Bail-in and Market Stabilization

Wolf-Georg Ringe is Professor of International Commercial Law at Copenhagen Business School and at the University of Oxford. This post is based on recent paper authored by Professor Ringe.

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 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 policy purpose of bail-in.

In a recent paper, Bail-In between Liquidity and Solvency, I trace the development of the bail-in concept since it was first conceived in 2010 and demonstrate that it has undergone an important conceptual metamorphosis over the past few years. I argue that the objective of bail-in has changed over time, developing from a purely redistributory goal (to avoid taxpayer liability) to a market stabilization purpose (to stem panic by avoiding value-destroying runs). 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.

From this insight, the paper derives a number of regulatory implications. 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. Chiefly, I argue 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, I make 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.

Overall, the 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. Measured against Bagehot’s classic toolkit, bail-in appears as 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. Crucially, however, the success of bail-in will depend on how credible the legal framework is.

The full paper is available here.

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