Before we dive into this month’s article, I just want to wish you and your family the Merriest Christmas this year. We have hope in this crazy world because we have a Savior that was born unto us. Celebrate Him with your family this season.
In recent memory, tumultuous events left many questioning the stability and integrity of the banking industry. Earlier this year, two significant banks, Silicon Valley Bank and Signature Bank, collapsed. Shockwaves rippled through the financial world with concerns about bank solvency and the specter of government bailouts should a systemic crisis grip depositors.
Amidst this uncertainty, many heard the term “bank bailout”. However, few are familiar with the obscure mechanism called a “bail-in”. The concept is controversial for some decrying it as legalized theft while others see it as a safeguard for taxpayers and depositors in a worst-case scenario. In this article, we aim to demystify the concept of a bail-in and provide insights into what you need to know to safeguard your assets in the event of a bail-in affecting your bank.
Understanding the Concept of a Bail-In
A bail-in is a financial relief mechanism designed to rescue banks teetering on the brink of disaster. Instead of being bailed out externally by taxpayers, a bail-in derives its resources from within the failing institution itself. This entails canceling debt by reducing the value of bank shares, bonds, and uninsured deposits (deposits above the Federal Deposit Insurance Corporation limit of $250,000 per individual).
While a bailout involves government (taxpayer) funds bailing out troubled banks, the concept of a bail-in was introduced in the United States with the enactment of the Dodd-Frank Wall Street Reform and Consumer Protection Act in 2010. In this act, Title II: Orderly Liquidation Authority (OLA), was established to prevent the need for massive governmental bailouts by implementing several key measures:
- Restricting Historically Riskier Bank Activities
- Expanded Government Oversight of Banking Practices
- Requiring Larger Cash Reserves
- Bail-In Mechanism Created: a process to liquidate failing financial institutions without resorting to public bailouts.
In 2018, under the Trump Administration, the Economic Growth, Regulatory Relief, and Consumer Protection Act (EGRRCPA) lowered the bank cash reserve requirement required under Dodd-Frank.
This change emphasized the bail-in mechanism over taxpayer-funded bailouts, thereby strengthening the emphasis on bank bail-ins as a more responsible approach.
Despite its existence in U.S. legislation, OLA has not yet been tested in practice. However, its fundamental purpose is to provide a structured framework for resolving failing banks, converting certain debt into equity, and allowing for Treasury funding, which in theory would be recouped once the bail-in process concludes.
The Mechanics of a Bail-In
Bail-ins operate by canceling a bank’s debt to its creditors and depositors, offering an alternative to taxpayer-funded bailouts. Gregory Garcia, the Chief Operating Officer of First Commerce Bank, asserts that bail-ins appropriately force investors to assume risks before depositors, as investors conduct more thorough investigations into the financial institutions where they invest.
For a bail-in to be implemented in the United States, it must satisfy a two-part test:
- Default or Danger of Default: A bank is in danger of default when it is on the verge of bankruptcy, its debt threatens to deplete most of its capital, its debts exceed its assets, or it is likely to be unable to meet its financial obligations in the normal course of business.
- Systemic Risk to the Banking Sector: Systemic risk is determined by evaluating the negative impact of the bank’s default on financial stability, low-income, minority, or underserved communities, as well as its impact on creditors, shareholders, and counterparties.
Should a bank meet these criteria, the bank’s board would vote on appointing the FDIC as the receiver of the bank. As the receiver under Dodd-Frank, the FDIC has three to five years to execute the following actions:
- Ensure that shareholders and uninsured creditors bear the losses.
- Remove the bank’s management responsible for the failure.
- Make payments to claimant’s equivalent to or exceeding the amounts they would have received under bankruptcy proceedings.
- Cover FDIC insurance liabilities for eligible depositors, protecting deposits up to $250,000 per individual.
While the United States has not yet experienced a bail-in, international examples shed light on its practical implications.
International Example: The Case of Cyprus
A bail-in example could be observed in Cyprus in 2013. Cyprus had faced the imminent risk of bank failures due to risky loans and investments within its banking system. In this situation, their government faced a predicament: it lacked access to global financial markets and loans, making a bailout unfeasible.
Consequently, the government resorted to a bail-in strategy, compelling depositors with balances exceeding 100,000 euros to write off 47.5% of their bank holdings (the equivalent of a U.S. bank depositor with funds above the FDIC limit of $250,000 taking a 47.5% haircut on those excess funds). While the bail-in effectively prevented bank failures, it also triggered market instability and raised concerns among investors and depositors.
In summary, bail-ins are a complex yet essential financial mechanism that could play a crucial role in safeguarding the banking sector and minimizing the need for taxpayer-funded bailouts. As an investor, be careful what bank equity and debt you invest in and as a depositor, watch your insured deposit limits.
I hope this is helpful to your retirement journey. Call us, come see us or visit us at www.woottonfinancial.com or www.facebook.com/woottonfinancial. We’d love the opportunity to help address your questions and concerns and provide you Clear Direction for Your Retirement®.
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