A bail-in occurs when an institution’s creditors must forgive some of its debt to save it from collapse. It may be used as an alternative to a bail-out during times of financial crisis.
Learn how bail-ins differ from bail-outs and how they work.
Definition and Example of a Bail-In
Most people are familiar with the concept of a bail-out following the global economic crisis, when many governments were forced to rescue private institutions. But there’s another term, called a “bail-in,” that can be used as an alternative to a bail-out, which has become increasingly unpopular.
In a bail-in, a bank or other institution’s creditors must write off a portion of their debts to save it from insolvency. An example is the rescue deal for the biggest banks in Cyprus in 2013, which required shareholders and creditors to bear some of the costs.
How Does a Bail-In Work?
With a bail-in, failing bank creditors are forced to bear some of the burden of having a portion of their debt written off. The new approach became especially popular during the European sovereign debt crisis.
For example, in 2013, 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.
Unlike bail-outs, which transfer risk from the bank to the taxpayer, bail-ins eliminate some of the risk for taxpayers by forcing the bank’s creditors to share in the burden. They are especially useful when the debt is overwhelming in proportion to the government’s ability to cover it, as was the case in Cyprus—the bill would have been 50% of that country’s gross domestic product (GDP).
Bail-Outs vs. Bail-Ins
| Bail-out | Bail-in |
|---|---|
| Government injection of money | Private injection of money |
| Taxpayer assumption of risk | Creditor assumption of risk |
| Designed to appeal to creditors | Designed to appeal to taxpayers |
Bail-outs occur when outside investors, such as a government, rescue a borrower by injecting money to help make debt payments.
For example, US taxpayers provided capital to many major US banks during the 2008 economic crisis to help them meet their debt payments and remain in business rather than being liquidated to creditors. This helped save companies from bankruptcy, with taxpayers assuming the risks associated with their inability to repay their loans.
Note
While both bail-ins and bail-outs are designed to keep the borrowing institution afloat, they take two very different approaches to accomplishing this goal.
Bail-outs are designed to keep 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.
An Alternative to Bail-Outs
Most regulators had thought that there were only two options for troubled institutions in 2008: taxpayer bail-outs or a systemic collapse of the banking system. Bail-ins soon became an attractive third option to recapitalize troubled institutions from within, by having creditors agree to roll their short-term claims over or engage in a restructuring. The result is a stronger financial institution that is not indebted to governments or external influencers—only its own creditors.
Similar strategies have been used in the airline industry to keep them running through bankruptcy proceedings and other turmoil. In these scenarios, companies were able to reduce payments to creditors in exchange for equity in the reorganized company, effectively enabling lenders to save some of their investment, and companies to stay afloat. The airlines would then benefit from the reduced debt load, and their equities—including those issued to debt holders—would increase in value.
Interestingly, bail-ins can complement bail-outs in some cases. Successfully bailing in some creditors alleviates some financial strain, while securing additional financing from others helps to reassure the market that the entity will remain solvent.
Note
The risk is that the bail-in of some creditors will discourage others from getting involved, since they’d need to take on the same reforms. This makes bail-ins less common during systemic crises involving many financial institutions.
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 bail-outs 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 by making future capital much more expensive.
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 actions and an idea of what will result.
Key Takeaways
- Bail-ins are a way to rescue failing banks by shifting some of the risk to creditors.
- When big banks in Cyprus were failing in 2013, a bail-in from bondholders, creditors, and uninsured depositors helped keep them afloat.
- Bail-ins differ from bail-outs, in which it is the taxpayer who assumes some of the risk of the bank’s outstanding debts.
- As bail-outs decline in popularity, bail-ins may rise to complement them.
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