The world experienced economic turmoil during the 2007-2008 financial crisis. Low-interest rates boosted borrowing, a boon to existing and prospective homeowners, but created a bubble that would impact consumers and the world's banks.
The Great Recession that followed ushered in the term too big to fail, the rationale for rescuing some of the largest financial institutions with taxpayer-funded bailouts. In 2010, Congress passed the Dodd-Frank Wall Street Reform and Consumer Act, which eliminated the option of bank bailouts but opened the door for bank bail-ins.
Key Takeaways
- Big banks were deemed too big to fail following the financial crisis of 2007-2008, resulting in government bailouts at the expense of taxpayers.
- Financial reforms under the Dodd-Frank Act eliminated bailouts and opened the door for bail-ins.
- Bail-ins allow banks to convert debt into equity to increase their capital requirements.
Bank Bail-In vs. Bank Bailout
Bail-ins and bailouts are designed to prevent the complete collapse of a failing bank. The difference between the two lies primarily in who bears the financial burden of rescuing the bank.
In a bailout, the government injects capital into banks, enabling them to continue their operations. During the financial crisis of 2007-2008, the government injected $700 billion into companies like Bank of America (BAC), Citigroup (C), and American International Group (AIG) using taxpayer dollars.
Bail-ins provide immediate relief when banks use money from their unsecured creditors, including depositors and bondholders, to restructure their capital. Banks can convert their debt into equity to increase their capital requirements. Banks can only use deposits over the $250,000 protection provided by the Federal Deposit Insurance Corporation (FDIC).
Bank Term Funding Program
Following the collapse of Silicon Valley Bank in March 2023, the Federal Reserve Board authorized all twelve Reserve Banks to establish the BTFP to make available additional funding to eligible depository institutions to help assure banks can meet the needs of all their depositors. The program will be a source of liquidity against high-quality securities, eliminating an institution’s need to sell those securities in times of stress.
Bail-Ins and Dodd-Frank
Giving banks the power to use debt as equity takes the pressure and onus off taxpayers. As such, banks are responsible to their shareholders, debtholders, and depositors. The provision for bank bail-ins in the Dodd-Frank Act was largely mirrored after the cross-border framework and requirements outlined in Basel III International Reforms 2 for the banking system of the European Union.
Dodd-Frank creates statutory bail-ins, giving the Federal Reserve, the FDIC, and the Securities and Exchange Commission (SEC) the authority to place bank holding companies and large non-bank holding companies in receivership under federal control. Since the principal objective of the provision is to protect American taxpayers, banks that are too big to fail will no longer be bailed out by taxpayer dollars. Instead, they will be bailed in.
According to the Treasury Department, the federal government recovered $275.2 billion through "repayments and other income" from banks that benefited from the Troubled Asset Relief Program (TARP), $30.1 billion more than the original investment.
European Bail-In Policy
The use of bail-ins was evident in Cyprus, a country saddled with high debt and the potential for bank failures. The country's banking industry grew after Cyprus joined the European Union (EU) and the Eurozone. This growth, coupled with risky investments in the Greek market and risky loans from two large domestic lenders, led to government intervention in 2013.
A bailout wasn't possible, as the federal government didn't have access to global financial markets or loans. Instead, it instituted the bail-in policy, forcing depositors with more than 100,000 euros to write off a portion of their holdings, a levy of 47.5%.
In 2013, the EU introduced resolutions to make the bail-in a common principle by 2016 in response to the effects of the European Sovereign Debt Crisis. It transferred the responsibility of a failing banking system from taxpayers to unsecured creditors and bondholders, the same way Dodd-Frank did in the United States.
Investor Assets
In a bail-in, banks use the money from depositors and unsecured creditors to help them avoid failure. This also includes depositors whose account balances are more than the FDIC-insured limit. Banks have the authority to take control of any capital that fits the criteria per the law. Investors with accounts that exceed the $250,000 insured limit may be affected and should:
- Monitor the performance of the financial markets and financial sector
- Ensure that chosen financial institutions are financially secure and stable
- Spread the risk by diversifying money and assets
- Keep balances at or below the $250,000 limit
- Avoid banking with any institution that has large derivative and mortgage books, which can be risky in times of crisis
What Are the Risks of a Bank Bail-In on Consumers?
Bail-ins allow banks to avoid bankruptcy by shifting some risks to their creditors rather than to taxpayers. This risk can be transferred to bank customers, too.
How Are FDIC Deposits Affected In a Bail-In?
Banks can only use money from accounts over the $250,000 limit protected by the FDIC. Depositors should monitor changes to federal government guidelines relating to banks and financial matters.
Are Bank Bail-Ins Legal In the United States?
Bank bail-ins are legal under the Dodd-Frank Wall Street Reform and Consumer Act. Banks have the authority to use debt capital as equity to avoid failure. This includes capital from unsecured creditors, common and preferred shareholders, bondholders, and depositors whose account balances exceed the FDIC-insured limit of $250,000.
The Bottom Line
Big banks are not immune to the effects of financial instability. After the 2007-2008 financial crisis and the passage of Dodd-Frank, the federal government shifted the risks to creditors by allowing financial institutions to use debt capital to stay afloat. This means that debtholders, unsecured creditors, shareholders, and depositors may shoulder problems within the financial sector when banks use bail-in measures.
