Bail-ins: Are your Bank Deposits Safe? By Les Nemethy, CEO Euro-Phoenix M&A Advisors, former World Banker and Leo Rioufrays

Most readers of this column will have heard of bail-outs (e.g. use of government money to stabilize banks and other financial institutions); few will have heard of bail-ins (e.g. where use depositors’ and bondholders’ funds) is 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 bail-ins. Bail-ins may be considered an additional method for bank resolution in the toolkit of regulators, allowing use of creditor funds to keep banks operational, arguably reducing systemic risk, but potentially increasing risks 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 (a) first provide a broad summary of the legislation passed over the past 10-15 years in some major jurisdictions; then (b) discuss the pros and cons of bail-ins; (c) provide a few examples of bail-ins; and then speculate as to (d) possible implications for investors’ portfolios.

a, Summary of legislation

Post 2008, both the US and EU quietly introduced legislation enabling bail-ins:
  • n the US, 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 the conversion of debt into equity or write-down of claims– designed to ensure that resolution costs are borne by creditors rather than taxpayers.
b, Pros and cons of bail-ins

From a regulator’s perspective, the major advantages of bail-ins is creation of a more streamlined process, avoiding the need for a messy bankruptcy, while limiting use of Government (e.g. taxpayers’) funds, while 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 or investing into financial institutions, hence increasing cost of capital. There have also been concerns about transparency of bail-ins.

Banking is essentially a confidence trick. Banks take in short-term deposits and provide long-term loans, hence a sudden wave of withdrawals will cause problems. The success or failure of bail-ins is may ultimately depend on how they affect confidence.

c, A few examples of bail-ins

Cyprus (2013). According to the IMF, bailing out the two largest banks in Cyprus would have cost 50% of GDP, as Cyprus had a huge financial sector. Hence a bail-in was implemented, which involved 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 imposition of capital controls. This bail-in was criticized as disproportionately affecting smaller depositors and potentially undermining confidence in the European banking sector.

Greece (2015). Four Greek banks were bailed in. Banks’ liabilities, were converted into equity. Losses were borne by depositors and bondholders. There was considerably less contagion here than in Cyprus, in part given the lesser size of Greek banks in relation to the overall economy.

Spain (2017). 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 billion 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 exists which 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 $250,000 limit in the US or EUR 100,000 limit in Europe. But bear in mind that the FDIC insurance fund, which provides the guarantee, has just $130 billion collateral – far less than 1% of deposits in US commercial banks, not even talking about derivatives in the banking system.

The reluctance of US 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 heath 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.

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