Evaluating the pros and cons of bail-in policies following bank failures.

In this article, Professor Avgouleas and Goodhart discuss the architecture and mechanics of the bail-in process and provide a legal and economic analysis of the challenges facing bail-in centered resolutions. The scale of losses flowing from bank failures is initially independent of the identity of those upon whom the burden of meeting that loss falls. But, such losses can also entail critical externalities. These have traditionally justified the use of public bail-outs to avoid the systemic threat that the failure of any bank beyond a certain size carries with it. Indeed, one of the key principles of a free market economy is that owners and creditors are supposed to bear the losses of a failed venture. The bail-in approach is intended to counter the dual threat of systemic disruption and sovereign over-indebtedness. It is based on the penalty principle, namely, that the costs of bank failures are shifted to where they best belong: bank shareholders and creditors. Namely, bail-in replaces the public subsidy with a private penalty or with private insurance forcing banks to internalize the cost of the risks they assume. Essentially, bail-in provisions mean that, to a certain extent, a pre-planned contract replaces the bankruptcy process giving greater certainty as regards the sufficiency of funds to cover bank losses and facilitating early recapitalization. Moreover, the bail-in tool can be used to keep the bank as a going concern and avoid disruptive liquidation of the financial institution in distress. But – as the Authors correctly point out - the idea that the penalty for failure can be shifted onto an institution, such as a bank, is incorrect. Ultimately all penalties and similar benefits have to be absorbed by individuals, not inanimate institutions. When it is said that the bank will pay the penalty of failure, this essentially means that the penalty is paid, in the guise of worsened terms, by bank managers, bank staff, bank creditors, or the borrowers. The real question is which individuals will be asked to absorb the cost. As the emerging-market crises and the entire history of financial crises made clear, imposing haircuts on bank creditors during a systemic panic is a sure way to accelerate the panic. The bail-in process also has some important disadvantages over bail-outs, as it could prove to be more contagious; more litigious; slower and more expensive as a process; requiring greater subsequent liquidity injections, and so on. What is strongly underlined is that achieving the goal of making private institutions responsible for their actions would be the best policy in an ideal world where financial ‘polluters’ would be held responsible for their actions. But, in practice, it might prove an unattainable goal. If this turns out to be the case, then developed societies might have to accept that granting some form of public insurance is an inevitable tax for having a well-functioning banking sector.