April 12, 2012
The solution to the recent Cyprus banking problem was not the usual “bailout”. For the first time, bond holders and uninsured depositors of the problem banks were asked to share the cost of the rescue. Hence, it has become known as a “bail-in”. If this becomes the model for solving future financial problems in Europe and elsewhere, it has important implications for depositors, debt holders, banks, central banks, and even the pace of economic activity.
Typically in the U.S. a bank that fails is “bailed out” by merging it into a stronger institution. The Federal Deposit Insurance Company honors the claims of the insured depositors. The uninsured deposits become a liability of the surviving bank and typically holders of such deposits do not suffer a loss. Bonds are a form of debt, so in the event of a failure bondholders have a better chance of getting their money back because the owners (the stock holders) have an obligation to repay creditors. As a result, bond holders often come out unscathed. Stockholders and preferred stock holders suffer the loss. This system has been used repeatedly and works well.
Following the financial crisis in Europe governments “bailed out” numerous banks. The cost of the bailout was borne largely by taxpayers in northern European countries — Germany and the Netherlands in particular. Bondholders were untouched and were thereby “bailed out”. Not surprisingly taxpayers in those countries have had enough and want to change the rules of the game.
When the problems in Cyprus emerged the finance ministers argued that Cyprus was a special case and required a different solution. It had attracted a lot of hot money, particularly from Russia. Taxpayers in northern Europe were not about to bail out wealthy Russians. Thus, the finance ministers agreed to shift some of the burden of the bailout from taxpayers to bondholders of the troubled banks in Cyprus, uninsured deposit holders, and even (briefly) insured deposit holders. They soon recognized that imposing a tax on insured depositors would have broken the sacred bond of trust between depositors and the government and, as a result, depositors in any weak Spanish or Italian bank would have been inclined to run. Fortunately that idea did not last long.
A “bail-in” which shifts some of the burden of a bank failure onto bondholders and uninsured deposit holders is very different from the typical “bailout” we have seen to date and has important implications.
First, uninsured deposit holders who can will distribute their funds across multiple banks to maintain their insurance coverage. But other very large depositors who may not be able to do so easily will need to rely on bank analysts to warn them of a potential problem. But if those analysts see a problem and warn their firm and the bank’s customers about the difficulty, they could trigger a run on the bank which could cause that particular institution to fail. Hence, the bail-in solution could make large banks even more systemically risky than they were under the bailout regime.
Second, under the bail-in uninsured depositors will gravitate to banks that have sufficient capital, size, and management quality to be regarded as above risk. Thus, only the biggest banks will be likely to survive. Unfortunately, by their very size they increase the systemic risk to the banking system.
Third, banks that are in that top tier know they have to be universally recognized as a “safe” institution. To achieve that status the bank will need to increase both liquidity and capital. But by doing so and by leaving these additional funds idle the bank may adversely impact its performance.
Fourth, banks finance much of their lending through bonds. If bondholders demand more interest because they are at risk in the event of a failure that could translate into higher rates for mortgages and other types of bank lending. Thus, a regulatory change to protect taxpayers could have negative consequences for the economy as a whole.
Finally, central banks may have more difficulty determining the appropriate volume of reserves to provide to the banking system. Currently the Fed imposes a 10% reserve requirement. This means that if it provides $1 billion of surplus reserves that has the potential to boost GDP by $10 billion. But if banks behave differently and do not lend all of their excess reserves, than the ultimate impact on spending will be reduced. If the Fed does not recognize this changed behavior it will under provide reserves and GDP growth will fall short of its objective.
Going forward, what will be the model if banks in Spain, Portugal, Ireland or Italy run into difficulties? Should taxpayers elsewhere in Europe pay for the “bailout” as has been the case prior Cyprus? Or should debt holders and uninsured depositors be “bailed in” and asked to share in the cost of the solution? In our opinion, option 2 is far preferable. It is unfair to ask taxpayers in Cyprus, Germany, or anywhere else to bail out those troubled banks. Let the bank fail. Protect the insured deposit holders, let the stock holders take the biggest hit, and let debt holders and uninsured depositors take a haircut.
Having said that, a shift from a bailout system to a bail-in regime will trigger changes in the behavior of depositors, bondholders, banks, and the central banks, and exactly how all this will play out remains to be seen.
Stephen Slifer
NumberNomics
Charleston, SC
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