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A New Year 'Bail-in' Resolution

January 12, 2015

The financial world is changing at a very fast pace and we would like to share with you some observations of alarming recent developments in the financial system. The New Year resolution of political leaders seems to be the global implementation of the bail-in framework, which should raise concerns for anyone holding large cash balances in the banking system.

An Overview of Our Risky Financial System

Our financial system can be visualized as an inverted pyramid with the asset classes of larger size (and risk) at the top. Most people are aware that gold is a scarce resource but are usually not aware of the sheer volume of other financial products which currently exist.

The best way to understand the inherent risk in the system is to imagine what would happen to the assets values above in the context of a crisis with interest rates spiking upwards. The upper layers of the pyramid would be liquidated in a panic that would likely involve the opaque over-the-counter derivatives markets. A few of the world’s largest banks hold the bulk of all derivative contracts (most of which are interest rate derivative contracts), which have notional amounts in the 10s of times their assets and 100s of times their market capitalizations. Some banks would lose tremendously and fail, and some others would gain tremendously but would be unable to recover their gains from failed counterparties. In a rising interest rates environment, the values of debt, real estate (financed by debt) and over-leveraged equities would fall.

Whilst the upper layers evaporate as their liquidity dries up, capital will seek refuge in the “most marketable good” or the most liquid asset further down the pyramid. Many people holding assets located at the top of the pyramid will lose parts of their capital on the way down in the flight to liquid and to less-risky assets.

Large Institutions Have Become Risky Counterparties

Most people have a hard time picturing large institutions failing but this happened in the very recent past (AIG, Lehman Brothers, Northern Rock, Bear Stearns, etc.) and it is likely to happen again in the near future. The largest banks have high leverage ratios, or low equity ratios (in the single-digit percentage points). This means that they can quickly become insolvent should the value of their assets decrease by a few percent. Therefore, they do represent a high counterparty risk and their large balance sheet can quickly become fragile in times of crisis.

Bank Depositors are Unsecured Creditors

It is a little known fact that depositors of a bank are unsecured creditors of that institution. Their funds are not held in segregated accounts nor are they being kept safe by the bank. A depositor is deemed to have lent his money to the bank and the money therefore belongs to the banker.

The current state of the law is expressed through several cases of jurisprudence in British courts and clearly indicates the nature of bank deposits as unsecured loans:

If Institutions Fail, Recapitalization Will Be Funded By Creditors in the Form of Bail-ins Following the global financial crisis at the Pittsburgh Summit in 2009, the G-20 leaders endorsed the objective of strengthening the financial regulatory system and, inter alia, finding a new approach to manage the systemic risks associated with failures of “too big to fail” institutions. Bail-outs are no longer an option, because of their unpopularity and of the dire state of public finances globally.

G20 leaders asked the Financial Stability Board (FSB) to develop a policy framework to address the systemic risks associated with large financial institutions. The FSB developed a set of policy measures that included, among other tools, mandatory creditor-funded recapitalizations (in other words, “bail-ins”). This framework was endorsed at the Seoul Summit in 2010 and implementation of these measures has started in 2012, with full implementation targeted for 2019.

Unsurprisingly, the creditor-funded recapitalization template laid out by the FSB has been endorsed by the Bank of International Settlements (BIS) and the International Monetary Fund (IMF) who have also released position papers in support of the bail-in framework.

The below reports released by powerful supranational institutions that are shaping our financial system highlight this shift in policy:

Financial Stability Board , 2011, Effective Resolution of Systemically Important Financial Institutions

Let’s See What Happens To Depositors In The Case Of a Bail-In Laiki Bank and Bank of Cyprus ran into financial difficulties in mid-2012. A bail-out was refused by European institutions and, after a 10-day bank holiday and over a weekend, the decision was taken in March 2013 to loot the accounts of depositors to recapitalize Bank of Cyprus while Laiki Bank was left to fail. Any deposit above EUR 100,000 at Laiki Bank was lost. At Bank of Cyprus, 47.5% of the amount of deposits above EUR 100,000 was converted into shares of the bank. The shares tanked to 20% of the issue price and stopped trading until this date. Let’s see how depositors fared during the bail-in of the banks: The fate of depositors of Laiki Bank & Bank of Cyprus during the Cyprus Bali-in

Cyprus Is Not A One-Off Event But A Template For The Future

Many countries are in favor of implementing the Cyprus template and have already passed legislation to do so. You will notice that most of these initiatives were started long before the Cyprus bail-in of 2013:

Europe passed the bail-in rule to be in effect in 2016 and Germany, as a good student, recently announced that it will apply these rules in 2015, one year earlier than the European rule.

In 2012, the Bank of England published a report in cooperation with the FDIC of the USA in favor of the bail-in system.

The United States has provisions in the Dodd-Frank act that allow a European style bail-in of a failed institution (under Title II’s Orderly Liquidation Authority).

Canada’s 2013 budget made an explicit recommendation of using a bail-in system in case of need (p. 145: “The Government proposes to implement a bail-in regime for systemically important banks.”).

In 2012, the Swiss Financial Market Supervisory Authority (FINMA) passed an ordinance that grants the FINMA “comprehensive powers to restructure and resolve banks” and which “has deliberately not excluded deposits from the "bail-in" and has instead placed the deposits last in the order of ranking”.

In 2012, the Australian Prudential Regulation Authority released the report “Implementing Basel III capital reforms in Australia” favoring the bail-in system.

In 2011, New Zealand introduced the Open Bank Resolution scheme which states that: “a portion of depositors’ and other unsecured creditors’ funds will be frozen to bear any remaining losses.”

Countries In Favor Of Or Having Implemented Bail-In Legislation

Bank Depositors Will Be Sacrificed In The Next Banking Crisis

Depositors with large cash balances are the worst positioned to face the next banking crisis due to their status as unsecured creditors. In the case of insolvency of a bank, the depositor stands last in the queue of creditors to be paid and is the first to suffer in the case of a bail-in (which seems to be the new standard to deal with failed institutions).

The bail-in framework turns the legal regime of bankruptcy on its head. Bankruptcy laws used to protect creditors while letting the failed enterprise disappear. The current bail-in regime does the exact opposite: it protects the failed institution at the expense of the creditor. This sure looks like the materialization of a Marxist dream.

It Is Imperative to Keep Liquid Assets Outside Of The Financial System