Resolving banking failures through the bail-in

While the eurogroup welcomed Spain’s demand for a European aid to recapitalize its banking system, and guaranteed a commitment up to 100 bn euros, another solution could be put in place for recapitalizing the spanish banking system : the bail-in.

This is too bad the Irish crisis’ story is so unknown from people. Why? Because it is the typical example of what not to to about a pure banking crisis.

In Ireland, as soon as the crisis showed up, the successive governments chose progressively to guarantee private banks debts through public recapitalization and State guarantees, leaving private investors untouched. Of course, Irish politicians told people a different story: the plan was to safeguard people’s money. Bank aids, skyrocketing public debt and austerity and troika’s supervision was just a relative costly price for the common interest of preventing a complete financial collapse.

At some point however, the truth cannot be hidden much longer. While People are asked for financial efforts, week after week, the treasury is pumping money into the seized banks that goes directly into the hands of private bondholders. In other words, we are not protecting any citizen’s money in Ireland, but slowly looting them to bail out private investors.

For the worst part, although bondholders’ identity is officially unknown, there are little doubts that these bondholders are not the ones that originally invested into the irish banks. Rather, these are known to be vulture funds that bought back these bonds at cheap price when the crisis deepened in Ireland between 2008 and 2010.

Today, many people in Ireland are urging the government to reconsider the bailout plan and force private investors to pay their for their responsibility in the crisis. In vain: the government is stucked into the plan, notably because of the ECB’s pressures.

Will we avoid this kind of dead-end and unfair situation in the future? Yes if we seriously consider the alternative: bailing-in instead of bailing-out.

What is bail-in?

The bail-in consist in funding a bank’s capital requirement gap through the restructuring of subordinated liabilities of the bank. Concretely, a bail-in is normally conducted through the conversion of the unsecured bonds (ie. junior/subordinated bonds) into equity. This debt-equity swap would then relieve the bank from a significant amount of debt repayments, and strengthen its capital base.

The first and obvious argument in favor of bail-in is that it does not involve public funds to recapitalize a failing institution, thus leaving taxpayers untouched.

Instead, private investors would pay the price of the the recapitalization through the write-down of a large part of their claims. But they wouldn’t be totally despoiled, since they would get equity shares in the process. Hopefully, with the stabilization of the  financial situation of the bank, it could prosper again and the shares values would rise again on the long-term thus minimizing the net losses for investors. At least, it would create an important incentive for these new shareholders to take the required decisions to make it so.

All in all, this proposal seems to be the most honorable and fair exit door for every stakeholder. And most of all, isn’t it the basic rule of capitalism to be responsible of its investment (ie. earn money when succeeding, lose when things go wrong?) I cannot see no valuable reason why bondholders should escape this simple rule. So…

How would this work in practice?

Let’s take the example of Spain’s Bankia. According to the spanish think tank Juan de Mariana, the bankrupt institution has 38.5 billion of debt, which are broken up as follows:

• 13.4 billions in subordinate debt.
• 11.6 billion in senior unsecured debt, maturing between 2013 and 2017
• 13.5 billion in senior unsecured debt maturing after 2017.

That’s it!

The need for a legal framework for bail-in

So far, the bail-in is a solution that have not been very widely known neither put into practice. Instead, government and central banks have done everything they could to bail out the banks with direct or indirect public funds, as the Irish story demonstrates.

However, some signals tend to show that policymakers are progressively considering the alternative. The IMF itself highlighted the bail-in solution in a recent paper called From Bail-out to Bail-in: Mandatory Debt Restructuring of Systemic Financial Institutions (pdf). The paper praises more or less the idea, but does not see it as a “panacea” though. In fact, according to the fund, this kind of resolution scheme is only relevant if conducted in the context of a “clear and coherent legal framework”.

Fortunately, yet policymakers are working on this.

A european directive (pdf) has been very recently approved by the european commission and will be discussed at the european parliament. In the context of this directive, which follows broadly the IMF’s recommendations, the bail-in is only part of a more wider legal framework that would be an important step towards a “banking union” (with a european deposit guarantee scheme and other supervisory measures).

In the US, the debate about bail-in has also been intense recently. The Federal Deposit Insurance Corporation (FDIC) has recently unveiled a strategy for winding up insolvent banks, including the use of bail-in tools. The Wall Street Journal reports:

The equity stakeholders of the large bank or other financial firm will be wiped out, and bondholders will face losses as their holdings are swapped for equity in a new entity, as a part of the FDIC’s plan.

Another good news about this: the FDIC is apparently conducting discussions with the british financial authorities, which could help the idea cross the ocean:

Eighty-eight percent of the international assets and derivatives of top U.S. banks are based in the U.K., where FDIC officials say they are actively seeking cooperation. Former Fed Chairman Paul Volcker, who is helping advise the FDIC, said he is “impressed” with the agency’s close work with the U.K.

How long will it take for this framework to be put in place? From both sides of the Atlantic, nothing is done yet. Assuming the european members of parliaments dont get mistaken by the banking lobby’ propaganda, the european directive could only be applicable by 2018. Which is certainly too far away.

But at least the very principle of the bail-in is gaining awareness and credibility, making a wider debate about it likely to emerge. Very hopefully, given the large size of the spanish banking system financial hole, there might be few others choices than doing it for Spain. In this regard, the case of the spanish bailout will be very interesting to observe when it will be fully implemented.