Public Statement

The credibility of bail-in

The recent failure of Credit Suisse and the subsequent bailout by UBS has raised questions about the effectiveness of bail-in regimes in maintaining financial stability. The framework for bank resolution, established after the Great Financial Crisis, relies on a credible bail-in mechanism to absorb losses when banks fail. However, the handling of Credit Suisse's demise has cast doubt on this approach.

Regulators had prepared a resolution plan that would have imposed losses on Additional Tier 1 (AT1) and bail-in creditors, but instead chose to facilitate a takeover by UBS, backed by public guarantees. This decision effectively shielded bail-in creditors from losses, raising concerns about the credibility of the bail-in mechanism. The episode has sparked debate among regulators, policymakers, and market participants about the implications for bank resolution frameworks and the need for further reforms.

Market reactions to the Credit Suisse failure have also highlighted weaknesses in bail-in regimes. Bond prices reflected the expectation that AT1 creditors would bear losses, but the actual outcome was different. Spreads on AT1 bonds rose in Switzerland, where they had been written down, while falling in the euro area and the United Kingdom, where authorities issued clarifications on the treatment of AT1 bonds. In contrast, bail-in bond spreads tightened across all three jurisdictions, indicating a uniform market response to the risk of loss for these creditors.

Why it matters

The recent failure of Credit Suisse and the subsequent intervention by authorities has raised questions about the credibility of bail-in, a key component of the global systemically important banks' (G-SIBs) resolution framework. The bail-in mechanism is designed to ensure that creditors, rather than taxpayers, bear losses when a bank fails. However, the outcome in Credit Suisse's case, where AT1 bonds were written down but bail-in creditors were left whole, has cast doubt on its effectiveness.

The credibility of bail-in is not just a matter of regulatory design, but also of market perception. If markets do not believe that bail-in will be implemented as intended, it can undermine the confidence in the banking system and lead to reduced market discipline. The recent episode highlights the need for regulators to carefully consider the implications of their actions on market perceptions.

The credibility of bail-in is closely tied to the effectiveness of the resolution framework as a whole. If the framework is not credible, it can lead to a lack of trust in the banking system and increased risk of bank failures. The recent developments in Credit Suisse's case underscore the importance of ensuring that the bail-in mechanism is robust and effective in preventing losses from being borne by taxpayers.

Key points

The credibility of bail-in was tested by the failure of Credit Suisse in March 2023, with regulators choosing a takeover over a bail-in resolution to mitigate financial stability risks.
A framework that measures changes in bail-in credibility is based on bond spreads across three types of bank debt: Additional Tier 1 (AT1), bail-in, and senior bonds.
Markets drew different lessons from the Credit Suisse failure, with AT1 bond spreads rising in Switzerland but falling in the euro area and UK where authorities clarified AT1 treatment.
The episode revealed weaker bail-in credibility and reduced market discipline, as investors responded less to bank earnings news and saw larger declines in the cost of bail-in debt for weaker banks.
Senior bond spreads barely moved, indicating that markets revised their view on loss allocation rather than bank failure risk, but still reflected a lower probability of bail-in.
The findings suggest that the resolution framework's credibility was weakened by the Credit Suisse episode, with investors assigning a lower probability to bail-in and reducing market discipline.

Institutional context

The institutional context in which bail-in operates is shaped by regulatory frameworks designed to mitigate the risk of bank failures. The establishment of a clear framework for resolving failing banks has been a key development in recent years, with regulators building on lessons learned from previous crises. However, the ability of these frameworks to credibly allocate losses among creditors and avoid taxpayer bailouts remains a subject of ongoing debate.

The European Union's Capital Requirements Regulation (CRR) and the Basel III framework have provided a basis for national regulatory bodies to develop their own resolution plans and procedures for dealing with failing banks. The implementation of these rules has been influenced by concerns about financial stability, as well as efforts to promote market discipline and ensure that creditors bear losses in the event of bank failure.

The recent episode involving Credit Suisse highlights the challenges of implementing bail-in effectively in practice. While regulators had a resolution plan in place, they ultimately chose to facilitate a takeover by UBS rather than imposing losses on bail-in creditors. This decision has raised questions about the credibility of bail-in and whether it can be relied upon as an effective mechanism for allocating losses among creditors.

Practical considerations

Practical considerations The recent failure of Credit Suisse has highlighted the need for robust resolution frameworks that can mitigate financial stability risks while maintaining the integrity of bail-in mechanisms. Practitioners must be aware of the evolving regulatory landscape and its implications on credit markets.

To navigate these complexities, banks should maintain close relationships with regulators and ensure they are well-versed in the applicable resolution frameworks. This includes understanding the treatment of different types of bank debt, such as Additional Tier 1 (AT1) bonds, bail-in bonds, and senior bonds. Banks must also be prepared to respond quickly to changes in market sentiment and regulatory signals.

Institutional investors, including pension funds and insurance companies, should conduct regular stress tests on their portfolios to assess the potential impact of bank failures on their investments. This can help identify areas for improvement in risk management and portfolio diversification. By taking a proactive approach to managing these risks, both banks and institutional investors can work together to maintain financial stability and promote the credibility of bail-in mechanisms.

Source: BIS Research Papers