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Bail ins are the new bail outs, but they won’t save banking

Taking on water is the last thing a sinking vessel needs. amirjina

Bail ins are the new bail outs, but they won’t save banking

Bailing out banks is so 2008. It seems 2013 is the year of the bank “bail in”.

It started with the Co-operative Bank in the UK, when the bank’s management decided to “bail in” some of its bond holders, who became shareholders, after it found itself on a financial precipice. Now the European Union has agreed to do the same with its failing banks.

Under the bail-in model, a bank that is in danger of going under will be recapitalised by its bond holders (people who have lent the bank money at a fixed rate of interest) and large depositors (people who have €100,000 of their money in an account in the bank). These two parties will need to provide 8% of the capital required by a failing banks. Governments can only provide an additional 5% of the required capital.

Many of the financial fraternity see bail-ins as an improvement on bail-outs because they decrease what economists call “moral hazard”. This effectively means shareholders, bond-holders and depositors in banks can’t shift the big risks which they are taking to someone else (such as the tax payer). A bail-in will force these other groups to bear some of the losses when things go wrong. It’s also hoped that bail-ins will quell the widespread public anger the bail-outs of the banks have created.

But while the Co-op bail-in proceeded smoothly, we are likely to see a string of serious issues arise as the practice becomes more widespread.

Negative spirals

The first problem is negative spirals. These appear when marginal banks find it increasingly difficult to raise money on the bond market. Investors become concerned that fairly low-risk bonds could easily become a high-risk equity if the bank finds itself in need of being “bailed in”. This then makes them far more cautious in buying bonds from the banks. The result is a high cost of borrowing for the bank that would further weaken its balance sheet – making a bail-in more likely.

So even a perception in the bond market that a bail-in may be future risk could force this ultimately undesirable outcome to become a reality. Under these circumstances, more banks that are perceived as risky would find themselves starved of financing from the bond market and pushed into a bail-in.

Bailing in is infectious

A further real risk of bail-ins is contagion. If one bank finds itself trapped in a negative spiral and bailed in, it is likely that others will follow. This is because the main holders of bank bonds are other banks. So if one bank is bailed in, and their bonds are converted into shares with a lower value, the balance sheets of the banks which hold the shares are no longer going to look so attractive.

And because the parties taking the hit are likely to be other banks, their weakened balance sheet could also push them to be “bailed in”. This of course would have knock-on effects onto other banks fairly quickly. The upshot would be if one bank was bailed in, others could quickly follow.

A question of trust

Contagion could spark a broader decline in trust in banks. This would happen when investors in banks find the type of assets that they owned had suddenly morphed into something else. Bond holders and savers would discover that they no longer had a relatively safe investment which promises a consistent annual return. Instead, they have a far more risky investment in the form of shares.

This would be like waking up one day and finding that your sober Volvo station wagon had suddenly been replaced with a kit-built sports car with an uncertain safety record. Clearly, if you knew this was a possibility, you would have thought twice before taking what appeared to be the safe option. The net effect of this kind of uncertainty would be that investors may begin to distrust the asset they own, and the people who sold it to them.

This is a profound problem. If depositors start worrying that their savings will suddenly be transformed into shares, then they will be far less likely to trust the bank with their money. And the proverbial mattress could begin to seem like a good option for stashing your money.

Bond holders on your back

If bond-holders and savers increasingly recognise that they could at least potentially become owners of the bank, they would be likely to become far more vigilant, but also more vocal about banking behaviour. They would probably begin to demand more of a say in how the bank runs. This would mean the management of banks would not only need to deal with the pressure from shareholders, but they would also have bond-holders as well as savers on their backs. This is not to mention the regulators, media and other parties who might take an interest in a bank’s day-to-day business.

In such situations, it is likely that each party will have quite different – and often contradictory - sets of demands. Shareholders might demand a risky profit maximising strategy while savers might push for a safe strategy that minimises risks. The upshot would be that banks would be pulled in multiple directions at once. Under these conditions, it is very difficult to develop a coherent, long-term strategy. There is a real risk that banks will lurch from crisis to crisis, continually changing their strategy in order to appease the most vocal party at a particular moment.

Monoculture takes hold

At the same time as the banks became overloaded, they would also become increasingly similar. This happen as banks with alternative ownership structures find themselves with more shareholders (or bond-holders and savers who behave as if they were shareholders). Clearly shareholders look for very different things in an organisation then a member does. The most obvious is a focus on maximising shareholder value.

And if this mantra takes hold, it is likely to ride roughshod over any other commitments a mutual, privately or publicly held bank might have. If the Co-op experience is replicated throughout Europe, it would mean that what is now a landscape with a rich diversity of business models (municipally owned, co-ops, state owned, privately held and so on) would come to resemble a monoculture. The shareholder-driven bank would become the norm.

Inevitably, larger players would use the rise of dispersed shareholdings as an opportunity to snap up small banks they could not get their hands on in the past. An inevitable wave of closures and consolidation would follow. The end result would be a European banking landscape dominated by a few large banks all with fairly similar business models. This would mean less choice for the customer, more systemic risk (as all our financial eggs will be in a few big baskets), fewer smaller players who are able to experiment with alternatives, and probably less patient investors who are willing to lend to provide capital to Europe’s businesses with a medium to long term perspective.