Bail-ins: Damned if we do; damned if we don’t

We have written on numerous occasions about the hitherto inseparable links between sovereigns and banks, and we have also written about the benefits of writing down bonds to create capital  (see The New Era for Bank Bonds: Send In The Clowns? and Equitisation of bank capital bonds) . In 2007 the global markets woke up to the fact that the US subprime market was blowing up, and in 2008 realised that due to financial engineering and securitisation, both of which were preposterously known at the time as ‘risk dissemination and minimisation’, banks the world over had major solvency issues as vast quantities of investments plummeted in value. This, in turn, led to a liquidity crisis as the investment markets shunned investment in banks and the interbank market froze over.

The crisis we are in today is the same crisis we were in 5 years ago. Sovereigns had to step in to guarantee their banking systems, so as to enable debt to be rolled over and confidence to return. In the short term the most important thing was to provide liquidity, which we saw through government guaranteed debt issuance and secured funding directly with central banks in the UK, US and more recently Europe. Next, sovereigns had to buy huge volumes of illiquid assets from their banks (US), or provide direct capital injections to support their solvency (US and UK), as the perception dawned that the liquidity crisis was caused by a solvency crisis.

All this time, the inevitable link between sovereigns and banks was becoming more and more deeply intertwined. And whilst it may feel that the Great Recession has metamorphosed from a banking crisis to a sovereign one, it hasn’t really: sovereigns took on increased liabilities to protect their banking systems and now find themselves in the ‘limelight’. It’s the same crisis, with a different focus.

Many European banks, though, remain substantially undercapitalised. Hence, the system is still overwhelmingly dependent on central banks to provide them with liquidity at an affordable cost. All the time the sovereigns providing liquidity are becoming more and more tied to the health or otherwise of their banks and the assets they are taking from them as collateral.

Has the time come for this cycle to end? Might the severance of this link bring the beginning of the end of the sovereign crisis? Many European banks are still on 24 hour life support, saddled by enormous levels of liabilities that are cutting off new lending and suffocating new investment through the multi-year crisis in confidence in lending to and investing in banks.

So how will this occur? Well my sense is that there’s abundant liquidity at the moment after all the LTROs, inter-central bank funding lines, secured lending facilities and covered bond new issuance. The problem is far more one of solvency and capital adequacy in Europe, where the very worst of the banking crisis continues today. For sovereigns to provide their national banks with the recapitalisations they need, via wholesale nationalisations, would only see a worsening of the sovereign debt crisis, as the funds would have to come from somewhere. So this approach doesn’t really work. And is it really desirable from the perspective of the taxpayer?

The solution? We need new capital, in substantial scale, and fast. The time may have come to sever a significant part of the link between a sovereign and its banks. Unsecured bank bonds in peripheral Europe where the sovereigns are struggling under high borrowing costs, and so where the cost of providing guarantees and funds to their banks are painful, should now be written down in certain cases. Both subordinated debt and senior unsecured bonds would see defaults, in some cases even to zero. This would generate huge amounts of capital (which writing down only subordinated debt would not achieve on its own), and does not involve the troubled sovereign having to borrow more from the markets or seeing debt / GDP levels spiralling. Yes this is painful for investors and to risk-taking savers who are exposed to bank bonds in their pensions and so who suffer losses there. But the write downs are taken. Capital is generated. Deleveraging of the system occurs quickly and substantially (at last!). And the severance of this part of the sovereign-bank link (deposit guarantees must remain in place)  means that the banks might just stop dragging the sovereigns down with them.

Policymakers and politicians must be aware (and I’m assuming they are already) of the benefits of this first step towards cleansing the system. If this doesn’t work, then nationalisation is the last resort, and the taxpayer must step in one last time. But this situation of creeping nationalisation where taxpayers provide 24 hour life support in European banks through emergency policy response after emergency policy response, at the expense of much higher tax and lower quality of life across all citizens for a very long time feels wrong, at least before the risk-takers have suffered. Could now be the time for bank bondholders to see defaults, where they are needed? There are countries where these dramatic measures aren’t needed, as well as individual banks where they won’t be needed within troubled systems. The process will be painful for bearers of risk (investors and savers), but it might, more importantly, provide the capital the system so needs to start restoring confidence in the banks, and the sovereigns would benefit from cutting the tie with the non-deposit banking system. So policymakers have to work out whether society overall would be better off with this new approach than the current one. They may very well conclude that the present situation of taxpayers being subordinate to bank bond holders, rather than vice versa, is a morally repugnant system.

Some of us are damned if we change tack and take this approach. All of us are damned if we don’t.

8 thoughts on “Bail-ins: Damned if we do; damned if we don’t

  1. The problem is that the authorities are trying to fix the banking system during a crisis. 

    Measures such as more & better quality capital & de-leveraging all make sense – but in a middle of a recession they’re   simply exacerbating the problem + asset quality deteriorates during downturns making it harder for banks to lend. 

    It’s not just a mass recapitalisation that is need, but economic growth to create more lending opportunities and to improve asset quality & hence less bad loans.

    I fear the way this crisis is unravelling markets are going to play a smaller and smaller role as the state takes over more and more functions of allocating capital.

    At some point it could get so desperate that QE is used to make direct loans to companies and households if private sector doesn’t perform and don’t count on the public sector being an improvement on allocating capital over the private sector, despite the latter’s disastrous record in terms of banks in run up to 2007. 

  2. Great ideology,

    Many of us would indeed like to see unprofitable and risky banks fail, well deserved punishment. Having said this I am not convinced it is this simple. I might be missing something here but I am under the assumption that private investors are only covered up to the first £50,000 they have deposited with a bank (in the UK at least).

    There is no doubting this is a large amount of money but there is one area which I do not believe we have covered. Many homeowners use mortgages, issued by banks, to help provide payment for their homes. Under these arrangements the house is used as collateral on the debt and one has to consider how homeowners would figure in the event of their lending bank becoming insolvent.

    Until we sever the link between retail and institutional banking I fear there is still some mileage yet to run in this old banger….

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  4. Owen,

    The attractiveness of the bank bond bail-in approach I wrote about is that it writes down bonds, which has the same effect as swapping debt for equity.

    It is absolutely paramount that depositor guarantees remain in place (£85k per person per bank at the moment I believe), and bail in should not affect this at all.

    Further, if Lehman’s failure taught us one thing it has to be that we must try to preserve the interbank market. Banks do not own large quantities of other banks’ bonds these days, and so the bail-in approach should not affect the other banks too hugely. Most of their exposure to other banks is through the inter-bank market (swaps, deposits, transactions etc), and bail-in should not impact this part of the market too much. In fact, once the extra capital is in place through the bond writedowns, this market should in fact benefit.

    And I entirely agree with you about the separation of retail and investment banking. It is another crucial tool in a regulator’s kit. They could indeed happen on the same day, to achieve very similar aims.

  5. Ben – I agree that write-downs make sense. Most banks have been trading at P/B <1x for so long, it’s clear there is no trust in bank accounting policies on impairment. Wiping out shareholders and equitising some sub debt would leave banks much more chipper and willing to grow. But what would the trigger be to allow the authorities to do this?

    I am not entirely sure about severing banks from states though. It’s a nice idea but in my view banks are inevitably public-private partnerships which fulfil, in maturity transformation, a critical public need.

    I do agree though that the banks are what should be looked after by states, not the junior capitalholders of banks.

  6. Anders,

    As for what the trigger would be: in the UK as well as elsewhere we’ve got ‘Special Resolution Regimes’ already in place, which enables regulators to effectively do what they want when they decide that emergency measures are called for. So it could be done today in some regimes.

    Another way of looking at what the trigger is would simply be to say that we’re in a period of sovereign crisis in peripheral Europe, where they can’t afford to protect anyone than their banks’ depositors, and so where these writedowns most need to be made. And just do it.

    With regards to your last point: in no way did I want to imply that the link should be entirely severed. Deposit guarantees must remain in place and be robust if needed. So the link should never be entirely severed!

  7. Debt for equity swaps are the logical solution – they could leave the banks with surplus capital, even against Basel 3 requirements, incentivising them to resume loan book growth, and they represent on of the few actions that avoid moral hazard. However, I think you do the approach a disservice by not addressing the obvious challenges of bail-ins. Clearly, there is a legal argument to be won, which would create uncertainty, over a protracted period, as to whether debt holders’ recoveries and the flip side, capital levels. Then there is contagion, particularly given the discredited nature of previous stress testing exercises, which would make it very difficult to draw a line between those needing bail-ins and those not. Then there is no guarantee that banks would be able or willing to increase their loan books, since the consumer, sovereign and highly leveraged corporate continue to de-leverage – if there’s no credit growth there won’t be much economic growth and in a world of low economic growth, there aren’t so many good investments and not much demand for debt. Debt for equity swaps are a relevant and elegant solution, but no panacea. Perhaps you could follow up with a discussion of these issues…

  8. What about contagion? Could 1 or 2 globally systemic institutions do a corporate bond default without all of them having to do the same through interconnections, both direct (e.g. cross holdings) and indirect (market panic taking valuations of distantly related assets down). It could also take down a large part of the insurance industry if it takes their reserves below regulatory solvency criteria.
    Given the bail-in legislations being prepared everywhere, it seems a likely scenario, and probably desirable on balance, but it seems people who advocate it may be underestimating the consequences and the speed with which it may unfold (you may end up with the entire western banking + insurance sector nationalised and running under emergency legislation within a week), or what exactly will emerge at the other end (hard to predict!).
    Also given that a simultaneous failure only raises capital net of cross-holdings and collateral damage, there may still be a tab left for taxpayers (on top of the losses via products they hold containing defaulted bonds!).

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