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What Is A Bail-In & How Does It Work?

Bail-Ins Versus Bail-Outs

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Martin Barraud/ OJO Images/ Getty Images

Most people are familiar with bailouts these days, after the global economic crisis forced many governments to rescue private institutions. But, there's another term that's becoming increasingly common in the financial media - "bail-in". In this article, we'll take a look at what a bail-in is and what it means for countries, companies and investors.

Bail-Ins Versus Bail-Outs

Bail-outs occur when outside investors, such as a government, rescue a borrower by injecting money to help make debt payments. For example, U.S. taxpayers provided capital to many major U.S. banks during the economic downturn in order to help them meet their debt payments and remain in business, as opposed to being liquidated to creditors.

According to The Economist, the magazine that coined the term, a bail-in occurs when the borrower's creditors are forced to bear some of the burden by having a portion of their debt written off. For example, bondholders in Cyprus banks and depositors with more than 100,000 euros in their accounts were forced to write-off a portion of their holdings.

While both bail-ins and bail-outs are designed to keep the borrowing institution afloat, the two different methods of accomplishing the goal vary greatly. Bail-outs are designed to creditors happy and interest rates low, while bail-ins are ideal in situations where bail-outs are politically difficult or impossible, and creditors aren't keen on the idea of a liquidation event.

Using Bail-ins to Save Institutions

Most regulators had thought that there were only two options for troubled institutions in 2008 - taxpayer bailouts or risking a systemic collapse of the banking system. But, bail-ins soon became an attractive third option to recapitalize troubled institutions from within, by having creditors agree to rollover their short-term claims or engage in a restructuring.

Similar strategies have been used in the airline industry to keep them running throughout bankruptcy proceedings and other turmoil. In these scenarios, the companies were able to reduce the payments to creditors in exchange for equity in the reorganized company, effectively enabling the lenders to save some of their investment and the companies to stay afloat.

Interestingly, bail-ins can complement bail-outs in some cases, with creditors falling into either category. Successfully bailing-in some creditors gets rid of some financial strain, while securing additional financing from others certainly helps the situation. But, the risk is always that the bail-in of some creditors will discourage others from getting involved.

The Future of Bail-ins

The use of bail-ins in Cyprus' banking crisis has led to concerns that the strategy would be used more often by countries when dealing with financial crises. After all, politicians can avoid the thorny political issues associated with taxpayer bailouts, while containing the risks associated with letting a bank failure lead to systemic financial destabilization.

The risk, of course, is that the bond markets will react negatively. Bail-ins becoming more popular could increase risks for bondholders and therefore increase the yield that they demand to lend money to these institutions. These higher interest rates could hurt equities and end up costing more over the long-term than a one-time recapitalization.

In the end, many economists agree that the world is likely to see a combination of these strategies in the future. With Cyprus having set a precedent, other countries now have a template for the actions and an idea of what will occur afterwards. The financial markets, on the other hand, remain anxious as share prices in Cyprus banks have reflected.

Key Takeaway Points

  • Bail-ins are situations where creditors agree to forgo their short-term claims and/or agree to a restructuring that reduces their holdings.
  • Bail-ins began as a public policy tool with Cyprus, which forced creditors and some depositors to forfeit some of their holdings to keep the banks alive.
  • Bail-ins are less politically taxing than bailouts, but could have a number of negative side-effects in the financial markets, including higher interest rates.

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