Bailout


A bailout is the provision of financial help to a corporation or country which otherwise would be on the brink of bankruptcy. A bailout differs from the term bail-in under which the bondholders or depositors of global systemically important financial institutions are forced to participate in the recapitalization process but taxpayers are not. Some governments also have the power to participate in the insolvency process; for instance, the U.S. government intervened in the General Motors bailout of 2009–2013. A bailout can, but does not necessarily, avoid an insolvency process. The term bailout is maritime in origin and describes the act of removing water from a sinking vessel using a bucket.

Overview

A bailout could be done for profit motives, such as when a new investor resurrects a floundering company by buying its shares at firesale prices, or for social objectives, such as when, hypothetically speaking, a wealthy philanthropist reinvents an unprofitable fast food company into a non-profit food distribution network. However, the common use of the phrase occurs where government resources are used to support a failing company typically to prevent a greater problem or financial contagion to other parts of the economy.
For example, the US government assumes transportation to be critical to the country's general economic prosperity. As such, it has sometimes been the policy of the US government to protect major US companies responsible for transportation from failure by subsidies and low-interest loans. Such companies, among others, are deemed "too big to fail" because their goods and services are considered by the government to be constant universal necessities in maintaining the nation's welfare and often, indirectly, its security.
Emergency-type government bailouts can be controversial. Debates raged in 2008 over if and how to bail out the failing auto industry in the United States. Those against it, like pro-free market radio personality Hugh Hewitt, saw the bailout as unacceptable. He argued that the companies should be dismantled organically by the free-market forces so that entrepreneurs may arise from the ashes; that the bailout signals lower business standards for giant companies by incentivizing risk, creating moral hazard through the assurance of safety nets that ought not be but unfortunately are considered in business equations; and that a bailout promotes centralized bureaucracy by allowing government powers to choose the terms of the bailout. Furthermore, government bailouts are criticized as corporate welfare, which encourages corporate irresponsibility.
Others, such as economist Jeffrey Sachs, have characterized the particular bailout as a necessary evil and have argued in 2008 that the probable incompetence in management of the car companies is an insufficient reason to let them fail completely and to risk disturbing the delicate economic state of the United States, as up to three million jobs rested on the solvency of the Big Three and things were bleak enough as they were.
Randall D. Guynn noted similar arguments for the financial bailouts of 2008, explaining that most policymakers considered bailouts to be the lesser of two evils, given the lack of effective resolution options at the time.
In the 2008 financial crisis, large amounts of government support were used to protect the financial system, and many of those actions were attacked as bailouts. Over $1 trillion of government support was deployed in this period and "voters were furious." The US Troubled Asset Relief Program authorized up to $700bn of government support of which $426bn was invested in banks, American International Group, automakers, and other assets. TARP recovered funds totalling $441.7 billion from $426.4 billion invested, earning a $15.3 billion profit.
In the United Kingdom, the bank rescue package was even larger, totaling some £500bn.
Controversial bailouts occurred in other countries as well, such as Germany, Switzerland, Ireland, and several other countries in Europe.

Bailout vs. bail-in

A bail-in is the opposite of a bail-out because it does not rely on external parties, especially government capital support. A bail-in creates new capital to rescue a failing firm through an internal recapitalization and forces the borrower's creditors to bear the burden by having part of the debt they are owed written off or converted into equity.

Theory

The bail-in was first proposed publicly in an Economist Op-Ed "From Bail-out to Bail-in" in January 2010, by Paul Calello and Wilson Ervin. It was described as a new alternative between "taxpayer bail-outs and systemic financial collapse." It envisioned a high-speed recapitalization financed by "bailing-in" bondholder debt into fresh equity. The new capital would absorb losses and provide new capital to support critical activities, thereby avoiding a sudden disorderly collapse or fire sale, as seen in the Lehman failure. Management would be fired and shareholders would be displaced by the bailed-in bondholders, but the franchise, employees and core services could continue, supported by the newly converted capital.
Around the same time, the Bank of England was developing similar architecture, given the pressing need for a better tool to handle failing banks during the 2008 financial crisis. The first official discussion of bail-in was set out in a speech by Paul Tucker, who chaired the Financial Stability Board Working Group on Cross Border Crisis Management and was also deputy governor for Financial Stability at the Bank of England. In March 2010, Tucker began to outline the properties of a new "bail-in" strategy to handle the failure of a large bank:
By October 2011, the FSB Working Group had developed this thinking considerably and published the "Key Attributes of Effective Resolution Regimes for Financial Institutions." The document set out core principles to be adopted by all participating jurisdictions, including the legal and operational capability for such a super special resolution regime.
The scope of the planned resolution regime was not limited to large domestic banks. In addition to "systemically significant or critical" financial institutions, the scope also applies to two further categories of institutions Global SIFIs and "Financial Market Infrastructures " like clearing houses. The inclusion of FMIs in potential bail-ins is in itself a major departure. The FSB defines those market infrastructures to include multilateral securities and derivatives clearing and settlement systems and a whole host of exchange and transaction systems, such as payment systems, central securities depositories, and trade depositories. That would mean that an unsecured creditor claim to, for example, a clearing house institution or a stock exchange could in theory be affected if such an institution needed to be bailed in.
The cross-border elements of the resolution of globally significant banking institutions were a topic of a joint paper by the Federal Reserve and the Bank of England in 2012.
Outgoing Deputy Director of the Bank of England Paul Tucker chose to open his academic career at Harvard with an October 2013 address in Washington to the Institute of International Finance in which he argued that resolution had advanced enough in several countries that bailouts would not be required and so would be bailed-in, notably the US G-SIBs. Although they were still large, they were no longer too big to fail because of the improvements in resolution technology.
In a similar vein, a GAO report in 2014 determined that the market expectation of bailouts for the largest "too big to fail" banks had been largely eliminated by the reforms. That was determined by various methods, especially by comparing the funding cost of the biggest banks with smaller banks that are subject to ordinary FDIC resolution. That differential, which had been large in the crisis, had been reduced to roughly zero by the advance of reform, but the GAO also cautioned that the results should be interpreted with caution.
In Europe, the EU financial community symposium on the "Future of Banking in Europe" was attended by Irish Finance Minister Michael Noonan, who proposed a bail-in scheme in light of the banking union that was under discussion at the event. Deputy BoE Director Jon Cunliffe suggested in a March 2014 speech at Chatham House that the domestic banks were too big to fail, but instead of the nationalisation process used in the case of HBOS, RBS and threatened for Barclays, those banks could henceforth be bailed in.
A form of bail-in was used in small Danish institutions as early as 2011, as well as the later conversion of junior debt at the Dutch Bank SNS REALL. However, the process did not receive extensive global attention until the bail-in of the main banks of Cyprus during 2013, discussed below. The restructuring of the Co-op bank in the UK has been described as a voluntary or negotiated bail-in.

Legislative and executive efforts

The Dodd–Frank Act legislates bank resolution procedures for the United States under Title I and Title II. Title I refers to the preferred route, which is to resolve a bank under bankruptcy procedures aided by extensive pre-planning.
Title II establishes additional powers that can be used if bankruptcy is seen to pose "serious and adverse effects on financial stability in the United States", as determined by the Secretary of the Treasury, together with two thirds Federal Reserve Board and two thirds of the FDIC board. Like Title I, it would force shareholders and creditors to bear the losses of the failed financial company, "removing management that was responsible for the financial condition of the company." The procedures also establish certain protections for creditors, such as by setting a requirement for the payout to claimants to ve at least as much as the claimants would have received under a bankruptcy liquidation.
The FDIC has drawn attention to the problem of post-resolution governance and suggested that a new CEO and Board of Directors should be installed under FDIC receivership guidance.
Claims are paid in the following order, and any deficit to the government must be recouped by assessments on the financial industry:
  1. Administrative costs
  2. The government
  3. Wages, salaries, or commissions of employees
  4. Contributions to employee benefit plans
  5. Any other general or senior liability of the company
  6. Any junior obligation
  7. Salaries of executives and directors of the company
  8. Obligations to shareholders, members, general partners, and other equity holders
A number of strategies were explored early on to determine how Title I and Title II powers could be best used to resolve a large failing bank, including "Purchase and Assumption" and "Loss Sharing". Over time, the preferred approach evolved to a bail-in strategy, which is more direct, as it does not require an acquisition party. That approach was developed under the FDIC Office of Complex Financial Institutions group led by James R. Wigand. The approach is described in a slide deck from January 2012 as well as in Congressional testimony.
The specific strategy for implementing a bail-in under the Dodd–Frank Act requirements has been described as the "Single Point of Entry mechanism". The innovative FDIC strategy was described by Federal Reserve Governor Jerome Powell as a "classic simplifier, making theoretically possible something that seemed impossibly complex." It created a relatively simple path by which bail-in could be implemented under the existing Dodd–Frank powers. Powell explained:
A comprehensive overview of this strategy is available in the Bipartisan Policy Center report "Too Big to Fail: The Path to a Solution".
The Canadian government clarified its rules for bail-ins in the "Economic Action Plan 2013", at pages 144–145 "to reduce the risk for taxpayers."
The Eurogroup proposed on 27 June 2013 that after 2018, bank shareholders would be first in line to assume the losses of a failed bank before bondholders and certain large depositors. Insured deposits under £85,000 would be exempt and, with specific exemptions, uninsured deposits of individuals and small companies would be given preferred status in the bail-in pecking order for taking losses. That agreement formalised the practice seen earlier in Cyprus. Under the proposal, all unsecured bondholders would be hit for losses before a bank was allowed to receive capital injections directly from the European Stability Mechanism. A tool known as the Single Resolution Mechanism, which was agreed by Eurogroup members on 20 March 2014, was part of an EU effort to prevent future financial crises by pooling responsibility for eurozone banks, known as a banking union. In a first step, the European Central Bank will fully assume supervision of the 18-nation currency bloc's lenders in November 2014. The deal needed formal approval by the European Parliament and by national governments. The resolution fund would be paid for by the banks themselves and will gradually merge national resolution funds into a common European one until it hits the €55 billion target of funding. See the EC FAQ on the SRM. The legislative item was split into three initiatives by Internal Market and Services Commissioner Michel Barnier: Bank Recovery and Resolution Directive, DGS and SRM.