Pondering "Bail-Ins" Instead Of "Bail-Outs"

The Economist had an interesting article recently co-written by Credit Suisse's investment banking head Paul Calello and former chief risk officer Wilson Ervin. They suggest that, rather than bail out banks in the future, they could be "bailed-in." What does that mean? Essentially that regulators could take hold of troubled banks and require them to rework their capital structure to avoid failure. It would sort of work like a pre-packaged bankruptcy. The idea makes sense, but I wonder: isn't this exactly what a new resolution authority would do?

We all remember how Lehman tried to avoid bankruptcy, but failed. The authors give a lengthy explanation of how a so-called bail-in would have worked in that case:

How would it have worked? Regulators would be given the legal authority to dictate the terms of a recapitalisation, subject to an agreed framework. The details will vary from case to case, but for Lehman, officials could have proceeded as follows. First, the concerns over valuation could have been addressed by writing assets down by $25 billion, roughly wiping out existing shareholders. Second, to recapitalise the bank, preferred-stock and subordinated-debt investors would have converted their approximately $25 billion of existing holdings in return for 50% of the equity in the new Lehman. Holders of Lehman's $120 billion of senior unsecured debt would have converted 15% of their positions, and received the other 50% of the new equity.

The remaining 85% of senior unsecured debt would have been unaffected, as would the bank's secured creditors and its customers and counterparties. The bank's previous shareholders would have received warrants that would have value only if the new company rebounded. Existing management would have been replaced after a brief transition period.

The equity of this reinforced Lehman would have been $43 billion, roughly double the size of its old capital base. To shore up liquidity and confidence further, a consortium of big banks would have been asked to provide a voluntary, multi-billion-dollar funding facility for Lehman, ranking ahead of existing senior debt. The capital and liquidity ratios of the new Lehman would have been rock-solid. A bail-in like this would have allowed Lehman to open for business on Monday.

So essentially, you wipe out current shareholders and convert a portion of debt to equity. Then hope banks provide (a lot of) liquidity. A few comments.

First, the authors don't see why bankruptcy code can't do this today. Here's their answer: it can, but not quickly. That's what bankruptcy proceedings are for, and they can last years. Clearly, that's not an option if you want to avoid a disastrous financial crisis. The authors want to streamline the process; well, I do too. And that's the whole concept behind a non-bank resolution authority. It would require "failure plans" from large institutions that would anticipate how to handle bankruptcy. Indeed, a firm's failure plan could look exactly like this. With the new regulator, this would be possible. But for now, it isn't. Once in place, it may wind-down some institutions if their problems are too great to keep them afloat, but in other instances it could rely on plans like this for reorganization.

My biggest concern with this idea is liquidity. I'm a little less confident than the authors that banks would get in line to provide billions of dollars in cash to their troubled brethren. After all, we're talking about a market where a credit crunch is probably underway. And liquidity is a significant problem for a bank that runs into trouble. I remember talking to people who worked at Lehman in 2008 about how, internally, people were worried about the firm making payroll in its final weeks.

But overall, I agree that a quick, orderly, bankruptcy plan makes sense. But so does everyone else who supports the idea of a non-bank resolution authority. Indeed, that's exactly what we're calling for. Other reforms should still be put in place, however, like leverage limits and higher capital requirements to promote bank safety in a more general sense.

(Thanks to our esteemed Deputy Managing Editor, James Gibney, for bringing this article to my attention!)



Wilson Ervin was kind enough to provide a response to this post:

We thought it might be helpful to address 2 important issues raised by this reviewer:

First of all, we share the reviewer's concern with liquidity - this was clearly the main short term threat to Lehman during their last weeks. But some less-publicized events from the "Lehman weekend" at the Fed are instructive here, as they actually tested liquidity options at a moment of high stress. Over that weekend, the CEO's of the major banks committed to fund a $37bn loan to the Lehman "bad bank" (the troubled assets that Barclay's intended to leave behind in their acquisition proposal). They also committed to a large funding facility to support other major institutions, should that be necessary. If funding can be raised under these circumstances, we believe that the prospects are reasonably good for for private funding of a recapitalized (i.e. post Bail-In) bank. However, to improve the likelihood of success further, we ave suggest that it would be useful to have the capability to treat new emergency funding ahead of other senior debt.

Second, the reviewer mentions that our idea is similar to many other plans for resolution authority. But there is a crucial - perhaps subtle - difference. The main distinction between our proposal and others is our emphasis on recapitalizing a troubled bank as a going concern, not killing it through an orderly liquidation. In the case of Lehman, the bankruptcy /liquidation option cost Lehman investors - and the system overall - well over $100 billion dollars vs a going concern solution. Perhaps a more orderly process would reduce the bill somewhat. But our view is that liquidation of a large bank is likely to be hugely expensive. It will likely still trigger the systemic knock-on effects that pounded our markets and economy. This is an unnecessary expense and unnecessary risk. Our proposed solution reduces the risk of systemic contagion by accessing other portions of the capital structure and keeping the institution alive. A system which uses private capital - not taxpayer bailouts - to resuscitate large banks would give us a powerful new solution to the bank resolution dilemma.

As for the subtlety: it was my understanding (or at least hope) that a resolution authority would actually seek to restructure and revive a firm if it's possible to do so through reconfiguring the capital structure. It is my understanding that the FDIC doesn't automatically close all troubled depository institutions, for example, but when possible orders changes so to keep them afloat. So I agree with the point, and understood this to be an implicit responsibility of the resolution authority. Of course, if a firm is beyond repair (read: AIG), then the regulator would wind it down.