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"Contingent convertible" notes – instruments that automatically bail in creditors when banks run into trouble – have proved a hit in the US, Europe and UK. Mario Draghi, European Central Bank president, is proving a rare exception. Berlin insists bail-ins of creditors – though not depositors – should be a condition for a bank to access EU bailout funds. Advocates say they would sort out failing banks by imposing losses on private investors, with the minimum of financial fallout and taxpayer exposure.
But bail-ins are fool’s gold. They will not save taxpayers from exposure to financial crisis – and they could, in some circumstances, make matters worse. Bail-in bonds are market-based insurance instruments. They may sound new but they are a throwback to the failed philosophy at the heart of the 2004 Basel II global banking rules, which made the market pricing of risk the frontline defence against financial crises. Financial crises are a result of market failure. Market prices cannot easily protect us from market failure.
Bail-ins are meant to occur before a bank has failed – in order to avert failure – but bail-ins at several simultaneously will bring forward a crisis and spread it further. Financial crashes occur because markets do not anticipate them. As bail-in investors face unanticipated losses, they and others will swing into risk-averse mode. Their fire-sale of other assets will cripple financial markets, sending asset values into further decline and making the banking system appear even less solvent.
Bail-ins make for good politics but bad economics. Ostensibly, their raison d’être is saving taxpayers. Yet in practice “creditor bail-ins” – such as those of Lehman Brothers, Bank of Cyprus and, more widely, in Spain and Greece – have been far more costly than when taxpayers move to temporary ownership, as with Lloyds and RBS in the UK.
The reality is that, once regulation has failed and a financial crisis is upon us, the only operator with enough of the assets that matter – liquidity and credit – is the taxpayer.
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