February 18, 2017    6 minute read

A New Financial Crisis Looms, but Are Bail-ins the Answer?

Sunset on Security    February 18, 2017    6 minute read

A New Financial Crisis Looms, but Are Bail-ins the Answer?

The contagious effect of the 2008 financial crisis was somewhat mitigated in the short term by bail-outs and massive money-printing by the central banks across the world. Systemic banking crises like the ones seen in 2008 are rare, but more could happen if the wrong policy is chosen and less strict financial regulation is passed. The growing popularity of the ‘bail-in’ is arguably one such example, as suggested by recent experiences in countries like Cyprus and India.

The world has come a long way since the 2008 financial crisis, but the problems of the financial world have in many ways remained the same. Monetary experiments in the form of quantitative easing, forward guidance, and negative interest rates could not boost the global economy in any meaningful way and have contributed to creating large debt loads in both developed and emerging economies.

The Financial World Scrambles to Prepare

The financial world looks to be approaching the same situation as of that of the run-up to 2008. Major banks in Europe such as Germany’s Deutsche Bank are in a serious financial mess. Major threats to European banking come from Monte Dei Paschi: the bank is running out of cash and, according to estimations, may become insolvent if fresh capital is not provided within four months’ time.

Many emerging economies like India, China, and Brazil are also facing similar problems with bad loans and NPAs (non-performing assets) as well as declining profits.

A rescue plan for the next crisis has already been put in place by the leaders of the G20 nations at the 2009 London summit, by formalising a new organisation called the Financial Stability Board. The board was set up to ensure that such systematic risks could not infect global banks again – in other words, to ensure that banks don’t fail.

Bail-ins: Worthy Solution or Cancer to the Economy?

Policymakers and central banks largely believe that banks’ capacity to fail destabilises and threatens the financial system. At the Brisbane summit in 2014, the G20 group endorsed the FSB proposal that drew up the new concept of a ‘bail-in to replace previous Bail-out (i.e- taxpayer funded) and ensure the stability of financial system.

The G20 nations also agreed to be regulated by the newly formed FSB and will introduce its recommendations. The mechanism of ‘bail-in’ is recommended when a bank has failed or on the verge of default, but it must be saved since its services are considered necessary.

A ‘bail-in’ is when a bank recapitalises by tapping its creditors, including common depositors. Contrary to the popular belief that when someone deposits money they own the asset, it is in fact the bank’s property – what the people own is in essence a liability. If a bank fails, people lose their deposits because banks do not give them any tangible security against it.

New Experiments, Old Story

The first test run of the bail-in strategy for insolvent banks was in Cyprus.  The financial system of Cyprus imploded in the spring of 2013, due to big Cypriot banks making bad investments, especially in buying up Greek government bonds. As Greece’s sovereign debt crisis deepened, Cyprus’ banks went broke.

40% of cash in Cypriot accounts worth over €100k was written off

Cyprus needed a €17.5bn bailout or a sale of the nation’s gold reserves in order to protect itself from a possible default. In return for the €10bn bailout from the EU, Cyprus agreed to a ‘bail-in’. The country’s banks were shut down, cash withdrawal limits were put into place and depositors with more than €100,000 in their account were forced to write off a 40% portion of their holdings in order to recapitalise the banks with liquidity.

Demonetisation: The First Stealth Bail-in?

The biggest experiment of bail-ins in actual fact happened in India, when Prime Minister Modi decreed that 86% of its currency would lose its status as legal tender overnight in name of the war on black money. The demonetisation programme can arguably be characterised as a bail-in, particularly in light of how the real reason for the move lay in the growing crisis plaguing the Indian banking sector.

8.6% of debt in India is made up of NPAs or bad loans

How bad was this crisis? According to a Credit Suisse report, aggregate non-performing assets or bad loans in the Indian banking sector stood at 6.5 trillion rupees, or 8.6% of total loans, at the end of June 2016. An overhang of bad debt not only hit the profitability of state-owned banks but also affected their ability to grow their loan book.

This caused serious issues for India’s overall credit growth, as state-owned banks account for two-thirds of the overall credit handed out by commercial banks.

A Fitch ratings report earlier this summer indicated that a large number of Indian state-run banks may not be able to meet the fresh capital requirement of $90n by 2019 in order to meet Basel III regulatory standards. India banks were in dire need of 2.3 trillion rupees of fresh capital in order to overcome the problems of bad loans, non-performing assets, and credit growth.

Raising capital from the markets posed a challenge for these banks due to their heavy reliance on the government for decision-making. India’s government had two options: either dip into the central bank’s emergency funds or demonetise some of its currency.

Raghuram Rajan, the RBI’s governor at the time, was highly critical of the government’s proposal of using the central’s bank emergency funds and raised concerns regarding the independence of the monetary policy body from the state. The government had only the demonetisation option left to choose from.

39% The proportion of withdrawn rupees now back in circulation

The modus operandi was same as that of Cyprus: the banks went on holiday, ATMs were closed, and capital control measures were taken. The November 8 decision resulted in the withdrawal of 15.4 trillion rupees from the currency supply, but only about 6 trillion rupees of new currency has been put back into circulation so far.

The reduced circulation of currency has allowed India’s banking system to get away with its problems of bad debt, and the deposit scheme to get people to hand in their old notes has led to an increase in the liquidity of its bank reserves. This policy raised serious concerns over the government’s narrative of a ‘war on black money’ – particularly as just 6% of the demonetised money was ‘black’.

When Will They Learn?

These bail-in experiments look likely to eventually be carried out in Italy as well as other nations. The question that arises now is how many times these banks will be rescued at the cost of taxpayers and depositors, protecting the system rather than holding those institutions accountable for their actions so that a hard message might be sent to the banking industry.

A bad policy decision affects everyone. How long will those in charge keep using theories and models that have resulted in a lost decade in terms of growth, employment, and future prosperity for India, to name but one example? Bail-ins might prevent the banks from failing in the short term, but they might lead to the collapse of the little amount of trust left in these global financial institutions.

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