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“This time is different” – how bail-ins should relieve taxpayers’ money

During the Financial Crisis of 2008 taxpayers’ money was frequently used to save banks from bankruptcy. In the Netherlands ABN-AMRO and SNS Reaal were bailed out by the government for the staggering amounts of 22 billion and 3.7 billion euro respectively. Moreover, the Irish government came into severe trouble after saving their financial infrastructure from the abyss. These rescues caused governments to take the full blow, resulting in a “free lunch” for banks’ shareholders and bondholders. As a result, taxpayers (and politicians too) were disappointed in and angry with those “irresponsible bankers”.

To prevent this from ever happening again, new legislation was drafted and approved by the European Central Bank (ECB). They introduced the European bail-in tool. The main goal of this tool is to safeguard financial stability in the European Union, by mitigating among others moral hazard issues apparent in systems, which lean heavily on bail-outs. Moreover, bail-outs create uneven level playing fields among banks. Only complex, Too-Big-To-Fail (TBTF) banks are saved with taxpayers’ money, while smaller less important banks are allowed to fail. TBTF banks are in a way “subsidized” by governments in obtaining cheaper funding. Lastly, strong links between banks and governments can have disastrous outcomes for a country as a whole. Consider the example of Ireland mentioned in the introduction. Ireland needed to be rescued by the EU and IMF after having saved its own financial system. These negative externalities should be solved by the bail-in mechanism. How does it work and will it solve these externalities?

When a bank gets into severe trouble or even goes bankrupt, shareholders will be the first to be completely wiped out. If this is not sufficient, the process of wiping out continues in a certain order. After the shareholders, contingent capital holders, junior unsecured debt, senior unsecured debt and uncovered deposits are wiped out. Only if this all isn’t enough, the taxpayer has to pay up to rescue the bank. The ECB does consider systemic risk of bailing-in bank liability holders. Some liability holders may cause severe contagion effects to the financial system at large. To avoid this, the ECB allows for a case-by-case exclusion of certain liabilities. As might be clear for now, the negative externalities arising from bail-outs are indeed solved by using bail-ins. These increase market discipline by liability holders, because they now have a stake in the game. Market discipline is a good mechanism to limit banks behaving in a way harmful to financial stability.

Nevertheless, some drawbacks exist as well. A multi-layered network model is built in order to simulate the bail-in of a bank and its effects on other banks in the system. They simulate what the systemic consequences will be of a bail-in at one bank. Such a system sounds promising, but making and maintaining a good system is difficult. Everything should be included to avoid mistakes and failures in choosing banks, institutions and other involved parties to bail-in. It will become very complex to keep observing all the correct linkages between the different parties in the financial system.

Another very important feature is not very likely to be part of the system, the bail-in of many small banks, which are at their own not likely to cause direct contagion risk, but collectively they will. In Spain for instance, many small banks exist. Bailing-in one of these banks will not cause systemic problems. However, in a financial crisis many more of these smaller banks will be bailed-in to keep other banks viable. The result can be that saving one bank leads to the existence of systemic risk via other banks. It should be noted here that the ECB is trying to discourage banks to invest in bail-in debt of other banks, in order to prevent the bail-in system from becoming to interconnected. To discourage they impose higher capital requirements on banks holding larger amounts of bail-in debt of other banks.

A third drawback is the bail-in of many small investors. In Italy for example, many households are small investors in banks. Bailing them in is exactly the same to them as a government bailing-out. Via both ways they are hurt. A couple of months ago, the Italian government announced that instead of a bail-in it would use a bail-out to rescue Popolare di Vicenza and Veneto Banca, two ailing regional banks in Italy. These drawbacks are some of a large pile of drawbacks to the newly imposed system, which is clearly still in its starting-up period. The new system has real potential to work, but attention should be paid to some major drawbacks.

All in all, the idea of bailing-in liability holders is good. It will avoid taxpayers taking the burden of failing banks. Negative externalities caused by using taxpayers’ money are solved. However, the outcome of using this new mechanism depends on how the system will be introduced and managed. It will be very complex and difficult to do it right. And we shouldn’t fall back on some feeling of euphoria because tax payers’ money will never be used again, a phenomenon called “This time is different syndrome”. Only time will tell whether the bail-in mechanism is sufficient to avoid the severe economic and financial contraction of the last crisis.

 

 

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