Finance: Research, Policy and Anecdotes

I am on my way back from Brussels where I spoke about Bailing-in vs. Bailing-out at the SAFE Summer Academy, a policy workshop organised every September by Jan Pieter Krahnen. The answer to bailing in or bailing out is not clear cut.  Trade-off is certainly one of economists’ most popular words (just ask Harry Truman who was desperate for a one-handed economist) and bank resolution is one of the areas where this trade-off is most prominent.  On the one hand, bailing banks out sends the wrong signal to banks that aggressive if not reckless risk-taking will always pay off (heads - I win, tail - you lose).  It is inherently unfair as those who took risk decisions are able to share the downside with the broader public, i.e., the taxpayer. And it has negative repercussions for resource allocation in the economy and thus, ultimately, for long-term growth.  On the other hand, contagion risks, the loss of access to external funding by borrowers and the protection of small depositors and savers are arguments in favour of bail-outs, especially in crisis times.  And the empirical evidence has provided evidence for both – for the moral hazard risks of too generous deposit insurance and the negative effects of bank failures for the real economy. And there is also a strong time inconsistency in this - ex–ante it is optimal to insist on market discipline and bail-in, ex-post it might be better to provide a bail-out. 

Europe has gone from a system that by construction was biased towards bail-out to a system that features many elements of bail-in.   By construction, as there were no proper bank resolution regimes in place in 2008, so that the options were to either send failing banks through corporate insolvency regimes (which would take years and exacerbates any negative effects of bank failure for the rest of the financial system and the real economy) or to bail them out.  In most cases, European governments went for bail out, partly motivated by the experience of the Lehman Brothers shock.  High debt/GDP ratios and political resistance has resulted in a shift towards more market discipline, formalised in the EU’s Bank Recovery and Resolution Directive, which prohibits state aid before bailing in junior debtholders or Tier 2 capital holders, and applied in several cases even before this Directive, including in the case of SNS Reaal in the Netherlands and the resolution of Cypriot banks. The recent bail-ins of retail investors in Italy (who most likely have been mis-sold their junior debt products) have led to second thoughts. There is also the question whether the new system has become too rigid in terms of focusing on bail-in rather than bail-out, not taking into account economic circumstances.  Most problematic, in my opinion, is that the new regime has been put in place without addressing the legacy problems across Europe.  

The experience so far provides for a rich policy agenda going forward. What exactly are the instruments to be bailed in?  There is still a high degree of heterogeneity across Europe, which calls for harmonisation if we want to achieve a single market in banking.  And who should hold these instrument?  Retail investors (maybe only if properly informed)? Institutional investors, such as public pension funds (would that have the same effect as bail-out by tax payers)?  Most importantly, can bail-in really work in a systemic banking crisis, when the main objective might be to limit contagion effects?   When it comes to more efficiently resolving banks, how can we improve the resolvability of banks? Do structural reforms such as ring-fencing help?  Are resolution and recovery plans (aka living wills) the way forward? Critically, does one size fit all?  While small and mid-sized banks might be resolved through good bank-bad bank and purchase and assumption techniques, this might not work for larger banks, where bridge bank solutions might be more feasible.   And this list does not even touch on the issue of cross-border banking, which I will leave for another day. 

In summary, market discipline is important and bail-in is an important part of that. Will the new regime be the end of any taxpayer-funded bail out?  No, and it might be for the better. 

Overview