The sector bail-out. It is worthy to look

The underlying agenda of this report is to draw a comparison between a financial bail-out (a private sector bail-out in our case) and the recently proposed “bail-in” method – policy methods that attempt to rescue private institutions facing financial trouble. The bail-out method has been traditionally used as a method by several governments to save their financial systems in times of extreme and systemic crisis. When the financial framework of an economy, which reflects in the performance and status of its financial and other thrift institutions, weakens to threatening levels, action must be taken in order to ensure survival. In such scenarios, bail-outs are when external or outside investors inject capital into the failing companies to save them from being liquidated to creditors or becoming bankrupt. More often than not, the external investor is the government, which basically uses taxpayers’ money to support the debt of these institutions. But external investors can definitely include individuals or corporations from the private sector, as we see in Too Big To Fail, where the fed asks other related corporations to invest in Lehman’s prospects, which, if it would have gone under, would have been a classic example of a private sector bail-out.

It is worthy to look at the Global Economic Crisis of 2008 in a detail, which essentially began in the United States of America. As the inflated real estate sector crashed, its effects rippled towards the financial sector. Huge corporations such as Bear Sterns needed help and JP Morgan Chase stepped in to rescue it. Similarly Lehman Brothers, the 4th largest American investment bank at the time, was on the edge of turmoil. Interestingly, firms and officials at the federal reserve were quick to acknowledge the fact that if Lehman failed, Citigroup, Merrill Lynch and several others were inevitably the next in line. It would be disastrous to the financial market which held the money of millions of people and paid thousands of workers. Situations worsened as Lehman Brothers declared bankruptcy and the biggest corporations such as AIG and others such as Fannie Mae and Freddie Mac began teetering as they continuously failed to sign private investments and injections. Before Lehman was forced into declaring bankruptcy, the fed decided to solve the mounting problem by introducing a private sector bail-out solution; the fed arranges a meeting in which it urges CEOs of other Wall Street giants to invest in the toxic assets of LB, in effect a private sector bail-out which did not involve taxpayer money.

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This was when the government rolled out the TARP, essentially America’s ultimate bail-out plan, under which it bought 250 billion dollars worth of preferential shares in the 9 largest institutions of the time. This was the more common case of a government assisted bail-out using taxpayer money. After slight dialogue, all nine corporations agreed and America was well on its way towards recovery (obviously, it wasn’t as simple and direct as that).

In contrast, the “bail-in” method requires the lenders or creditors of the institution (the people/organisations it owes money to) to bear a part of the burden by writing off a part of their recorded debts as “bad debts”. By having creditors forgo short term claims, it has recently grown as an attractive alternative which recapitalises distressed institutions from within, giving birth to a financially stronger institution.

A famous example of the bail-in method was its application to support Cyprus’ banking sector crisis. Bondholders and depositors in Cyprus banks with more than 100,000 euros in their accounts were forced to write off a part of their deposits. The ruling Indian government has also moved for a provision in a bill to identify and accept this methods, as the problem of “non-performing assets” has begun to haunt Indian banks in the wake of a slowdown in economic growth.

Bail-ins are a politically favourable option since they do not put to risk taxpayer money as seen in bail-outs, but may lead to adverse repercussions on the financial market. The clear risk is that the bonds market may respond negatively. The increasing popularity of bail-ins in the future increases the risk for bond holders and they might increase the yield demanded on any money to be lent to these institutions. This will subsequently result in higher interest rates, which can eventually be more taxing than a one-time recapitalisation.

As the word “bail” suggests, both bail-in and bail-out methods attempt to keep a financial institution afloat/solvent in times of trouble, but they vary greatly in how they go about achieving the goal. Bail-outs are constructed in a way to secure creditors and keep interest rates low, while bail-ins are ideal in situations where bail-outs are difficult or impossible in the given eco-political context and where it is in the best interest of the creditors to avoid the liquidation of these entities.

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