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Bail-In Clause

Used in times of bankruptcy or financial distress

What is a Bail-in Clause?

A bail-In clause is used in times of bankruptcy or financial distress and forces the borrower’s creditors to write-off some of their debt in order to ease the financial burden on the borrowing institution.

 

Bail-In Clause

 

The ultimate goal of a bail-in clause is to keep the institution afloat and operating, even in times of distress. Bail-in clauses usually either involve the creditor losing a part of their claim or restructuring the debt by issuing equity worth an equal amount.

 

Bail-In Clause – History

During the 2008 Global Financial Crisis, the U.S. Government issued bailouts for a number of failing, bankrupt financial institutions due to the substantial impact of their failure on the economy, and the expectation that the collapse of the companies would result in an overall economic disaster.

The total cost of the bailout was estimated to be around $700 billion. It was largely funded by U.S. taxpayers, which caused political turmoil among taxpayers since their money was being used for purposes other than improvements in infrastructure and healthcare services. To avoid the issue, the concept of bail-ins was introduced, which protects depositors and taxpayers at the expense of the creditors’ debt claims.

 

Bailouts vs. Bail-in Clause

A bailout is the opposite of a bail-in clause and allows the borrowing organization to stay in business and continue operations through the injection of capital or funds by a financially stable institution (e.g., the government) or investor.

On the contrary, a bail-in clause places more financial burden on the creditors, requiring them to reduce their debt so that the institution can survive and protect its depositors and the taxpayers.

Therefore, bailouts expose taxpayers to more risk and financial burden, whereas bail-ins put the same pressure on creditors – especially on unsecured creditors since they do not require any collateral before agreeing to the lending contract.

 

Bail-ins – Implications

 

1. Taxpayers

Taxpayers benefit the most from bail-in clauses, especially if there is an ongoing financial crisis where institutions need to be protected from failure and complete bankruptcy. By putting the pressure on creditors, bail-ins protect the taxpayers’ money and allow it to be allocated on public sector expenditure for better healthcare, infrastructure, and defense systems.

 

2. Politicians

Politicians may use the bail-in clause over the bailout clause in order to gain traction and favor among taxpayers, who are also the voters that decide the outcomes of elections.

 

3. Depositors

Depositors are well-protected by the bail-in clause. In case of financial distress to the institution (a bank, in this case), the depositors are unlikely to lose money if the funds to keep the institution running are provided by creditors.

 

Bail-ins – Risks

 

1. Moral hazards

Bail-Ins and bailouts both carry the risk of creating a moral hazard problem among the distressed institutions. By offering the institution a way out of financial trouble, bail-in clauses may encourage irrational and risky behavior that can lead to turmoil in the future.

 

2. Higher costs of borrowing

If a loan agreement includes a bail-in clause, lenders may charge a higher interest rate to compensate for the additional risk of losing a portion (or all) of their debt share in case of bankruptcy or financial distress. Therefore, borrowing institutions may face a higher cost of borrowing.

 

Practical Example: The Cypriot Financial Crisis

In 2012-13, the Republic of Cyprus faced an economic crisis due to the failure of Cypriot banks, which led to the use of bail-in clauses where depositors and creditors with claims of more than 100,000 euros had to forego a portion of their accounts to keep the bank operating and the economy from collapsing. The move took the potential burden of a bailout off of the taxpayers of Cyprus and led to the large creditors and depositors losing some of their share of the funds.

 

Related Readings

CFI offers the Certified Banking & Credit Analyst (CBCA)™ certification program for those looking to take their careers to the next level. To keep learning and advancing your career, the following resources will be helpful:

  • Quality of Collateral
  • Free Cash Flow
  • Cost of Debt
  • Financial Modeling Guide

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