tag:theconversation.com,2011:/id/topics/bail-ins-6389/articlesBail ins – The Conversation2014-11-10T19:29:57Ztag:theconversation.com,2011:article/323622014-11-10T19:29:57Z2014-11-10T19:29:57ZExplainer: too big to fail and the push for ‘bail ins’<figure><img src="https://images.theconversation.com/files/62784/original/twb6qn92-1414368011.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=496&fit=clip" /><figcaption><span class="caption">Shifting bank risk to taxpayers is deeply unpopular, and there is an alternative.</span> <span class="attribution"><span class="source">Lisa Norwood/Flickr</span>, <a class="license" href="http://creativecommons.org/licenses/by-nc/4.0/">CC BY-NC</a></span></figcaption></figure><p>In the last decade or so, the global financial landscape has endured two major shocks - the first with the 2007 collapse of the sub-prime mortgage market in the United States, and the second emanating out of Europe, with a major loss of confidence in the quality of debt issued by a number of European countries.</p>
<p>The full extent of the collapse in the mortgage backed securities market was not immediately clear, with the financial crisis peaking over a year later in the second half of 2008. The crisis was, of course, not limited to the US - a number of banks and building societies across Europe (notably in England, Ireland, the Netherlands, Spain and Iceland) also sought government assistance.</p>
<p>The European shock was both directly related to the GFC and the increased debt issued by European governments to bail-out their financial institutions, and indirectly via the economic slowdown observed in the US and Europe following the crisis.</p>
<h2>The instrument of choice thus far: bail-outs</h2>
<p>Central bankers have attempted to address the financial crisis by injecting liquidity into credit markets, including extending the types of securities accepted as collateral by central banks, and allowing a wider range of institutions to deal directly with central banks.</p>
<p>Governments, on the other hand, have proposed a number of rescue plans revolving around the partial nationalisation of financially stricken institutions, the provision of deposit guarantees, and the delivery of assistance packages to parts of the economy heavily affected by the ensuing economic downturn. </p>
<p>Bailouts include the US government’s rescue of Fannie Mae and Freddy Mac, the British government’s 2008 nationalisation of Northern Rock, and the provision of emergency loans to a number of European nations. During the last quarter of 2008 alone, governments (predominantly in the US and Europe) purchased about US$1.5 trillion of preference shares in distressed banks.</p>
<p>Government bailouts essentially involve using taxpayer funds to assist distressed institutions. This has typically been undertaken through the provision of financial assistance to the institution in return for an allocation of preference shares. Through this mechanism, taxpayers effectively become investors in a managed fund used to buy toxic or potentially toxic assets.</p>
<p>The rationale for this process is that it’s relatively straightforward for the government to support a shaky financial institution by providing it with funds in return for capital. A potentially lengthy and complex restructure of the institution’s debt and equity structure is avoided. This quick fix is, however, extremely costly - a disproportionately high level of risk is shifted away from bank creditors to taxpayers.</p>
<h2>Bail-out or bail-in?</h2>
<p><a href="https://www.imf.org/external/np/seminars/eng/2012/fincrises/pdf/ch15.pdf">Research</a> has suggested a number of potential problems associated with the government purchase of preferred stock in distressed banks. </p>
<p>Encouraging banks to participate in (fully or partially) voluntary rescue schemes typically requires governments to overpay for preferred stock. Even when governments overpay, however, there is no guarantee banks will increase their lending levels – something all too readily observed during the GFC. Indeed, the probability that banks will increase their lending following a preferred stock recapitalisation appears to be proportional to the extent that governments overpay for preferred stock.</p>
<p>There’s also the possibility of moral hazard, where larger banks are likely to accept greater risk on the basis of an implicit insurance policy formed by the understanding that they are “too big to fail”. Indeed, the issue of moral hazard is at the core of the bail-out or bail-in issue.</p>
<p>In a bail-in, recapitalisation is internal, and results in bondholders accepting a greater level of risk. This typically involves holders of subordinated debt (holders of lower-ranking, unsecured bonds) being forced to convert some of their bonds to equity. </p>
<p>The Financial Stability Board’s proposal to be put to the G20 summit participants in November requires the world’s largest banks to hold a certain amount of capital in the form of bonds that could become equity under certain conditions. Both the capital formula and the conversion trigger points, however, are still under debate. </p>
<p>This capital – defined as the Gone Concern Loss Capacity (or GLAC) – would act as a buffer during any banking crisis, forcing bondholders to accept a higher level of responsibility for their bank’s decisions.</p>
<p>Is this a positive move? It would seem to be. To some extent, bank bondholders have been earning excess returns while essentially holding government bonds. This lowers costs of capital for banks and creates an environment of cheap funding. The GFC is a prime example of the possible consequences stemming from these types of price distortions. Any increment in the cost of capital will, of course, be passed to consumers. This will be the immediately incurred cost of reducing the probability and magnitude of any future bail-out.</p>
<p>If the GLAC measures are implemented correctly, however, this will result in a shift in risk - and its associated costs - away from taxpayers and towards bank debtors and creditors. The accompanying repricing of bank bonds should encourage investors to better evaluate the lending practices of banks. Bondholders will require a greater return for lending to riskier banks, thereby increasing the cost of capital for those banks, and yielding a return for investors more commensurate with the true risks in the banking sector.</p><img src="https://counter.theconversation.com/content/32362/count.gif" alt="The Conversation" width="1" height="1" />
<p class="fine-print"><em><span>Sarantis Tsiaplias does not work for, consult, own shares in or receive funding from any company or organisation that would benefit from this article, and has disclosed no relevant affiliations beyond their academic appointment.</span></em></p>In the last decade or so, the global financial landscape has endured two major shocks - the first with the 2007 collapse of the sub-prime mortgage market in the United States, and the second emanating…Sarantis Tsiaplias, Senior Research Fellow, Melbourne Institute of Applied Economic and Social Research, The University of MelbourneLicensed as Creative Commons – attribution, no derivatives.tag:theconversation.com,2011:article/194562013-10-22T13:54:19Z2013-10-22T13:54:19ZCo-op’s latest blunder spells the end for ethical banking<figure><img src="https://images.theconversation.com/files/33483/original/rkc2qpdc-1382448522.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=496&fit=clip" /><figcaption><span class="caption">Dance with the devil and the devil don't change: he changes you.</span> <span class="attribution"><span class="source">HowardLake</span></span></figcaption></figure><p>The Co-operative Bank is no longer. What was once an experiment in working class self-help has become the <a href="http://www.bbc.co.uk/news/business-24609998">latest victim</a> of rapid changes sweeping the financial sector. It seems unlikely that the ethical values on which the bank was built will survive the transition.</p>
<p>Instead of being a co-operative institution owned and run by its customers, the Co-op is now largely owned by private investors. Its shares will be traded on the stock exchange and will essentially become as any mainstream bank.</p>
<p>How did this bastion of practical socialism fall into the hands of North American hedge funds? To understand this tale, we need to go back to the heady days following the financial crisis. Up until this point, the Co-op had been a relatively stolid institution serving largely working class communities. It was not exciting, but that is how its customers and owners liked it. It was part of the broader Co-op group which provided services such as supermarkets and funerals.</p>
<p>This broader group of businesses traced its origins back to the <a href="http://www.rochdalepioneersmuseum.coop/">Rochdale pioneers</a> in the North of England who had founded co-operatives as an alternative to the private businesses offering them over-priced and poor quality goods. The movement had taken off and spread throughout the country. Parts of the co-op movement were actually the engines of many modern business innovations – particularly in the retail sector.</p>
<p>In 2008 the Britannia building society was the second largest mutual society in the UK. Although it had not demutualised, it had sought to be an aggressive competitor in the financial landscape. This had led it to engage in the riskier end of lending in the property market. When the financial crash came, the idea of merging the Co-op and Britannia to create a “super mutual” was proposed.</p>
<p>Politicians were keen on the plan as it would create a larger organisation that would be a viable alternative to the big high street banks. The CEOs of the companies were pleased as it would be a nice line in their CVs. Customers seemed pleased as it would extend their services. This new super mutual was the darling of the financial sector for a short time. It was hailed as an ethical alternative to the naughty high-street banks.</p>
<p>But mergers and acquisitions are often <a href="http://www.jstor.org/stable/2393810">driven by hubris</a> at the top and sure enough, the goodwill went to the heads of some members of the Co-op’s senior management, who seemingly overlooked the negatives when deciding to merge with Britannia. When Lloyds was forced to sell off more than 600 branches to comply with competition law, they saw an opportunity to extend their operations even further. If the Co-op’s bid was successful, they thought, it would become one of the biggest players on the high street.</p>
<h2>Trouble in paradise</h2>
<p>But behind the scenes, all was not well. After the merger, things began to look a little less rosy. For a start, integrating the IT systems from the Co-op and Britannia proved to be a costly exercise. But the big shock came when it was revealed that a series of bad loans had been secreted away on Britannia’s balance sheets. This only became public knowledge when Moodys downgraded the Co-op’s credit rating to <a href="https://www.moodys.com/research/Moodys-downgrades-Co-Operative-Banks-ratings-following-announcement-of-exchange--PR_275850">junk status</a>.</p>
<p>The plans to take over the Lloyds branches were dropped. On top of this, <a href="http://www.bloomberg.com/news/2013-06-17/co-op-bank-to-raise-1-5-billion-pounds-to-improve-capital-base.html">the Financial Conduct Authority</a> found the Co-op had a £1.5 billion hole in its balance sheet when it conducted an inquiry into capital ratios on the main high street banks.</p>
<p>While its commercial competitors could go back to shareholders and money markets to fill any gaps, the Co-op was in a tighter spot. It did not have shareholders to hit up or a profitable investment banking operation it could plunder. So instead, senior management concocted a plan whereby bond holders (people who had lent the bank money for a fixed rate of return) would accept a new deal with the bank.</p>
<p>A key feature of the deal was that if the bank went belly up, it would be “<a href="https://theconversation.com/bail-ins-are-the-new-bail-outs-but-they-wont-save-banking-15826">bailed in</a>” by the bondholders. This would mean their bonds would be converted into shares of the hypothetically worthless company. The big advantage of this was that the Co-op could guarantee to the government that it would not need to fork out for a potentially costly bail-out. Instead, bondholders would bear the brunt.</p>
<p>Naturally the deal proposed by the Co-op did not thrill many of the bondholders. The small time investors, who owned about £60m worth of bonds, complained about additional risk and potentially lower returns and the bigger investors were annoyed that they were being asked to burden the risks which typically come with being a shareholder without getting the benefit of having a say in how the company is run. </p>
<p>These concerns led the largest bondholders, including two US hedge funds, to refuse the terms on the table. Instead of having bonds that could be bailed in at any time, they demanded shares in the Co-op. And this, eventually, is what they got. The upshot of this weekend’s wrangling is that, ultimately, the Co-operative group will only own 30% of the Co-Op Bank. The remainder will be private.</p>
<h2>Ethics out the window?</h2>
<p>The management of the Co-op has, as one might expect, given assurances that the changes will not affect the bank’s distinctly “ethical” approach. But the evidence of what happens when a mutual banks goes private casts some doubt on these fine words. [Studies](http://envplan.com/epc/fulltext/c21/c30m.pdf](http://envplan.com/epc/fulltext/c21/c30m.pdf) suggest that demutualised banks tend to drop their focus on doing good and instead focus on doing well for shareholders.</p>
<p>This was evident when many ex-mutuals became some of the <a href="http://research-information.bristol.ac.uk/files/7177468/From_Demutualisation_to_Meltdown_Klimecki_Willmott.pdf">worst offenders</a> in the lead up to the financial crisis. Banks that were formerly co-operatively owned, such as Northern Rock and Bradford and Bingley were dominated by a hard-driving sales culture, and dodgy loan books to match.</p>
<p>This entrepreneurial zeal did not make ex-mutual banks much more successful. Mutually owned banks actually tend to <a href="http://www.sciencedirect.com/science/article/pii/S0378426698001228">outperform</a> shareholder owned banks and this became apparent when, on the whole, the ex-mutuals became <a href="http://www.emeraldinsight.com/journals.htm?articleid=1896085&show=abstract">less efficient</a>. When these banks began to cost more to run than they produced, the whole sector became less efficient as a consequence.</p>
<p>The switch to shareholder ownership also meant customers had <a href="http://onlinelibrary.wiley.com/doi/10.1111/j.1467-8683.2007.00644.x/full">less choice</a> in terms of financial products which they might buy and that financial services shifted into the <a href="http://onlinelibrary.wiley.com/doi/10.1111/j.0020-2754.2000.00221.x/abstract">City of London</a>.</p>
<p>If we take the evidence seriously, then the transfer of the Co-op into private hands is likely to make it a less ethical, less well staffed, and less efficient institution. It will also mean customers have less choice and local communities may find increasingly isolated from access to finance.</p><img src="https://counter.theconversation.com/content/19456/count.gif" alt="The Conversation" width="1" height="1" />
<p class="fine-print"><em><span>Andre Spicer does not work for, consult, own shares in or receive funding from any company or organisation that would benefit from this article, and has disclosed no relevant affiliations beyond their academic appointment.</span></em></p>The Co-operative Bank is no longer. What was once an experiment in working class self-help has become the latest victim of rapid changes sweeping the financial sector. It seems unlikely that the ethical…Andre Spicer, Professor of Organisational Behaviour, Cass Business School, City, University of LondonLicensed as Creative Commons – attribution, no derivatives.tag:theconversation.com,2011:article/158262013-07-09T13:29:50Z2013-07-09T13:29:50ZBail ins are the new bail outs, but they won’t save banking<figure><img src="https://images.theconversation.com/files/27165/original/qvd8mxv5-1373366930.jpg?ixlib=rb-1.1.0&rect=34%2C390%2C2861%2C1504&q=45&auto=format&w=496&fit=clip" /><figcaption><span class="caption">Taking on water is the last thing a sinking vessel needs.</span> <span class="attribution"><span class="source">amirjina</span></span></figcaption></figure><p>Bailing out banks is so 2008. It seems 2013 is the year of the bank “bail in”.</p>
<p>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 <a href="https://theconversation.com/what-went-wrong-for-the-co-op-bank-14308">financial precipice</a>. Now the European Union has agreed to <a href="http://www.guardian.co.uk/business/2013/jun/27/eu-agrees-banks-bail-in-deal">do the same</a> with its failing banks. </p>
<p>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.</p>
<p>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.</p>
<p>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.</p>
<h2>Negative spirals</h2>
<p>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. </p>
<p>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.</p>
<h2>Bailing in is infectious</h2>
<p>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. </p>
<p>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.</p>
<h2>A question of trust</h2>
<p>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. </p>
<p>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. </p>
<p>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.</p>
<h2>Bond holders on your back</h2>
<p>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. </p>
<p>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.</p>
<h2>Monoculture takes hold</h2>
<p>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. </p>
<p>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. </p>
<p>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.</p><img src="https://counter.theconversation.com/content/15826/count.gif" alt="The Conversation" width="1" height="1" />
<p class="fine-print"><em><span>Andre Spicer does not work for, consult, own shares in or receive funding from any company or organisation that would benefit from this article, and has disclosed no relevant affiliations beyond their academic appointment.</span></em></p>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…Andre Spicer, Professor of Organisational Behaviour, Cass Business School, City, University of LondonLicensed as Creative Commons – attribution, no derivatives.