The world experienced a major upheaval during the 2007-2008 financial crisis. The problems didn't happen overnight. In fact, they were years in the making. Rock bottom interest rates led to an increase in borrowing, which was a boon to existing and prospective homeowners. But it would prove to become a bubble destined to burst—one that would greatly impact not only consumers but also some of the world's major 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 the public's displeasure over the use of their tax dollars in such a way, Congress passed the Dodd-Frank Wall Street Reform and Consumer Act in January 2010, which eliminated the option of bank bailouts but opened the door for bank bail-ins.
- Big banks were deemed too big to fail following the financial crisis of 2007-2008, resulting in government bailouts at the expense of taxpayers.
- Financial reforms ushered in with the Dodd-Frank Act eliminated bailouts and opened the door for bail-ins.
- Bail-ins allow banks to convert debt into equity to increase their capital requirements.
- They shift the risk to unsecured creditors, including depositors whose account balances exceed the FDIC limit of $250,000.
- You can avoid bail-ins by spreading your assets across different banks and by monitoring changes in financial regulations.
Bank Bail-In vs. Bank Bail Out
Bail-ins and bailouts both serve the same purpose: they are designed to prevent the complete collapse of a failing bank. But 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, the government bailed out major banks by injecting $700 billion into names like Bank of America (BAC), Citigroup (C), and American International Group (AIG). Since the government doesn't have its own money, it must use taxpayer funds.
Bail-ins work a little differently, providing immediate relief. Banks use money from their unsecured creditors, including depositors and bondholders, to restructure their capital to stay afloat. Put simply, they 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 in excess of 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, which are supposed to be used to hedge their portfolios. However, the 25 largest banks hold more than $247 trillion in derivatives, which poses a tremendous amount of risk to the financial system. 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 end up using their own capital when governments don't have enough money in their coffers to 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 set forth 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 the American taxpayers, banks that are too big to fail will no longer be bailed out by taxpayer dollars. Instead, they will be bailed-in.
According to the Treasury Department, the federal government recovered $275.2 billion through "repayments and other income" from banks that benefited from the Troubled Asset Relief Program (TARP). That's $30.1 billion more than the original investment.
Europe Experiments With Bail-Ins
One of the key examples of the use of bail-ins was in Cyprus, a country saddled with high debt and the potential for bank failures. The country's banking industry grew at an alarming rate 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 the need for 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 over the possibility that these bail-ins may become more widespread. Investors are concerned that the increased risk to bondholders will drive yields higher and discourage bank deposits. With the banking systems in many European countries distressed by low or negative interest rates, more bank bail-ins are a strong possibility.
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.
How to Protect Your Assets
With bailouts, governments inject money back into troubled banks and corporations to help them avoid bankruptcy. But that isn't the case with bail-ins because banks use the money they have available from depositors and unsecured creditors to help them avoid failure. That means your money may be at risk of being used to help your bank keep itself afloat.
Remember that bail-ins are the new norm. 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, as well as common and preferred shareholders. This also includes depositors whose account balances are in excess of the FDIC-insured limit.
So what does this mean for consumers? 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. Anything above that amount can be used for bail-in purposes.
If you want to protect your assets, here are a few tips you may want to take into account:
- 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
- Don't bank with any institution that has large derivative and mortgage books, which can be risky in times of crisis
How Can a Bank Bail-In Be Avoided?
Bail-ins allow banks to help avoid bankruptcy by shifting some of the risks to their creditors rather than to taxpayers. This risk can be transferred to bank customers, too. If you want to avoid the effects of a bank bail-in, make sure you are aware of the financial stability of the financial institutions with which you do business and ensure you diversify your assets and holdings across different banks and credit unions. You can also help keep your savings intact by monitoring changes to financial regulations.
How Do I Protect Myself From a Bank Bail-In?
You can protect yourself from a bank bail-in by taking several steps. First, make sure you monitor the financial markets and study the financial security of any institution with which you choose to do business. Ensure you spread your money across different banks. Remember, banks can only use money from accounts in excess of the $250,000 limit protected by the FDIC. To ensure your money remains protected, make sure your account balances don't go above that amount. Keep up to date with changes to federal government guidelines relating to banks and financial matters.
Are Bank Bail-Ins Legal in the U.S.?
Bank bail-ins are legal in the United States. They became the new norm with the passing of the Dodd-Frank Wall Street Reform and Consumer Act, which was ushered in as a response to the Great Recession. The federal government will no longer inject taxpayer dollars to prevent big bank failure. Instead, banks now have the authority to use debt capital as equity to avoid going under. This includes capital from unsecured creditors, common and preferred shareholders, bondholders, and depositors whose account balances exceed the FDIC-insured limit of $250,000.
The Bottom Line
Big banks learned a very important lesson following the financial crisis and the Great Recession that ensued. Despite receiving billions in bailouts, recovering, and repaying back the money they received, they're still not immune to the effects of financial instability.
Rather than put the onus on taxpayers, though, the federal government shifted the risks to creditors by allowing financial institutions the ability to use debt capital to keep themselves afloat. This means that debtholders, unsecured creditors, shareholders, and depositors may be responsible for problems within the financial sector. So if you're worried about what this means for your bottom line, make sure you follow the tips outlined above.