16.2 Creditor Bail-ins by Regulators
16.2.2 Bailable Instruments and the Amount of Losses
Common to all forms of creditor bail-in, whether it occurs outside or within a formal
bankruptcy procedure, is the question of which classes of debt instruments are eligible for impairment or conversion. Absent a special exemption from normal priority rules,
applying debt-to-equity conversion across the entirety of a financial institution’s capital structure will expose short-term unsecured debt holders to the risk of impairment, encouraging them to exit preemptively from an institution that is perceived to be in distress, considerably increasing the risk of a run. Shielding short-term debt holders (in particular, uninsured deposits including foreign deposits, nondeposit short-term debt, plus all the other systemically important liabilities that are likely to exit instead of accepting impairment) from the imposition of losses will, however, override ordinary rules of contractual priority controlling inter-creditor relationships outside of bankruptcy, altering the pricing of longer term bailable instruments that beforehand may have ranked equivalently with (or senior to) shorter term debt in order of recovery but now will in effect have been demoted.
At the least, the power of regulators conducting bail-in to unsettle existing inter-creditor contracts for the purpose of favoring systemically relevant debt is likely to raise the cost of unfavored bailable instruments proportionately. Further, short-term creditors that harbor doubt about whether exemptions will actually be given or the strength of the legal footing for a regulatory carve-out will rationally prefer to withdraw from a distressed institution rather than remain invested during a bail-in and, taking their chances in court.
The FDIC’s SPOE proposal, pursuant to OLA, discussed below, seeks to avoid these problems by limiting bail-in to the holding company, which is generally funded by only longer term debt. This in turn creates the necessity to downstream new capital from the restructured holding company to the banks and other operating subsidiaries, a matter we examine in our discussion of OLA.
The Basel Committee proposal on bail-ins limits bail-in conversion to noncommon tier I and tier II capital instruments only. Under this formulation, short-term debt
presumably will be excluded from conversion, since it is not a capital instrument. This will reduce the danger of setting off a run or spreading contagion, since short-term debt would be protected. Limiting the selection of bailable instruments to tier I and tier II capital only, however, could restrict the total amount of capital potentially available to
absorb losses, narrowing the usefulness of bail-ins to situations in which institutional losses are no greater than total existing capital. Short-term investors who suspect that their issuer’s long-term debt and common equity are insufficient to facilitate the
recapitalization will expect to be impaired too despite ex ante assurances of a carve-out, and may run anyway. This concern is even more acute in the case of an Institute of International Finance (IIF) proposal, which ordinarily reserves only subordinated debt, but not senior debt, for bail-in conversion, and thus increases the chance that a severely impaired firm will be unable to marshal the financial resources necessary to support a successful bail-in. Although the IIF proposal does permit bail-in of senior indebtedness in extraordinary circumstances, it would require a separate decision by regulators.46 If
short-term creditors had any doubt that this decision would be timely and forthcoming, they might panic and run.
Provided in table 16.1 is an illustrative bail-in based on Citigroup’s consolidated balance sheet as of December 31, 2008. It depicts a bail-in at the holding company level.
Table 16.1 Illustrative bail-in of Citigroup balance sheet as of December 31, 2008 (USD millions)
As the table suggests, the firm possessed enough senior and subordinated long-term
debt, about $1.9 billion, to support losses of 20 percent, or about $260 million, to its trading, investment, and loan portfolios through bail-in, without impairing guaranteed, short-term, and otherwise ineligible instruments. Losses greater than approximately 30 percent of the carrying value of these assets, however, would have exhausted the amount of long-term debt eligible for bail-in, requiring public support to fully restore the pre–
bail-in leverage ratio without converting shorter term instruments. The issue of sufficient bailable instruments at the holding company level is a concern inside formal resolution like OLA, as well as outside formal resolution.
Table 16.2 Illustrative bail-in of Citigroup under IIF proposal with subordinated debt only (USD millions)
Under the IIF proposal, however, in which bail-in is confined (at least initially) to subordinated and junior subordinated debt instruments only, losses of 20 percent or more would exhaust bailable capital and subordinated debt, requiring public support or the conversion of senior indebtedness (via separate regulatory approval) to effectuate the bail-in. As of December 31, 2008, subordinated debt held at Citigroup’s parent and
subsidiaries levels totaled no more than $57.7 billion, or just 16 percent of Citi’s
cumulative long-term debt maturities recorded on balance sheet (the remaining $301.6 billion represented senior long-term instruments) (see table 16.2). A bail-in of Citigroup assuming even modest balance sheet losses would thus have overwhelmed the total amount of liability claims the IIF proposal would make available to regulators. The current solution to this problem for bail-ins within resolution is to impose minimum requirements of unsecured debt that would be available for potential bail-in, through TLAC, or total loss absorption capacity requirements, discussed below under OLA.47