How a Bail-In Could Save the Italian Financial System: Quicktake Q&A

The term bailout became well known -- and widely hated -- during the 2008 financial crisis as governments around the world spent almost $1 trillion to rescue their banks from collapse. The term bail-in was coined after the crisis by bankers who wanted to assure the public that the biggest lenders could survive without any more taxpayer handouts. So bail-in is supposed to be the antidote to bailout.

1. What’s a bail-in?

A bail-in forces creditors of a bank to shoulder losses when the firm fails. Banks go belly-up when their shareholder equity is wiped out, which happens when loans or investments they’ve made go sour. When you bail in the creditors -- typically through a debt-for-equity swap -- they become new shareholders of the bank while it goes through a resolution process similar to bankruptcy. It’s less disruptive because the bank can continue functioning with the fresh capital from the creditors. Although it was originally construed as part of a quick resolution mechanism, the term bail-in has come to cover every case of creditor loss-sharing when a bank gets in trouble.

2. Why is it in the news?

Italy is hammering out details of its rescue of the world’s oldest bank, Banca Monte dei Paschi di Siena SpA. In this case, Italian taxpayers are still going to foot much of the bill and the bank won’t be wound down. Yet European Union rules require some sort of bail-in before a government bailout is allowed. Call it the bail-in before the bailout.

3. Who’s pushing the idea?

Credit Suisse Group AG executives coined the term in 2010 when they proposed a resolution mechanism that would replace government bailouts. Other bankers and then regulators in the U.S. and Europe quickly jumped on the bandwagon. The U.S. and the EU both included the concept of bail-in in their bank resolution laws. Republicans in the U.S. Congress, who have long opposed a resolution process run by regulators, are trying to repeal that section of the 2010 bank reform. If they succeed under President Donald Trump, bail-in would cease to exist in the U.S. as part of the regulation.

4. What’s the case for bail-in?

Bankers and most regulators have long argued that banks can’t be put through a regular bankruptcy process because their assets lose value extremely fast. A regulator-supervised resolution that keeps a bank running while winding it down could help prevent a loss of value. Banks need continuous funding to maintain their assets and a bail-in provides fresh equity to help bridge the gap. Creditors who are bailed in benefit if assets can be sold in an orderly fashion. Putting bondholders on the hook is also supposed to reduce the moral hazard of managing banks, which have enjoyed an implicit government backing because of potential risks to the financial system and the economy.

5. What does the market say?

Prices of bank subordinated bonds, which would be the first ones to be bailed in, gyrate wildly when a bank’s financial health comes into question. Yet banks that were bailed out by their governments just a few years ago can sell bail-in-able debt at low yields as well. Markets seem to be mixed on whether they believe bail-ins will happen next crisis around.

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