February 9, 2016    10 minute read

The Negative Externalities of Bailing in a Bank

   February 9, 2016    10 minute read

The Negative Externalities of Bailing in a Bank

It was Monday, September 15th, 2008 when The Wall Street Journal headlined:

“Crisis on Wall Street as Lehman Totters, Merrill Is Sold, AIG Seeks to Raise Cash”

At that time, the Federal Reserve had already agreed with the US government to bail-out Fannie Mae and Freddy Mac and to orchestrate the sale of Bear Sterns to J.P. Morgan Chase & Co. A different fate was attending Lehman Brothers, but the FED still played one of the most important roles in rescuing AIG and the Merrill Lynch acquisition by Bank of America. About the latter operation, Ben Bernanke, who at that time was the Federal Reserve’s Chairman, denied any implication in its audition before the Committee on Oversight and Government Reform at the US House of Representatives on June 25th, 2009:

“On September 15, 2008, Bank of America announced an agreement to acquire Merrill Lynch. I did not play a role in arranging this transaction and no Federal Reserve assistance was promised or provided in connection with that agreement. As with similar transactions, the transaction was reviewed and approved by the Federal Reserve under the Bank Holding Company Act in November 2008. It was subsequently approved by the shareholders of Bank of America and Merrill Lynch on December 5, 2008. The acquisition was scheduled to be closed on January 1, 2009.”

Despite this, public opinion, the press and many well-known economists believe that Ben Bernanke bailed out Wall Street. Keeping in mind what happened in the US, the European Union has not been not immune from contagion during the financial crisis. The Member States faced the necessity to actively intervene to bail-out banks already full of toxic bonds and preserve financial stability.

In April 2008, the Royal Bank of Scotland (RBS) announced the necessity to raise funds of £12bn, a substantial amount. At that time, RBS Group was the fifth largest bank in the world in terms market capitalisation. The main reason for the state of distress for RBS was the risky acquisition of ABN Amro for £49bn in 2007.

But it was too late for sophisticated evaluation of merit, rather RBS needed a massive capital injection. It was the UK Government’s task to inject RBS with £15bn in November 2008, in exchange for a 58% stake in the bank. The year after the government launched another bank rescue plan, pumping in an additional £37bn into RBS.

The situation in the UK was not an isolated one. In March 2009, the German Government passed the Draft Act to Develop Financial Market Stability whose primary objective was the detoxification of balance sheets of financial institutions. The Deutsche Bundesbank monthly report of May 2009 clarified the concept as follows:

 “The draft act focuses on freeing up balance sheets by hiving off financial assets subject to a severe impairment risk to special purpose vehicles (“bad banks”).”

Following the approval of the act, in 2010, the German Government constituted a public owned bad bank FMS Wertmanagement, via the wind-up plan of Hypo Real Estate Holding AG (HRE Group). However in 2010, the Bank Recovery and Resolution Directive (BRRD) was not yet on the political agenda, and public money could still be used as life jackets to keep the financial institution afloat, but public concern was rising.

Interviewed by the CNN years later, Bernanke, in answering to the critics he bailed out Wall Street with taxpayers’ moneys, explained the rationale of the FED decision to rescue financial institutions, saying:

“I’m totally sympathetic with that concern. I have to say that […] it was not something we wanted to do, but the reason we did it was not because we cared in anyway about banks, their shareholders or even their employees; we cared because we knew that in a massive financial panic if banks begin to fail in large numbers as we saw in the great depression the implication for the average guy on Main street are going to be massive.” 

What as a bail-in and how does it work?

The bail-in is a new rescue tool appointed by the European Commission in the Bank Recovery and Resolution Directive (BRRD). It may be defined as a creditor-funded recapitalisation with the purpose to keep afloat the financial institution. The difference in the bail-out and bail-in lies in the method through which the aim is achieved. On one hand, bail-out means that external operators, such as governments, pump the needed liquidity into the bank, making it solvent again. On the other hand, bail-in occurs when borrower’s creditors contribute to the rescuing plan via bearing a partial or total writing off of their debt.

According to the BRRD, in order to opt for a bail-in, some conditions need to be fulfilled: the bank is failing or likely to fail; no other alternative measures of private nature (as recapitalisation) or supervisory measures will be able to avoid the failure; the liquidation of the bank would harm the financial stability and, therefore, the rescue is a matter of public interest.

The aim of the BRRD is well summarised by a Commission Press Release (December 2014):

“The objective of resolution is to minimize the extent to which the cost of a bank failure is borne by the State and its taxpayers. To this end, should the bank in distress continue to fail, the BRRD provides resolution authorities with a credible set of resolution tools. These include the power to sell or merge the business with another bank, to set up a temporary bridge bank to operate critical functions, to separate good assets from bad ones and to convert to shares or write down the debt of failing banks (bail–in). These tools will ensure that any critical functions are preserved without the need to bail out the bank, and that shareholders and creditors of the bank under resolution bear an appropriate part of the losses.”

The (potential) negative reaction of bond markets

Some observers have raised serious concerns regarding the fact that the bail-in paradoxically might harm a bank’s viability, instead of representing a solution to a bank’s financial distress. The assumption on which the theory relies can be summed up as follow: since the BRRD was enforced, investors knew that subordinated bonds and even senior bonds would see their value written off in the case of the bank rescue. Depositors are aware of the same and, that their deposits over €100,000 might also participate in the bank bail-in.

It means that according to the new legal framework, those financial instruments are riskier. Consequently, investors and retail investors will be more sceptical about buying bank’s bonds and, thus, this will constitute an additional burden on bank’s balance sheet. As their bonds became less attractive, their funding costs increase. Indeed, to convince an investor to buy those products the bank should offer higher interest rates or, at least, most favourable terms than in precedence.

In this respect, the data in Italy demonstrates something meaningful. On 22 November 2015, the Italian government approved Decree Law n. 183 (the so-called Salva Banche), whose aim was to support four banks representing the 1% of the Italian banking market, via a partial bail-in, before the enforcement of the BRRD (1 January 2016). Following the Decree, Banca Etruria, CariFerrara, CariChieti and Banca Marche were rescued via the creation of a bad bank in which non-performing loans (NPL) were transferred, and four new bridge banks were constituted to assure the stability of that business and in light of their future sale.

Also, for the first time, subordinate bondholders (in particular retail investors) were involved in the resolution plans, together with shareholders. Their asset value was written off. It had a disruptive impact on small savers that invested in subordinated bonds relying on mutual trust with those local banks, and an indirect effect on banks’ reputation.

In a survey carried out for Repubblica few days after the operation was concluded, 84% of the interviewed affirmed to have little or no trust in banks. A data that has been confirmed by the fact that in Italy between September 2014 and September 2015, the number of bonds owned by retail investors decreased by 27%.

The point is that distrust and fear play a critical role as drivers of customer behaviour. The weight of those feelings in determining the market conduct is explained in Ben Bernanke’s The Courage to Act as follow:

“As distrust grew, banks hoarded cash and lent to each other only reluctantly, causing the federal funds rate, the rate at which banks lend to each other overnight, to rise above the 5-1/4% target the FOMC had affirmed two days earlier […] Just as the bank runs of the Panic of 1907 amplified losses suffered by a handful of stock speculators into a national credit crisis and recession, the panic in the short-term funding markets that began in August 2007 would ultimately transform a “correction” in the subprime mortgage market into a much greater crisis in the global financial system and global economy.”

It means that if the degree of the investors’ distrust overtakes the survey on the profitability of the bank, banks in difficult or said to be in difficult but still viable might be threatened by insolvency simply because of customer fear.

Supporters of bail-in argue that it is a useful tool to encounter moral hazard. The transfer of the insolvency risk of investors’ pockets would increase the degree of control they exercise on bank boards with the aim to prevent it from entering into unreasonable operations, from a risk perspective. It is quite challenging to evaluate the impact of the new tool on moral hazard at present. Given that and waiting for future figures, what we now know that moral hazard is a difficult problem to target because it is hard to identify at the outset. The concept lies on the thin line between reasonable risk and unreasonable risk. An assessment that may be properly sorted out only in presence of an ex ante the buyer’s ability to evaluate the risk connected with the purchase of a financial product, the complexity of which is extremely high, especially for some financial instruments, and in a context that is by its very nature risky, namely financial markets.

Not all that glitters is gold

From a policymaker perspective, the rationale of bail-in lies in the idea that economic crisis will no longer be palatable. Investors are now on the front line, followed by deposits over €100,000 and only as a last resort, a public funds injection will be allowed. EU regulators’ defence is based on the assumption that posing a burden on investors, prior than to governments, will encourage responsibility on their markets. The aim in itself is laudable. However, if on one hand, asking to bondholders to bear a consistent risk and, thus, to exercise a meticulous control on the board of their banks seems reasonable, on the other hand, it appear still due for national governments to provide reliable control mechanisms both in form of supervisory authorities and efficient regulatory frameworks.

In conclusion, observers’ concern regarding the potential impact of bail-in, in weakening their funding activities and fuelling the tension on the banking market should not be underestimated, especially at present, in which the financial crisis seems to be overcome, but an enormous amount of non-performing loans is still hidden in the European banks.

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