Bail-ins: Are Your Bank Deposits Less Safe Than Your Tax Dollars?
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Most readers of this column will have heard of bail-outs (in other words, the use of government money to stabilize banks and other financial institutions); in this column, Les Nemethy and Leo Rioufrays discuss the much less well-known bail-ins, where depositors’ and bondholders’ funds are used to stabilize banks.
During the 2008 Great Financial Crisis, regulators had no legislative authority for bail-ins. Hence, in 2009, many countries began quietly passing legislation to authorize them. Bail-ins are an additional method for bank resolution in the regulator’s toolkit, allowing the use of creditor funds to keep banks operational, arguably reducing systemic risk but potentially increasing the threat to bank depositors and creditors.
The purpose of this article is to familiarize those not familiar with bail-ins and discuss possible implications. We will first provide a broad summary of the legislation passed over the past 10-15 years in two significant jurisdictions; then talk about the pros and cons of bail-ins; provide a few examples; and speculate on possible implications for investors’ portfolios.
Post 2008, both the United States and the European Union quietly introduced legislation enabling bail-ins:
• In the States, the Dodd-Frank Act (2010) contains a provision called the “Orderly Liquidation Authority,” which permits the Federal Deposit Insurance Corporation (FDIC) to use creditor funds to resolve a financial institution by converting them to equity.
• The EU introduced the Bank Recovery and Resolution Directive (BRRD) in 2014, which sets out a range of tools regulators can use to resolve failing institutions, including bail-ins. Creditors can be required to take losses, either through converting debt into equity or writing down claims, designed to ensure that creditors rather than taxpayers bear resolution costs.
From a regulator’s perspective, the major advantages of bail-ins are creating a more streamlined process, avoiding the need for a messy bankruptcy while limiting the use of government (in other words, taxpayers’) funds, and avoiding the moral hazard of bail-outs.
The biggest downside of bail-ins is that they may augment contagion. The mere possibility of bail-ins may accelerate the process of withdrawing deposits or selling bonds. Bail-ins, once implemented, oblige creditors and depositors to write off all or part of their investments, possibly triggering a domino effect. Bail-ins may increase risks associated with lending to or investing in financial institutions, and hence increasing the cost of capital. There have also been concerns about the transparency of bail-ins.
Banking is essentially a confidence trick. Banks take in short-term deposits and provide long-term loans, meaning a sudden wave of withdrawals will cause problems. The success or failure of bail-ins may ultimately depend on how they affect confidence. Here are a few examples.
According to the IMF, bailing out the two largest banks in Cyprus would have cost 50% of the GDP, as Cyprus had an enormous financial sector. Hence a bail-in was implemented, which involved the conversion of a portion of depositors’ balances into bank shares and the closure of one of the country’s largest bank, Cyprus Popular Bank. The bail-in caused panic among depositors, leading to a bank run and the imposition of capital controls. This bail-in was criticized as disproportionately affecting smaller depositors and potentially undermining confidence in the European banking sector.
Four Greek banks were bailed-in. Banks’ liabilities were converted into equity. Depositors and bondholders bore the losses. There was considerably less contagion here than in Cyprus, in part given the lesser size of Greek banks in relation to the overall economy.
The BRRD was applied in the case of Banco Populare, a medium-sized bank. In addition to EUR 1.3 billion of equity being wiped out, EUR 1.97 bln of Tier 1 capital and EUR 716 million of Tier 2 capital were wiped out, after which Banco Santander stepped in to buy the bank for a symbolic euro.
Impact on Investors’ Portfolios
Legislation can convert your bank deposits to equity or give them a haircut, literally with the stroke of a pen. You may also think your funds are safe up to the USD 250,000 limit in the United States or EUR 100,000 limit in Europe. But, bear in mind that the FDIC insurance fund, which provides the American guarantee, has just USD 130 billion collateral, far less than 1% of deposits in U.S. commercial banks, not even talking about derivatives in the banking system.
The reluctance of U.S. regulators to use bail-ins during the recent wave of bank failures is probably owing to a fear of contagion effects. However, should bank failures become particularly large or systemic, regulators may have no choice but to use bail-ins on a massive scale.
What can be done? You may wish to a), at a minimum, examine the financial health of the financial institution in which you deposit funds; b) diversify deposits across multiple institutions, perhaps even in multiple jurisdictions; and c) you may consider holding some of your wealth in liquid physical assets outside the financial system, such as gold.
Les Nemethy is CEO of Euro-Phoenix Financial Advisers Ltd. (www.europhoenix.com), a Central European corporate finance firm. He is a former World Banker, author of Business Exit Planning (www.businessexitplanningbook.com), and a previous president of the American Chamber of Commerce in Hungary.
This article was first published in the Budapest Business Journal print issue of April 21, 2023.
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