Bail-In between Liquidity And Solvency

Wolf-Georg Ringe
Copenhagen Business School – Department of Law; University of Oxford – Faculty of Law

May 24, 2016

Oxford Legal Studies Research Paper No 33/2016

Abstract:

The concept of “bailing in” a distressed bank’s creditors to avoid a taxpayer-financed public rescue is commonly accepted as one of the most significant regulatory achievements in the post-crisis efforts to end the problem of “Too Big To Fail”. Yet behind the political slogan, surprising uncertainties remain as to the viability of the concept and its optimal legal design. This paper traces the development of the bail-in concept since it was first conceived in 2010 and demonstrates that it has undergone an important conceptual metamorphosis. Bail-in, first understood as fulfilling the “redistributory” purpose of sparing taxpayers from rescuing banks, has more recently been promoted as additionally serving a “market stabilizing” function: to stem a panic and to avoid run risks.

Whilst this trend is to be welcomed, it requires a number of changes to the present legal frameworks that are in place in many jurisdictions around the world. Issues to be addressed include, inter alia, to formulate appropriate criteria to trigger bail-in measures and to overcome a natural reluctance by resolution authorities to intervene and apply bail-in powers. This paper makes the case for early intervention triggers and demonstrates that liquidity provision by a lender of last resort during resolution is crucial to make bail-in credible. The paper places bail-in as a conceptual tool into the broader debate of how to deal with distressed banks and derives a number of concrete regulatory proposals.

Bail-In between Liquidity And Solvency – Introduction

The concept of “bail-in” is increasingly understood as the most significant regulatory achievement in post-crisis efforts to end “Too Big To Fail”. First articulated by Paul Calello and Wilson Ervin in 2010,1 it describes regulatory efforts to impose losses on a failing financial institution’s creditors, with the more fundamental objective of avoiding taxpayers’ rescue of banks that are too big to fail. Bail-in can be understood as the modern alternative to the two traditional crisis-fighting tools that were famously described by 19th century economist Walter Bagehot. In his influential book Lombard Street, Bagehot famously distinguished two alternatives: to provide central bank liquidity for banks that are illiquid, and to wind down insolvent ones.2 Bail-in is the “third way” to handle a failing institution by seeking to self-insure banks so that a rescue with public money becomes unnecessary. Over the past several years, this concept has won over a startling number of supporters across the world.

Yet, five years since the concept was first conceived, surprising uncertainties remain as to the precise regulatory objective of bail-in, as well as its trigger and the requirements for applying bail-in powers. Further, broad scepticism is voiced as to decisiveness of regulators to make use of their bail-in powers. In short, serious doubts persist as to the credibility of the concept, in particular relating to the fear that regulators may shy away from taking bail-in action in the decisive moment of rescue operations. Regulatory frameworks are ambivalent about the precise trigger requirements and substantial conditions for applying it. At the bottom of this vagueness is a surprising uncertainty about the precise purpose of bail-in.

This paper seeks to place the bail-in idea into the broader debate around the different operational tools that regulators and central banks have when dealing with a troubled global financial institution. It argues that the objective of bail-in has changed over time, developing from a purely redistributory goal (to avoid taxpayer liability) to a market confidence purpose (to stem panic by avoiding value-destroying runs). From this insight, the paper derives a number of regulatory implications. Chiefly, it is argued that bail-in can and should be applied to both insolvent and illiquid financial institutions, and that the regulatory framework should encourage making use of bail-in powers probably even earlier than that. Further, the paper makes the case for providing liquidity to a resolved financial institution by a robust lender of last resort, as bail-in in itself only addresses the recapitalization of an institution, but fails to make provision for ensuring its liquidity.

The remainder of this paper is structured as follows. Section I. introduces the emergence of the bail-in concept in the context of post-crisis regulatory thinking and demonstrates the regulatory learning process over the past five years. Subsequently, section II. evaluates bail-in in the context of alternative rescue methods and demonstrates that the purpose of bail-in has been redefined: the original purpose was mainly to internalize the costs of bank failure instead of threatening the public purse; since then, however, bail-in has become a contributor to market stability and to address potential bank runs. This development has important ramifications for both the appropriate trigger for bail-ins and the question of incentivizing resolution authorities to intervene early. Section III. turns to liquidity provision by the lender of last resort and makes the case for enhanced central bank involvement in the post-resolution phase to restore the institution’s viability. Section IV. concludes.

Solvency, Liquidity, Bail-In

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