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Financial stability and bank bail-in regimes

Research by Professor Emilios Avgouleas and Professor Charles Goodhart (LSE) on the financial stability impact of the application of the new bail-in regimes for bank resolution has resulted in a rethink of the scope of these new regimes and their recalibration to avoid a full-blown bank creditor run and panic.

Canary Wharf

After the collapse of Lehman Brothers in September 2008, global markets entered a turbulent period and the collapse of the western financial system seemed almost inevitable. A string of expensive bailouts of the world’s biggest banks prevented this from happening, and during this time numerous banks proved to be Too-Big-to-Fail (TBTF). As a result, the existence of private institutions that have to be continually bailed through public money proved to be a major source of perverse incentives for bank management and shareholders and shielding private institutions from failure through the use of public money constituted a serious distortion of competition in free market economies. Eventually, the political mood against the financial sector darkened and a number of punitive bank resolution regimes were put in place to avert any future bailouts and battle the TBTF phenomenon. But, in the rush to implement bank rescue legislation that punished bank creditors rather than taxpayers to avert bailouts, US and EU authorities grossly underestimated the impact of bail-ins on financial stability and creditor confidence.

The application of bank bail-ins

Professors Avgouleas and Goodhart undertook influential research that showed bail-ins also presented several important risks. Their findings revealed that social savings were not that large if pension funds and their insured bore the losses of bank failures rather than taxpayers, and that financial stability could be imperilled if a bail-in regime was applied to systemic bank failures (e.g., occurring from pervasive and far-reaching market risks with the potential to trigger a full industry collapse) rather than to an idiosyncratic bank failure (e.g., one-off occurrences associated to an individual bank or asset, such as through fraud) or to a non-systemic bank (e.g., a bank without the potential to destabilise the economy if it were to fail). They further argued that the fear of triggering a financial stability crisis after the bail-in of the creditors of a systemic bank would make regulators and bank management reluctant to act early, even though speedy regulatory action is key to the successful implementation of any bank recovery and resolution regime.

They suggested a number of remedies to deal with the accumulation of non-performing loans that plague banks in the Eurozone periphery and avert a system-wide bail-in that could lead to serious systemic turbulence; specifically, they suggested the formation of private sector Asset Management Companies that can manage bank non-performing assets to both repay and minimise Eurozone bank losses.  

The critique of the shortcomings of bail-in regimes by Professors Avgouleas and Goodhart received widespread attention from policymakers, regulators, respected think-tanks and the media; especially, their argument that the application of bail-in regimes outside the context of a smaller bank or failure due to idiosyncratic reasons is today one of the foremost concerns in building effective bank resolution regimes. Their work has led to more careful application of bail-in regimes by regulators and a revival of the discussion on Asset Management Companies as a way to tackle banking sector non-performing loans (NPLs) in the EU and the United States.