Bad Banks, Bail-ins, and the Importance of Following Plans

There aren't any fun options for dealing with a failing bank. Bail it out with taxpayer funds, and taxpayers are A) marginally poorer (perhaps temporarily), and B) very upset. Bail it in with bondholder funds, and bondholders are A) notably poorer, B) also very upset, and C) maybe freaked over their exposure to other banks, potentially sparking a wider selloff. After 2008, governments sought to strike a balance between keeping up political appearances and mitigating economic disruption. In 2014, the European Commission tried to remedy the uncertainty and protect taxpayers, crafting bank resolution rules requiring bondholders to take a hit before banks could tap government funds. Debate will continue over whether or not this was the right choice. But a key is that they have a rule-and sticking to it would provide a big improvement over 2008's haphazard approach. The question, however, is: Will they? The years-long story of one bad Austrian bank, which largely concluded Monday, sets a loose precedent and template.

In 2008, regulators didn't follow any standard playbook, instead getting "creative" and dealing with each bank encountering issues uniquely. Bear Stearns, a troubled investment bank facing a liquidity crunch, finds a buyer (JPMorgan Chase) with the Fed's help in March. Yet Lehman Brothers, a troubled-yet-solvent investment bank facing a liquidity crunch, fails after the Fed prevents a sale. Fellow investment banks Goldman Sachs and Morgan Stanley are allowed to re-register as bank holding companies over a weekend-permitting them to tap the Fed for liquidity aid. Three approaches just for investment banks! Wachovia and WaMu are allowed to fail before buyers swoop in. Fannie Mae and Freddie Mac were nationalized. AIG (troubled insurance company, etc.) is partly nationalized. Sometimes bondholders were hit, sometimes just stockholders. See a pattern? Neither do we, and neither did markets at the time, which panicked (in part) due to regulator-induced uncertainty. That's haphazard.

Now, to the tale at hand: When the 1990s began, Hypo Alpe Adria (HAA) was just a small regional bank making boring loans to vanilla borrowers in Carinthia, an Austrian province. But in 1992, a shady partnership with a local politician brought HAA official Carinthian backing for all its loans. Lower borrowing costs allowed HAA to expand its reach throughout Southeast Europe, while the Carinthian guarantee allowed it to make extremely risky (and often fraudulent) loans. By 2006 the jig was up, and HAA was put up for sale.

German bank BayernLB bit, buying a controlling stake in 2007, despite its own analysts labeling the bank a "squeezed-out lemon." (Later lawsuits alleged its top executives misled the board about the potential risks.) This was a prescient metaphor: HAA bled cash through 2009, at which point BayernLB refused to provide any more capital, and HAA, Carinthia and perhaps even Austria's entire deposit insurance system was feared insolvent. In stepped the authorities: In December 2009, Austria nationalized HAA for pennies on the euro. But after desperately trying for five years to squeeze more juice from the lemon by hunting down and selling nonperforming assets, they gave up. In October 2014, Austrian regulators split HAA into two banks-one with salvageable assets,^[i] and the other with everything else (€18 billion worth): a "bad bank" called Heta Asset Resolution.

A bad bank is designed to hold and gradually liquidate nonperforming assets. This simultaneously shields the original lender from losing money, and allows the new company to focus on working out terms with creditors.^[ii] Austria "bailed in" BayernLB by voiding 800 million euros of loans, plus another 890 million euros in junior debt held by a range of lenders. This was the first usage of the EU's bank resolution rules, and it ruffled some feathers. BayernLB sued. Austria sued back. Moody's downgraded debt at 11 Austrian banks. And it still wasn't over: After burning through even more taxpayer money (to the tune of €5.5 billion since 2009), Austria was staring at another €7.6 billion funding hole.

Austria then sought to end the story. In March 2015, Heta declared a 15-month moratorium on further debt payments while they worked out a final deal with creditors-an even deeper haircut for bondholders. "Uncharted territory," said one analyst. "An unprecedented and severe blow to the capital markets," said another. But Austria stuck to its guns. After months of negotiations, Austria announced Monday that 98.7% of Heta's creditors voted to accept a haircut on the remaining €11 billion debt pile.^[iii] No one got quite what they wanted, but at least the expensive legal battles underway are now moot, Carinthia seems free of its debilitating guarantees and the Austrian financial system gains back some of its lost credibility. Other banks with exposure had already written down the debt by more than what they'll get-not only didn't the European financial system implode, but a few banks will book a gain of sorts. Above all, though, Austria applied the bail-in rule more or less as it is designed.

The application of bail-in rules has been a contentious point in the eurozone since at least late last year, when Portugal and Italy saw vast political blowback when they forced bail-ins of junior bondholders in two long-troubled institutions. That stirred some uncertainty at the year's outset as to what eurozone regulators would do in the future. Would the rule bring the intended predictability or would regulators cave to political pressure, reintroducing haphazard behavior?

While we still can't say for certain how regulators will behave whenever the next crisis arrives, HAA's story suggests there is willingness to stick to bail-in rules. Crucially, setting a clear, predictable bail-in precedent also changes the choices outlined in the introduction. The bail-in option still hits bondholders, but is less likely to spark a wider sell-off because creditors start out more aware of their investments' riskiness and don't have to suddenly adapt to a negative surprise. In 2008, regulators appeared to be making it up as they went along, introducing new and dialing up existing risks and uncertainties. Rules like the EU's that set forth a clear roadmap for bank resolution should help avoid such wild responses in the future.