What Is a Bail-In? Definition & How It Works
Weāve all heard of a bailout.
Ā Most commonly used in regards to bank failures, a bailout is when a business, individual, or government provides money to a failing company. This is with the aim to prevent that businessās potential downfall. That can include bankruptcy which leads to the business defaulting on its financial obligations.
Ā Bailouts were a strong tool in the 2008 Financial Banking Crisis, where some of the largest banks defaulted. This spread the knowledge of this term to the wider public. But bail-ins are less commonly known.
Ā But what exactly is a bail-in?
Ā Weāll take a closer look at the definition of a bail-in and show you how it works.
Table of Contents
KEY TAKEAWAYS
- A bail-in is a form of financial relief for a financial institution.
- It is the opposite of a bailout, which is normally associated with banking.
- Bail-ins help to alleviate the burden on taxpayer dollars that are associated with bank bailouts.
What Is a Bail-In?
A bail-in is a form of financial relief for a financial institution. It provides relief for an institution that is at risk of failure. It does this by making it so that any debt that is owed to depositors and creditors is canceled.
A bail-in is not the same as a bailout. A bailout is the rescue of a financial institution by external parties. Whereas a bail-in places the burden on depositors and shareholders.
The investors of a troubled financial institution tend to prefer to keep the business solvent. This is rather than losing the full value of their investments in the event of a crisis. It is also preferable for Governments to not have a large financial institution go bankrupt. This is because large-scale bankruptcy increases the chance of a systemic problem for the wider market. Which is why government bailouts are a well known solution.
How Does a Bail-In Work?
Bail-ins work by canceling the debt or surety bonds that are owed by a financial institution to creditors and depositors. They take place for one of three reasons:
- The relevant government doesnāt have the financial means to leverage a bailout.
- The collapse of the financial institution isnāt likely to create a systemic problem. This would mean that it lacks the ātoo big to failā consequences.
- The resolution framework needs a bail-in to be used to mitigate the number of allocated funds from taxpayer bail-outs.
A depositor that is based in the U.S is covered by the Federal Deposit Insurance Corporation. This insurance covers up to $250,000. In the scenario where a bail-in occurs, the financial institution would use only the amount that is in excess of the $250,000 balance.
Example of Bail-Ins
An example of a bail-in scenario was in the Cyprus financial crisis in 2013. The biggest banks in Cyprus required an emergency rescue deal which required numerous creditors, debt holders, and shareholders to take on a portion of the costs.
This was a common tactic throughout the costly bailouts of the European sovereign debt economic crisis. Where billions in bailouts and bail-ins were spent.
Summary
When financial institutions fall into a crisis, bail-in provisions are a different option of bank bailout schemes. Depending on the bail-in plans, this can sometimes be necessary if the consequences of the institution’s failure would lead to widespread damage to the financial markets.
FAQs on Bail-Ins
The Bank Recovery and Resolution Directive (BRRD) set out the regulatory technical standards. It involves bail-in policy that requires EU businesses to include a contractual recognition of the bail-in clause. This is in a very wide range of a law-governed bail contract.
A bank bail-in is where shareholders of distressed banks are divested of their shares by a resolution authority. And creditors of the bank have their claims canceled or at the very least the original bail reduced. This is to the extent necessary to get the bad bank stock back to being financially viable.
During a bail-in, the liabilities of the failing institution are written down. This is to ensure that any losses are borne by the shareholders, rather than through external sources.
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