Bail-InExplained & Defined

Written By:
Lisa Borga

What is a Bail-In?

A Bail-in refers to a process in which the bondholder, depositors, and creditors of a financial institution are required to accept some of the responsibility for the financial institution’s situation by canceling some of their debts.

This is quite different from a bail-out in which a financial institution is rescued by an external party, generally the government, with taxpayer money.

If the financial institution receives a bail-out, creditors don’t have to lose money.

But, if it is rescued through a bail-in, creditors lose money.

Explaining Bail-Ins

Bail-Outs and Bail-Ins occur when a financial institution is on the verge of failure.

Bail-outs were a very useful tool during the financial crisis of 2008.

However, bail-ins can be quite useful as well.

Deposit-holders and investors that have money tied up in a financial institution would rather help keep the institution solvent than have the financial institution fail, thus causing them to lose their entire investment or deposit.

Governments do not want to have financial institutions fail either, as a large bankruptcy increases the risk of serious problems occurring in the market.

This is why the government was willing to use bail-outs to rescue financial institutions in the financial crisis of 2008.

These bail-outs also led to reforms.

When Bail-Ins Are Used

Most people have heard of bail-outs, but bail-ins are a good strategy in some situations as well.

Europe has made use of this strategy in some difficult situations.

In fact, the Bank of International Settlement (BIS) has discussed the use of bail-ins in the European Union.

Bail-ins are generally used when a government bail-out is not likely to occur, such as in the following situations.

• If the financial institution fails, it is unlikely to cause systemic problems, and it is not so big that the government won’t let it fail.
• The government doesn’t have sufficient resources to perform a bail-out.
• The framework of the resolution stipulates that in order to limit the use of taxpayer funds, a bail-in must be used.

What is a Bail-In Clause?

A bail-in clause requires creditors to write off or cancel some of a financial institution’s debts to keep the financial institution from failing and causing economic problems.

This is typically done to try and rescue financial institutions in danger of collapsing in hopes that they will recover.

Bail-Ins in the European Union

The Cypriot Financial Crisis

Bail-outs drew a lot of attention in the United States after the Great Recession of 2008.

However, bail-ins drew attention a few years later in Cyprus in 2013 when they were used by government officials in Cyprus.

Using the bail-in strategy in this situation caused people with deposits over 100,000 euros to lose a significant amount of their money.

These depositors did receive bank stock, but this was not enough to make up for their losses.

The European Commission

The European Commission released guidelines to be used when bailing banks that have failed.

These became the Bank Recovery and Resolution Directive (BRRD).

This directive was intended to keep taxpayers from having to bail out troubled financial institutions.

But, what it ended up doing was to force creditors and shareholders to help rescue troubled financial institutions through bail-ins.

Bail-Ins in the United States

The public was unhappy with the bail-outs of large financial institutions as a result of the 2008 financial crisis.

This led to reforms intended to protect consumers.

The Dodd-Frank Act was passed to help protect consumers and place restrictions on financial institutions to help prevent another financial crisis such as the one in 2008.

One thing this Act did was to try and reduce the amount taxpayers would have to pay in the event of a bail-out by making it easier for bail-ins to occur.

Key Takeaways

• A bail-in provides some relief to a financial institution that is about to fail by forcing its depositors and creditors to cancel some of the debts of the financial institution.
• Bail-outs and bail-ins are both resolution tools that can be used to help financial institutions in distress.
• Bail-ins are an alternative to bail-outs that lower the burden on taxpayers of rescuing banks.