Why Bank Bail-Ins Are the New Bailouts

The world experienced economic turmoil during the 2007-2008 financial crisis. Low interest rates boosted borrowing, a boon to existing and prospective homeowners, but created a bubble that would impact consumers and the world's banks.

The Great Recession that followed ushered in the term too big to fail. Regulators and politicians used it to describe the rationale for rescuing some of the country's largest financial institutions with taxpayer-funded bailouts. Heeding critics over the use of tax dollars, Congress passed the Dodd-Frank Wall Street Reform and Consumer Act in 2010, which eliminated the option of bank bailouts but opened the door for bank bail-ins.

Bank Bail-In vs. Bank Bailout

Bail-ins and bailouts are designed to prevent the complete collapse of a failing bank. The difference between the two lies primarily in who bears the financial burden of rescuing the bank.

With bailouts, the government injects capital into banks, enabling them to continue their operations. During the financial crisis of 2007-2008, the government injected $700 billion into companies like Bank of America (BAC), Citigroup (C), and American International Group (AIG) using taxpayer dollars.

Bail-ins provide immediate relief when banks use money from their unsecured creditors, including depositors and bondholders, to restructure their capital. Banks can convert their debt into equity to increase their capital requirements. Although depositors run the risk of losing some of their deposits, banks can only use deposits over the $250,000 protection provided by the Federal Deposit Insurance Corporation (FDIC).

Unsecured creditors, depositors, and bondholders fall below derivative claims. Derivatives are investments that banks make among each other, used to hedge their portfolios. To avoid a potential calamity, the Dodd-Frank Act gives preference to derivative claims.

Bail-Ins Become Statutory

Just like bailouts, bail-ins take place when banks are too big to fail, but banks use their capital when governments don't bail them out. Giving banks the power to use debt as equity takes the pressure and onus off taxpayers. As such, banks are responsible to their shareholders, debtholders, and depositors.

The provision for bank bail-ins in the Dodd-Frank Act was largely mirrored after the cross-border framework and requirements outlined in Basel III International Reforms 2 for the banking system of the European Union. It creates statutory bail-ins, giving the Federal Reserve, the FDIC, and the Securities and Exchange Commission (SEC) the authority to place bank holding companies and large non-bank holding companies in receivership under federal control.

Since the principal objective of the provision is to protect American taxpayers, banks that are too big to fail will no longer be bailed out by taxpayer dollars. Instead, they will be bailed in.

Example of European Bail-In

The use of bail-ins was evident in Cyprus, a country saddled with high debt and the potential for bank failures. The country's banking industry grew after Cyprus joined the European Union (EU) and the Eurozone. This growth, coupled with risky investments in the Greek market and risky loans from two large domestic lenders, led to government intervention in 2013.

A bailout wasn't possible, as the federal government didn't have access to global financial markets or loans. Instead, it instituted the bail-in policy, forcing depositors with more than 100,000 euros to write off a portion of their holdings, a levy of 47.5%.

Although the action prevented bank failures, it led to unease among the financial markets in Europe that these bail-ins may become more widespread with investors concerned that the increased risk to bondholders drive yields higher and discourage bank deposits.

In 2013, the EU introduced resolutions to make the bail-in a common principle by 2016 in response to the effects of the European Sovereign Debt Crisis. It transferred the responsibility of a failing banking system from taxpayers to unsecured creditors and bondholders, the same way Dodd-Frank did in the United States.

Protect Your Assets

With bailouts, governments inject money back into troubled banks and corporations to help them avoid bankruptcy. In a bail-in, banks use the money from depositors and unsecured creditors to help them avoid failure.

Dodd-Frank aimed to protect taxpayers from costly bailouts by allowing banks to use bail-in provisions, putting the onus on and shifting the risk to unsecured creditors, debtholders, and common and preferred shareholders. This also includes depositors whose account balances are more than the FDIC-insured limit.

Banks have the authority to take control of any capital that fits the criteria as per the law. This means anyone who has an account that exceeds the $250,000 insured limit may be affected so it is important to:

• Keep a watchful eye on the performance of the financial markets and financial sector
• Ensure the financial institutions you choose are financially secure and stable
• Spread the risk by diversifying your money and assets across different banks and countries
• Keep balances at or below the $250,000 limit
• Make sure you monitor any changes to federal government policies about bank deposits
• Avoid banking with any institution that has large derivative and mortgage books, which can be risky in times of crisis

The Bottom Line

Big banks are not immune to the effects of financial instability. After the 2007-2008 financial crisis and the passage of Dodd-Frank, the federal government shifted the risks to creditors by allowing financial institutions to use debt capital to stay afloat. This means that debtholders, unsecured creditors, shareholders, and depositors may shoulder problems within the financial sector when banks use bail-in measures.