You put your savings in a deposit account in a bank of your choice, probably for convenience because it is close to home or work. Suddenly a banking crisis breaks out and the bank that held your deposit goes under and makes national headlines. What would be the first thought to cross your mind? Will my money be saved? Will the government step in to help? Why didn't anyone warn me that my bank would fail while the others would stay afloat? Unfortunately, some of these questions and their answers will have to change _ in a radical way.
A series of unfortunate events: In 2008, the US government bailed out two giant mortgage lenders, Fannie Mae and Freddie Mac, and later took control of American International Group (AIG) after the sub-prime debacle. In the same year, the British government rescued one of the UK's largest mortgage lenders, Northern Rock, along with Lloyds Banking Group and Royal Bank of Scotland Group.
Traditionally, when a large organisation is in trouble, especially one with great importance to the economy, the national government will step in. For instance, back in the late 1970s the American automobile industry had serious financial problems. One of the Big Three applied for federal assistance, and the US Congress subsequently passed the Chrysler Corporation Loan Guarantee Act of 1979. It provided US$1.5 billion worth of loan guarantees that the company then used to borrow $1.2 billion to finance its operations.
In a costly attempt, a huge amount of taxpayers' money was spent in order to restore confidence. A bailout by government diverts public monies that could have been used, say, for public investments or welfare, to private businesses with their own (private) shareholders. Naturally it begs the question: Why must the public buy shares in stressed institutions at the worst possible time? And why didn't their private shareholders come to the rescue of their own institution?
As a matter of fact, national authorities since then have increasingly tried to solve similar problems by using an opposite approach. Instead of securing additional capital from outside, banks that have found themselves in trouble have to find the solution from within. A "bail-in" programme, so to speak.
How a bail-in works: In its simplest form, a bail-in gives the authorities the power to write down a distressed institution's unsecured debt and/or convert it to equity. The Dodd-Frank financial reform act in the US, for example, includes a "resolution regime" that gives regulators the unconventional ability to impose losses on bondholders.
The European Union is also considering a bill to set a clear pecking order for the liquidation of collapsing banks. This bill, expected to be effective in 2018, would allow for the use of deposit funds over the guaranteed level of 100,000 euros, exactly the same threshold applied in the latest rescue of Cypriot banks.
Under the EU plan, shareholders would be the first group a troubled bank must tap for funds, followed by certain types of bondholders, and then customers with deposits above 100,000 euros. These three types of creditors combined would need to take minimum losses of 8% of a troubled bank's total liabilities before any taxpayer-supported aid would be considered.
For one thing, a bail-in better aligns risks with expected returns. Lenders, insured or otherwise, should be prepared to accept a loss in relation to their profit _ if the obligor goes under. A government bailout implies that both bondholders and savers are almost identically shielded from any loss, making it a seemingly risk-free activity.
For proponents, even deposits are viewed essentially as investments, and hence they should also bear risks. This is even more true for large depositors who have many other investment options available to them, unlike small retail depositors, whose savings may be all that's left after their monthly expenses. Thus, the threshold on guaranteed deposits is usually set relatively high so that retail depositors will hardly be affected, but still even retail depositors must beware of the risk they may be facing.
Reassessing risks: Once recognised, bail-in risks need to be priced in. Yields on debentures and interest rates on uninsured deposits will have to go up to compensate for the risks; as a result, banks' funding costs will probably rise. The exact impact, however, is harder to predict as it depends on the creditworthiness and perceived risks of each bank.
An International Monetary Fund study suggests that the effect of a bail-in can be determined by the extent of initial support offered to a bank by the relevant authorities: a bank with greater initial support will take a greater hit. The research argues that banks' credit ratings have had a strong degree of public support built into them. If so, the withdrawal of government support could bring down ratings by as many as five notches, practically dropping some investment-grade institutions to junk level.
The cost of such downgrades to junk status could be as high as 200 basis points; that's a two-percentage-point increase in funding costs. In other words, it could potentially wipe out the thin net interest margins some banks are clinging to. No wonder the ratings agencies fuss about bail-in risks. Early last month, Moody's Investors Service downgraded the subordinated debt ratings for eight Australian banking groups precisely because of a lack of foreseeable government support.
For Thailand, it's just a matter of time before investors take full account of bail-in risks. During the 1997 Asian crisis, the Thai government used public funds to save big banks from failing, just like in the United States during the sub-prime crisis.
But future Thai policy is pointing in a different direction, with the transfer of some Financial Institutions Development Fund (FIDF) debt payments back to financial institutions last year. In addition, the cost of the Deposit Protection Act is only one basis point, not close to being enough to cover an actual banking crisis, at the maximum level of coverage of 50 million baht per deposit.
While there is no planned change in the levy, the coverage level will be reduced to 25 million from August 2015, and then to 1 million in 2016. As the guaranteed threshold is lowered, banks might have to counter with higher interest rates to compensate for their risk. So, even though we may not be talking about a plan for a bail-in yet, but all signs are clearly pointing that way. For some depositors, sadly, the answers to the questions posted at the beginning will be "No and No".
TMB Analytics is the economic analysis unit of TMB Bank. Behind the Numbers is co-authored by Benjarong Suwankiri and Warapong Wongwachara. They can be reached at tmbanalytics@tmbbank.com