The era of the bank bail-in could very well be upon us.
This week, The Wall Street Journal reported that several big banks, including Wells Fargo (WFC), JPMorgan Chase (JPM) and Citigroup (NYSE:C), had presented to the Federal Reserve plans that involved issuing a certain amount of debt along with equity, specifically to shield depositors and taxpayers from losses in the event a bank subsidiary failed.
Per the Journal:
Banks said they each would agree to hold combined debt and equity equal to 14% of their risk-weighted assets, according to people familiar with the proposal. Long-term debt, they said, could be part of that mix. For the six biggest U.S. banks that may have to hold an additional buffer because of international guidelines, the total could be as high as 15% to 16.5%, the people said.
The plan was presented as an alternative to regulators, who have suggested previously that banks issue more long-term debt in an effort to prevent future taxpayer bailouts. News of the proposal comes one week after U.K. regulators signed off on Co-operative Bank's plan to ask subordinated bondholders to swap their debt securities for bank shares to avoid a government bailout. Senior debtholders were not affected by this plan, but they have suffered losses in the European Union before, most recently during the Cyprus bailout this year. Europe is reportedly writing new rules that would impose bail-ins for struggling banks in its poorer countries.
"We do believe that concept of bail-in capital is getting greater regulatory attention and banks may have to issue more unsecured debt in the future," KBW analysts wrote in a report released Tuesday.
U.S. regulators have yet to weigh in on the specifics of the big banks' proposal. BankThink readers should expect to hear more debate on this topic.
For starters, asking creditors to take a hit would mark a significant departure for the modus operandi of the financial crisis and would, at the very least, take some getting used to.
"Banks want to pay bondholders like bondholders when times are going good but they want them to bear equity-like risk when times turn to the worse," one Journal commenter wrote. "Who in their right mind would own bank debt under this proposal by the banks at current spreads?"
"If debt investors are to shoulder the risk of suffering a loss, they will need more confidence about what lurks in banks' balance sheets," write Neil Unmack and Peter Thal Larsen in a Reuters Breaking Views column.
Others argue bail-ins beat the alternative, the bailout.
"The bail-in method is much closer to what is observed in a true bankruptcy proceeding," writes Forbes blogger Richard M. Salsman. "The petitioner is insolvent, so haircuts of some magnitude must be suffered by the relevant creditors, but no haircuts at all are imposed on the general public, which stands outside the courtroom and is not a party to the case at hand."
Some industry experts, including former Federal Deposit Insurance Corp. chairman William Isaac, who proposed a similar plan regarding capital requirements in a recent BankThink op-ed, argue mandatory long-term debt issuance is part of a viable solution to "too big to fail." Requiring banks to regularly access the debt markets would provide a measure of discipline, this line of thinking goes, since unlike equity investors, bondholders have no upside and would spurn issuers that take reckless risks.
But others call debt an inadequate substitute for equity. "Imposing losses or expenses from the resolution process on a bank's creditors or on surviving institutions, which themselves might be systemically important and likely to be weak at the same time, might further destabilize the economy in a crisis," Anat Admati, a professor at Stanford University and co-author of The Bankers' New Clothes, wrote in a BankThink piece this week.
Should bondholders be required to bail in banks? If so, which classes of bondholders should be on the hook: Just the subordinated ones, or more senior creditors? Would bail-in mechanisms effectively curb systemic risk? Let us know in the comments below.