Legal Aspects of Bank Bail-ins
LSE FINANCIAL MARKETS GROUP PAPER SERIES, LSE-FMG-SP-205, ISSN 1359-9151-205
35 Pages Posted: 25 Jan 2021
Date Written: January 20, 2012
The aim of bail-in is that governments should have an alternative option to taxpayer-funded rescues of systemic banks. It operates through a mechanism whereby an insufficiently solvent bank can be returned to balance sheet stability by writing down not only the claims of its subordinated creditors but also some of its senior creditors; converting their claims to equity. To be effective, the mechanism should be "hybrid", in that the terms of the relevant instruments should provide for the bail-in to operate through private contract, but the power to trigger the bail-in and to determine the extent of write-down and the resulting compensation should be vested in the relevant public authority.
The primary objective of bail-in is to enable the relevant institution to avoid a sudden and disorderly liquidation by enabling it to continue in business as a going concern until it can be restructured or run down. This avoids the systemic damage which results from a "sudden stop" insolvency, reduces contagion within the financial system and potentially preserves critical functions. It is particularly attractive in respect of institutions or groups whose business are too complex or too international to be capable of being disintegrated into a "good bank"/"bad bank" model in the relatively short space of time required if the good bank is to continue in business without government support.
The primary weakness of a bail-in as a bank restructuring tool is that although it renders the firm creditworthy, it provides no new cash. Thus in order to survive the firm must not only be creditworthy, but credibly creditworthy to at least its central bank, and preferably to the market as a whole. It is therefore likely that bail-in will require statutory backing in order to convince counterparties to continue dealing with it post-reconstruction.
Much of the discussion about bank resolution is predicated on the basis of the simplifying assumption that a bank is a single entity. In economic terms this is broadly correct, but in legal terms it is clearly not. Most banks, and all systemically important banks, are groups of legal entities. In legal terms groups do not exist – it is only the companies which comprise the group which can enter into contracts, incur liabilities or fail. This is not, however the way that economists (or people generally) see the world. Businesses are generally thought of as single undertakings –"Ford" or "BP" are unitary concepts. Thus for a lawyer it makes perfect sense to talk of a group being partially insolvent, in that some of its components are insolvent whilst others are not. For non-lawyers, however, the concept is almost meaningless – it is like speaking of a human being as being partly dead.
However, in the same way that it is possible in emergencies to preserve the life of a living organism by removing dead parts, it is possible in emergencies to save parts of bank groups by allowing other parts to become insolvent. To press the analogy slightly further, the question of whether this is possible or not rather depends on the functions of the parts being amputated. There are some parts of a group whose removal can be accomplished without damaging the business of the group as a whole; but there are others whose removal entails the immediate and automatic extinction of the entire organism. It is by no means always crystal clear which is which. There is therefore no automatic answer to the question "what are we trying to resolve – the group or the bank?" - the only meaningful answer is "it depends".
Consequently it is necessary to think about bank resolution tools not only in the context of individual undertakings, but also in the context of how those tools could be applied to bank subsidiaries within a group, to parent companies of banks, and potentially to non-bank subsidiaries of banks. This is a difficult piece of analysis. To complicate matters further, bank groups are by no means uniform, and different bank managements have different strategies as to how the economic activity of the bank should be reflected in the legal structure of the group. I conclude by suggesting a basic taxonomy of bank groups which may permit these issues to be addressed.
Keywords: bank, resolution, bail-in, bail-out, bankruptcy, insolvency, banking system
JEL Classification: G21, G33, E58
Suggested Citation: Suggested Citation