‘Bail-in’ rather than bailout, says European markets group

A European financial markets lobby group on Thursday proposed a form of debt to equity conversion as a means to avert expensive taxpayer-funded bailouts.

The Association for Financial Markets in Europe (AFME), the lobby group, advocated the use of so-called "bail-in capital", where debt is converted to equity at the behest of regulators, as a means to recapitalise troubled firms without drawing on government funds.

If a regulator judges a firm to be failing and a bail-in to provide better value for investors, then the conversion to debt to equity would occur along with a writedown a firm's assets and a conservative estimate of the amount of capital they would need. Different haircuts would apply depending on the class of bondholder. As a check on regulators' ability to take these actions unilaterally, lawmakers would need to deliberate safeguards, the AFME said. Politicians must ensure equal treatment for all creditors of the same class, that rules are clear to investors before any action is taken, transparency, and that property rights are protected, the lobby group said. "Execution [of the bail-in] would be fast-tracked, given the time pressures and results would be imposed, not negotiated, via a clear and fair protocol that would be transparent to investors," the AFME said.

The proposal resembles that for contingent capital, which first appeared in a 2002 paper by Mark Flannery, a professor at the University of Florida, and recently popularised by Raghuram Rajan and Anil Kashyap, two academics at the University of Chicago, and Jeremy Stein, a professor at Harvard University. Contingent capital bonds, or CoCos, are debt instruments that automatically convert to equity when a pre-determined floor of individual or industry-wide losses is breached.

Mark Austen, the acting chief executive of the AFME, on Thursday said both approaches would ensure taxpayers are not called upon to shoulder banks' losses. "A well-considered resolution and recovery scheme, using bail-in or contingent capital, could not only mitigate against contagion but also pull a firm back from the brink of insolvency, so liquidation can be avoided," Austen said.

The key difference between CoCos and bail-in capital lies in the trigger, or the pre-set level of losses. Firms set trigger levels when issuing CoCos. Bail in capital, on the other hand, would require regulators to set and enforce the trigger level. Bail in capital would require primary legislation to be enacted. CoCos are already being issued by lenders, including Deutsche Bank and Lloyds, a British bank.

Problems
That regulators, rather than issuing firms, set the trigger level at which debt is converted into equity is seen as an advantage of bail in capital over CoCos. However, Charles Goodhart, professor emeritus at the London School of Economics and a former member of the Bank of England's Monetary Policy Committee, told CentralBanking.com that this could prove problematic. "Clearly, regulators would have to set the conditions, as they cannot just do it by discretion," Goodhart said. "But in a time of stress, the authorities will find it hard to announce to the world that there is a crisis because of what that does to market confidence. It seems bail-in capital would require them to do precisely that." He added: "The difficulty with [both] ideas is that what makes sense in terms of reducing moral hazard and increasing market discipline frequently doesn't make sense when you apply it to the financial system as whole, because of the impact on market prices and the ability of banks to recapitalise themselves."

Goodhart looked to New Zealand for a less convoluted alternative to both CoCos and bail-in capital. "If a bank goes down, the authorities should assess what the funding shortfall is after the shareholders are wiped out, and then apply an appropriate haircut on bondholders," he said. Making creditors aware that haircuts would be levied, should the situation require it, would have the same effect on market discipline and spreading out risk, he added.