of capital. The recapitalization would have been executed without outside cash — and certainly no taxpayers’ money.
Debt investors could end up better off, too. In the Lehman example, as laid out in August by the Association for Financial Markets in Europe, senior unsecured creditors would recover at least 85 percent of their principal value, as opposed to the 20 percent or so trading value of their claims after the firm’s bankruptcy.

Even banks might not mind issuing bail-in debt. Credit Suisse executives, making a case for the idea in the Financial Times in January, suggested any increase in a bank’s cost of capital would be mitigated by the better recoveries under a bail-in and by the reduction in uncertainty compared with the multifarious outcomes seen during the recent crisis.
But that’s all mainly theory. In practice, one big concern is that any effort to adopt bail-ins could, depending on the jurisdiction, require significant changes to the rights of creditors. Rewriting insolvency laws in some places could take years.

Global regulators, meanwhile, are preoccupied trying to develop other schemes to make winding down troubled institutions easier. New Basel III capital standards are also top of mind. And other ideas of narrower scope, like contingent convertible securities that can absorb losses without triggering default, are in the works. All this activity, however, shouldn’t rule out considering bail-ins as well.

Another drawback could be that the hypothetical bail-in example is a bit too slick. How, for instance, would a Lehman-style bail-in be triggered? Reported measures of capital strength lag reality; market measures, like credit default swap values, tend to overshoot; and leaving it to the discretion of regulators brings back some of the uncertainty the concept is supposed to eliminate.

Of course, watchdogs like the U.S. Federal Deposit Insurance Corp regularly decide when to seize banks. But even if appropriate trigger criteria could be set, how much of a haircut should creditors suffer? One lesson from Lehman’s failure and bailouts like that of American International Group is that the exact size of problems is not immediately obvious.

So in real life, a bail-in would have to err heavily on the conservative side. That means banks would need to have most, or even all, of their liabilities in bail-in-friendly form, and that creditors could initially lose more on paper than the Lehman example suggests, though they might later recover value.

Banks that still enjoy government support and regulators reluctant to lose influence might not be too keen on bail-ins. But governments determined not to rescue any more banks — especially in places like Switzerland and Britain, where the financial sector is large relative to their economies — should logically be eager to try to overcome the difficulties.

And for most financial firms, adopting the idea could spare them further intrusive regulation, aside from other advantages. A secondary benefit for governments would be that a bank’s creditors would have an extra incentive to keep an eye on its risk levels. The bail-in idea deserves a strong push. Not doing so would suggest resignation to calling on taxpayers yet again.

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