Bail-in vs. Bail-out
What is Bail-out?
Bail-outs occur when an outside investor, such as the government, injects money to help a borrower make payments on debts. It has helped save companies and whole countries from bankruptcy in the past, with taxpayers bearing the risk of their inability to repay loans.
In the financial crisis of 2007-2008, banks recognized as "too big to fail" were helped by the governments with a vast amount of taxpayer money to rescue them from bankruptcy and keep their operations running. In the US, for example, the government bailed-out the most prominent banks by injecting $700+ billion in order to save them from bankruptcy. The reason why governments bail-out these so-called "too big to fail" banks is, that due to the interconnectedness, a domino effect might be triggered if one of those banks fails. The result could be a crash of the whole financial sector, as we saw with the bankruptcy of Lehman Brothers.
The crisis taught governments that they must implement new resolution regimes for banks, that shift the burden of failing banks away from taxpayers to investors. This concept resulted, in the European Union, in the Bank Recovery and Resolution Directive (BRRD).
What is Bail-in?
Similar to the bail-out, a bail-in is used in times of bankruptcy or financial distress. However, it allows to write-down debt owed by a bank or to convert it into equity in order to ease the financial burden on the borrowing institution. This ensures that the taxpayers' money is not used in rescue operations by the government. Bail-in clauses are designed to keep a financial institution afloat, recapitalize them and secure operations during times of distress.
The BRRD implemented in 2014 across the EU28, includes a “bail-in mechanism” to ensure that banks' shareholders and creditors, including uninsured depositors, pay their share of the costs.
During the first half of 2013, many of BRRD's provisions (not yet implemented at the time) were used to resolve the banking crisis in Cyprus. It happened because, according to the IMF's Debt Sustainability Analysis, Cyprus could not afford to save its two largest commercial banks, as the funds needed would have been nearly 50% of Cyprus’ GDP. Thus, it is unsurprising that international creditors led by the IMF demanded bail-ins to resolve this crisis. That means that unsecured deposits larger than EUR 100.000 in the Bank of Cyprus were converted to equity to maintain the bank's operations going and to recapitalize the bank.
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