You're overselling the bail-in provisions here. Frank-Dodd and the bail-in regulations it includes certainly introduced some much-needed improvements. But let's not pretend that the bail-in is either proven in practice nor a cure of any kind in truly dire situations.
The problem with the bail-in is that at the end of the day, if there isn't enough wholesale capital available, depositors are still on the hook. Indeed, we saw the only instance of the bail-in in practice (that I'm aware of at present) so far in Cyprus resulted in depositors having a portion of their savings converted to equity (in a nearly-insolvent entity).
At the end of the day, the risk still lies with the public if things get bad enough at a big bank. Through their deposits, through the FDIC, or through a bail-out, if the political winds blow that way.
The truly safest solution is to separate investment banking from depository banking again and to further limit both the size and the allowable exposure levels of investment banks.
I don't think the bail-in can yet be framed as a good thing. It's theoretically helpful in limited situations where enough wholesale capital is available (or can be made available) to solve a crisis of liquidity. Outside those boundaries, it induces greater risk on depositors. And in that situation, it may actually be good (in a perverse way) that the public doesn't know more about it, because if they did it'd likely increase the incentive/pressure on deposit bank runs.
Again, the solution here is to separate depository banking from investment banking. Or, put another way, to very tightly regulate the sorts of investments that depository banks can make. On top of that investment bank investments should be regulated more than they are today. And on top of all that, continuing with a rapid-insolvency process + bail-in would make sense for both depository and investment banks, should the need ever arise in either case (which likelihood would be greatly reduced through these further regulations). But the bail-in without these other measures carries risk and will be of only limited assistance.
You are absolutely right that bail-in only helps if you have debt to bail-in, and that was not the case for Cyprus.
Bail-in will only be useful when the banks have built up enough bail-inable capital, and depending on what is the definition of bail-inable capital, most banks are not there yet (regulators take different views on what constitutes good bail-inable debt).
However all the draft regulations that are being prepared now point to relatively high requirements, in the region of 25-30% of the Risk Weighted Assets, which should be ample to absorb a very large loss.
So if the crisis happens this week, it won't help, if it happens in 5 years or after it will certainly help a lot, and be a first line of defence before contemplating a bail out.
On the separation of commercial and investment banks, I am not convinced it actually helps. Reproducing another of my comments on this article:
If we take the example of the UK, all of the bank failures were because of non investment banking activities. RBS failed because of its excess of leverage as a result of its disastrous acquisition of ABN AMRO and because of its loan book, HBOS because of its loan book (essentially commercial real estate exposures), and Northern Rock because of their over-reliance on wholesale funding.
There are examples of banks failing or making large losses because of the investment banking activities (Lehman, Merrill, Bear Stearn, UBS) but my point is rather that the principle "Retail banking = safe, Investment banking = risky" is simply not true.
In a way, universal banks tend to be more robust than a specialized bank, as it benefits from funding and revenues diversification (and cheer size to absorb losses).
> Bail-in will only be useful when the banks have built up enough bail-inable capital, and depending on what is the definition of bail-inable capital, most banks are not there yet
I'm glad to hear you say this. There is definitely a wide gap between the reality of available bail-in capital today and the promise of the theory if it were available.
> However all the draft regulations that are being prepared now point to relatively high requirements, in the region of 25-30% of the Risk Weighted Assets, which should be ample to absorb a very large loss.
Theoretically. But the problem is the "Risk Weighted Assets". How do you do the weighting? A great deal of work has gone into this (as you know), but RWA calcs existed pre-crisis, as did specific RWA tiers for securitized instruments. We failed to properly weight the risks before and nothing says we won't do so again. The Fed is still wrestling with "advanced approaches" to RWA and the last time I checked finalizing the requisite approach was on "indefinite delay".
Point being... we don't have any assurance here. And we don't want to repeat the mistakes of overconfidence in our prowess of risk-assessment that we made last time around.
> So if the crisis happens this week, it won't help, if it happens in 5 years or after it will certainly help a lot, and be a first line of defence before contemplating a bail out.
I agree with you fully here. We also need to address what happens in the more extreme cases (and we need to go further in preventing the likelihood of more extreme cases).
> On the separation of commercial and investment banks, I am not convinced it actually helps. Reproducing another of my comments on this article:
You were replying to me in that other comment as well. :)
As I mentioned there, I also think depository banks should be more regulated in a) the total risk they can take on, and b) what sorts of investments they can make. (So the total quantity of risk and the type of risk.)
The depository banks in the UK were not regulated enough, clearly. I don't see how combining poorly regulated depository banking risk with poorly regulated investment banking risk would possibly help. Imagine Lehman directly combined with RBS... it's an even bigger disaster.
Besides, my contention is not that retail banking = safe while investment banking = risky. Both are risky. It's that contagion is bad. Increased correlation is bad. Combining retail banks and investment banks is a bad idea both theoretically and as proven in practice.
We should contain risk. Let's allow some institutions (investment banks) to create complex derivatives, advanced securitizations, make markets, participate in diverse investments, trade fairly liberally and generally do what investment banks do. Let's put that type of risk in one bucket, and still regulate the total risk they can take on, the means by which they are unwound in crises, etc.
Let's have a separate bucket of risk for depository/retail banks, which is as separated as possible (in an interconnected and fast-moving economy and financial system) from that bucket of risk.
The only possible reason not to separate these two buckets of risk is if you think they diversify each other. But that's not right even theoretically and it definitely has not been the case in practice.
> Let's have a separate bucket of risk for depository/retail banks
Correct me if I'm wrong, but isn't the key ingredient for contagion (in an available capital freeze scenario) uncertainty? And doesn't money from depository banks eventually end up in investment banks anyway?
My (possible stupid) question: why are they attempting to regulate the actors when the internet has shown us the benefits of regulating interfaces (i.e. robustness, innovation, scalability).
Allow depository banks to put capital to good use via investment / other financial institutions, but severely restrict the instruments they have available to do so. Limited differentiation, simple terms, able to be modelled. With the goal of building a de facto contagion firewall through standardization and control of the boundary rather than the market actions on either side.
> You were replying to me in that other comment as well. :)
Sorry! Will teach me to not read avatars!
On your point on RWA, whether RWA appropriately reflect the risks of a financial institution is I think a separate debate, but the definition of "appropriately capitalised" from a regulator point of view is based on RWAs, and therefore sizing how much debt needs to be bailed in to recapitalize the bank on RWAs is not absurd.
The problem with the bail-in is that at the end of the day, if there isn't enough wholesale capital available, depositors are still on the hook. Indeed, we saw the only instance of the bail-in in practice (that I'm aware of at present) so far in Cyprus resulted in depositors having a portion of their savings converted to equity (in a nearly-insolvent entity).
At the end of the day, the risk still lies with the public if things get bad enough at a big bank. Through their deposits, through the FDIC, or through a bail-out, if the political winds blow that way.
The truly safest solution is to separate investment banking from depository banking again and to further limit both the size and the allowable exposure levels of investment banks.
I don't think the bail-in can yet be framed as a good thing. It's theoretically helpful in limited situations where enough wholesale capital is available (or can be made available) to solve a crisis of liquidity. Outside those boundaries, it induces greater risk on depositors. And in that situation, it may actually be good (in a perverse way) that the public doesn't know more about it, because if they did it'd likely increase the incentive/pressure on deposit bank runs.
Again, the solution here is to separate depository banking from investment banking. Or, put another way, to very tightly regulate the sorts of investments that depository banks can make. On top of that investment bank investments should be regulated more than they are today. And on top of all that, continuing with a rapid-insolvency process + bail-in would make sense for both depository and investment banks, should the need ever arise in either case (which likelihood would be greatly reduced through these further regulations). But the bail-in without these other measures carries risk and will be of only limited assistance.