Bail-ins and bail-outs

Since the start of 2016, there has been a rule in the EU that no bank can be “bailed out” by an EU state without first attempting a”bail-in”. That is EU regulations now ensure that those who own a bank’s capital (bond holders) and those that own the bank (shareholders) must first sacrifice before those who do not directly profit from the bank (taxpayers) can intervene.

This is different from 2008, when no such rules existed. During that time, state bailouts would rescue private investors at the cost of the public purse. Private investors were not responsible for being the first responders to protect their investments. Now however, EU rules dictate that bondholders must sacrifice first. These are individuals who are owed payment first. Then shareholders, who generally sacrifice from tangential collapsing share prices – and the loss of any dividends.

The bail-in rule will be especially influential in Italy over the next few months, where many are particularly concerned about the country’s €360bn non-performing loans. These non-performing loans threaten the credibility of the banks and weaken investor confidence. As the Italians are being bound by the EU bail-in rules, their ability to undertake opportunistic preemptive intervention to rebalance the financial sector is severely curtailed. Italian banks will be the first to attempt to coerce bond holder and shareholder intervention to stave off failure.

Intriguingly, the potential negative impact of  such operations on the country’s financial sector would be compounded by the national characteristic that most of the bonds are held by local retail investors with small holdings – not institutional. Thus enforcing any “bail-in” rules will have a repercussive impact on the demand side of the economy: as the retail investors see their capital used to protect asset value and investments, they will have less disposable income for efficient investment elsewhere. Arguably, this would be less impactful in other economies with greater institutional dominance – as these investors are better diversified and potentially more able to balance the effects. However the caveat under this EU law is that states may retroactively compensate small shareholders after any bail-in – which may alleviate any such problems in Italy during the long-run.

Still, any short-run impacts may trigger a run on Italian investments that can cause immediate pressure on the Eurozone as a whole.

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