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Bail-in to End the “Too Big To Fail” Dilemma

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  • Author HWANG.Sunjoo
  • Date 2017/02/16
  • Series No. KDI FOCUS No. 80, eng.
  • Language English
SUMMARY □ Designed to resolve failed banks via loss-sharing by shareholders and creditors, bail-ins were introduced to substitute bailouts, which are known to create moral hazards in banks and a crisis in national finance. However, in cases wherein the majority of creditors are the general public, governments are still more inclined to bail out, despite the bail-in instruments being available. To increase the effectiveness of bail-ins, supplementary methods, such as depositor preference and contingent convertible bonds (CoCo bonds) with rule-based triggers, are needed.

- Bailouts create moral hazards, and could lead to another banking crisis.

- Bail-ins resolve failed banks by sharing the burden of loss between the shareholders and creditors.

- Italy’s recent banking crisis shows that bail-ins can be futile.

- Deposits are applied to deposits, general bonds, CoCo bonds, etc.

- CoCo bonds help banks meet the regulatory capital requirements without diluting shareholders’ equity, and thus, issuance volume expands rapidly.

- Governments are more likely to bail out when the majority of creditors are the general public.

- When the market anticipates a bailout, the government will likely choose to bail out, and vice versa.

- As for ‘discretionary’ CoCo bonds, the government directly determines the losssharing, hence the political buren is larger.

- Due to the difference in political burden, ‘discretionary’ CoCo bonds tend to have a lower interest rate.

- A regression analysis finds that ‘discretionary’ CoCo bonds have a 1.72%p lower average interest rate.

- Adopting depositor preference would help increase the implementability of bailing in general creditors.

- Strengthening qualifications of investors in general bonds and CoCo bonds could enhance the implementability of bail-ins.

- Issuing ‘rule-based’ CoCo bonds could enhance the implementability of bail-ins.
KDI VOD Report
As we saw with the recent banking crisis in Italy,
the government tried to bail out, despite previously legislating the bail-in regime,
due to the political pressure from creditors, who were mostly local residents.

The majority of creditors in Korea also are the general public.
As such, bail-ins may become obsolete
if there are no additional institutional tools in place.

This study first introduces the bail-in regime,
and then, analyzes factors influencing the implementability of bail-ins,
and finally, presents the institutional tools needed to enhance their efficiency.

Depositors, general creditors and contingent convertible bond creditors
are all subject to bail-ins.
And while the government activates the bail-in
for deposits and general bonds, that for CoCo bonds is automatically triggered
by pre-established conditions.

In Korea, bail-ins for CoCo bond creditors have been in operation since 2013
and that for depositors and general bond creditors will be legislated within the year.

Of the bonds subject to bail-ins,
only deposits exceeding the deposit protection limit of 50 million won are included.

These deposits take up the largest share
of the total financing of Korean banks at 27.5%.

However, within this type of structure,
much like in the case of Italy,
the government will most likely choose a bail out,
even if bail-ins are avaliable, due to the heavy political burden
posed by the vast number of individuals, small business operators and SMEs.

So, what are the factors affecting the implementability of bail-ins?

Theoretically, when the market anticipates a bailout,
there is an increase in the number of investors.
This, in turn, increases the political burden for the government,
who will then, choose to bail out.

In contrast, if the market anticipates a bail-in,
the number of investors declines, which will reduce the political burden for the government, and a bail-in will be implemented.

This means, market expectations over the means of loss-sharing
and the resulting political burden are the main factors that influence implementability.

To examine what the actual market expectations are
over the implementability of a bail-in,
an analysis was conducted using CoCo bonds.

A comparative analysis on the interest rates of CoCo bond issuing countries reveals that,
the higher the share of discretionary, that is, government triggered, CoCo bonds, the lower the interest rates.

The results imply that the market assumes
there is little possibility of a government-activated bail-in
in a time of crisis due to the political burden.
Therefore, more will invest, despite the low interest rates.

To put it another way,
this means that investors do not believe that CoCo bonds will function as designed, and expect a bail-out in a crisis.

Specifically, there are three methods to boosting bail-in implementability.

Firstly, with regards to deposits, the government can implement depositor preference, which offers more protection to depositors than creditors.
However, the scope must be limited to those who require more consideration,
for example, individuals and SMEs.

Secondly, more rule-based CoCo bonds, that automatically trigger a bail-in
based on pre-established conditions, rather than discretionary CoCo bonds,
should be issued to lessen the political burden for the government.

Lastly, investor qualification for bank bonds and CoCo bonds
should be strengthened to reduce the share of non-professional investors.
This will also reduce the political pressure.
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