Forget bailouts. Here’s how a bank ‘bail-in’ works

An emerging but little-understood bank failure remedy called a bail-in has brought more confusion to the conversation. So let’s unpack bank bail-ins: what they do, who they affect, and what you need to know to protect your assets if a bail-in comes to your bank.

What is a bail-in? 

A bail-in is a form of financial relief for banks that are in danger of collapsing or going bankrupt. The relief comes from canceling some or all of the bank’s debt by reducing the value of bank shares, bonds, and uninsured deposits. (Note: The Federal Deposit Insurance Corporation (FDIC) insures most bank deposits up to $250,000 per individual.)

A bail-in is the opposite of a bailout. Instead of relief funds coming from outside (taxpayers), the funds come from inside (shareholders and depositors). Although bail-in relief has been implemented in Europe, it has never been used in the U.S.

Even so, bail-in relief was legalized in the U.S. with passage of the 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act, following the 2007–2008 financial crisis in which banks deemed “too big to fail” were bailed out by the U.S. government. The specific section of Dodd-Frank that deals with bail-ins is Title II: Orderly Liquidation Authority (OLA).

To prevent mass bailouts in the future, OLA:

• Restricts some of the riskier activities banks have engaged in previously
• Increases government oversight of banking activities
• Forces banks to maintain larger cash reserves
• Creates a process (bail-in) to liquidate failing financial institutions without a bailout

In 2018, the amount of cash reserves banks were required to have under Dodd-Frank was lowered with passage of the Economic Growth, Regulatory Relief, and Consumer Protection Act (EGRRCPA) by the Trump administration. 

Although OLA has never been tested, it is designed to provide a more structured resolution process for a failing bank than previous bailouts. In addition to converting certain debt into equity, OLA also allows for funding from the Treasury, which in principle, would be recouped once the bail-in process is complete.

How does a bail-in work?

Bail-ins, which cancel a bank’s debt owed to creditors and depositors, serve as an alternative to bailouts.

“In my view, a bail-in appropriately forces investors to take risks before depositors, who do not do the same level of investigation on their financial institution when placing their funds in the bank,” says Gregory Garcia, chief operating officer of First Commerce Bank.

A bail-in can take place in the U.S. if the Secretary of the Treasury determines that the bank meets the conditions of a two-part test:

1. The bank is in default, or in danger of default. A bank is in danger of default when it is likely to file for bankruptcy, has debt that will deplete all or most of its capital, has greater debts than assets, or will likely be unable to pay its debts in the normal course of business.
2. The bank represents a systemic risk to the banking sector. The likelihood of systemic risk is based on the negative effect of default on financial stability; low income, minority, or underserved communities; and on creditors, shareholders, and counter-parties.

If, as a result of the evaluation, the Secretary and/or the bank’s board of governors believe the bank is a candidate for a bail-in, the board will vote on providing a written recommendation to the Secretary for the FDIC to be appointed receiver of the bank.

Under Dodd-Frank, as receiver, the FDIC would have three to five years to liquidate the bank and:

• Ensure that shareholders and uninsured creditors bear the losses of the failed bank
• Remove bank management responsible for the failure
• Make payouts to claimants that are at least equal to the amount that would have been received under bankruptcy
• Cover FDIC insurance liability to qualified depositors up to $250,000

“Bail-ins are a strong political statement,” notes Schulman. “They limit the exposure of taxpayers to the risks of bank failures and simultaneously attempt to limit [the government’s] political fallout that comes with the perception of rescuing fat-cat banks or financiers.”

Since this has never actually happened in the U.S., let’s take a closer look at some examples of bail-ins abroad.

Cyprus

Prior to 2013, Cyprus faced potential bank failures due to a combination of risky loans and investments in the banking sector. The Cypriot government decided to intervene in 2013, but could not effect a bailout due to a lack of access to global financial markets and loans. 

Instead, the government initiated a bail-in, forcing depositors with more than 100,000 euros to write off 47.5% of their bank holdings. The bail-in prevented bank failures, but led to market instability and investor unease over fear bail-ins would become more common and discourage bank deposits. 

Further, in 2015, Greek investors who claimed to have lost more than 120 million euros ($135 million) sued Cyprus to recoup their losses. A European Union court dismissed the case in 2018, saying that “the individuals and companies which initiated the actions have not succeeded in demonstrating an infringement of the right to property, of the principle of protection of legitimate expectations, or of the principle of equal treatment.”

EU Banking Authority regulations

At the end of 2013, the European Union reached agreement on an EU bail-in system to deal with struggling banks. As with all bail-in systems, the EU system was designed to ensure that the institution and its investors would be “first in line” to pay for any failure.

The EU system requires shareholders and bondholders to take the initial hit, with unsecured depositors (over 100,000 euros) to be affected last. The bail-in would apply until at least 8% of total assets were lost, resulting in the likely liquidation of all shareholder and bondholder assets. After that, the bank would be able to access funds up to a maximum of 5% of the bank’s assets.

The Center for Economic Policy Research concluded that although the efficacy of the EU bail-in model “has been demonstrated for smaller idiosyncratic failures, its ability to maintain stability in cases of large bank failures and system-wide crises remains untested.”

Are bail-ins legal in the U.S.? 

Yes. Technically, bail-ins have replaced bail-outs for “too big to fail” banks under Dodd-Frank. It’s important to note, however, that no bail-ins have occurred in the U.S. so far. In fact, the recent failures of SVB and Signature banks resulted in a systemic risk exception, so all SVB and Signature depositors would be made whole.

Would I lose my money during a bail-in? 

Most depositors in most financial institutions in the U.S. wouldn’t lose money during a bail-in. That’s because the median value of individual transaction accounts (such as checking, savings, and money market accounts) was $5,300 in 2019, the last year for which data is available. That’s well below the maximum protected by the FDIC.

As far as which types of accounts are insured by the FDIC up to $250,000, they include:

• Checking
• Negotiable order of withdrawal (NOW)
• Savings
• Money market deposit accounts
• Certificates of deposit
• Cashier’s checks
• Money orders

FDIC insurance does not cover:

• Stocks
• Bonds
• Mutual funds
• Crypto assets
• Life insurance policies
• Annuities
• Municipal securities
• Safe deposit box contents

Any insured assets you have in the bank in excess of $250,000 would, theoretically, be at risk, as well as all uninsured assets. But most banks remain well-capitalized and are in a much better position than before the global financial crisis in 2007–2009. Going back to 2015, there have been just 31 bank failures and zero bail-ins. 

Although midsize banks with an asset base of $10 billion to $25 billion show some weakness, within this category, SVB and Signature were big outliers on their balance sheet positions, and the segment overall remains solvent.

There is, of course, concern that panic could spill over to other banks. However, policy measures like the Fed’s new Bank Term Funding Program (BTFP), or potentially raising the threshold for insured deposits from the current $250,000, should help contain the panic going forward, according to experts.

How do I keep my money safe? 

Assuming you have no plans to drain your bank account and stuff cash under your mattress (unwise for many reasons, potential theft and zero interest being two), there are strategies you can employ to provide reasonable assurance you will not lose money in the event of a bank failure.

1. Ensure you’re covered

Schulman says if you have multiple accounts at the same bank or financial institution, you should clarify with your banker whether any of that money is uninsured. He also notes that the FDIC’s Electronic Deposit Insurance Estimator (EDIE) can help you calculate insurance coverage based on account balances and ownership categories.

2. Diversify your deposits

If you have deposits that exceed FDIC limits, it can be a good idea to spread that money across other financial institutions. 

“The authorities’ response to the collapse of Silicon Valley Bank was to protect depositors, including all those who had balances above the current FDIC-insured amount of $250,000, and not its stock or bond holders, which were wiped out,” notes Adrian Cronje, chief executive officer of Atlanta-based wealth management firm Balentine. “Until such time as regulators clarify the situation and whether this will apply generally to the banking industry in the future, a good strategy for business owners is to diversify banking relationships and to have deposits over the current FDIC $250,000 amount invested in ultra-short-term government T-bills.”

Schulman notes that the Certificate of Deposit Account Registry Service (CDARS) is also one way to work around FDIC insurance limits. “A CDARS placement and custodial agreement invests money through a network of members distributing your CD holdings to various banks in order to stay below FDIC limits at each member bank,” he explains. “You could use this to place millions of dollars and still be FDIC-protected.” However, he adds, you’re still limited by the rules and illiquidity provisions that come with CDs.

3. Stay informed

Finally, avoid putting on blinders when it comes to financial industry news and practices. It’s important to stay on top of what’s going on in the banking industry and how major events can impact your money.

“One way to protect yourself from the impact of a bail-in is to look at publicly available reports that rate financial institutions on their safety and soundness,” says Garcia. Learning how to keep tabs on your bank can help you identify any potential problems.

The takeaway 

Bank bail-ins are not a likely cure-all for bank failure. “Whereas there is little support for bank bailouts in America, there is likely to be little appetite to allow banks to utilize unsecured credit lines and uninsured deposits as well,” says Robert Maddox, chair of the Banking and Financial Services Practice Group at national law firm Bradley Arant Boult Cummings. “Such actions likely would meet with the same or similar public and political fallout.”

The likelihood of an explosion of bank bail-ins may not be as imminent as some people think. So before you empty your bank account to purchase precious metals, NFTs, or crypto, keep in mind that the FDIC and its regulations exist for one simple reason—your financial protection.