No more taxpayer bailouts for British banks

Bank of England explains how it will deal with failed banks in future, and it won't involve taxpayer money.

The Bank of England has set out its new plan for dealing with failed British banks, making clear there will be no repeat of the taxpayer-funded bailouts of the financial crises.

The plan covers three distinct stages:

Stabilisation phase

Once a bank, lender or deposit-taking firm has entered the Bank of England's 'resolution' process, it will decide on how best to stabilise the firm. This may be through transferring some of its business to a third party, or through a 'bail-in' of bondholders to recapitalise the failed firm.

Restructuring phase

Once the firm has been stabilised and recapitalised, it will need to restructure to address the causes of failure and restore confidence.

Exit from resolution

This is the end of the Bank’s involvement with a firm in resolution. Either the firm will cease to exist, or it will be restructured and no longer require liquidity support.

This new three-step regime will come into force in January 2015, in order to comply with the European Union's new Banking Recovery and Resolution Directive.

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Bank bosses and bondholders bear the brunt

In practice, what does this new programme mean - and, most importantly, how will it insulate British taxpayers from yet another round of bailouts?

The first thing to note is that the Bank will have powers to dismiss a failed bank's directors and senior managers within 48 hours. Had this power been in force in 2008, it would likely have led to the swift dismissals of bosses such as Fred Goodwin at RBS and Adam Applegarth of Northern Rock.

The second important power taken by the Bank is the right to impose losses on bank investors, including shareholders and bondholders. In an extreme scenario, shareholders could be completely wiped out and bondholders forced to convert their bank debt into equity (shares). This did not happen during the 2007/2009 financial crisis, largely because UK authorities were worried about senior bondholders losing faith in UK bank debt.

By bailing-in creditors, the Bank of England hopes to keep banks operating, while avoiding any need for taxpayer backing. However, forcing bank investors and creditors to suffer losses could lead to massive lawsuits and global haggling between regulators later down the line.

The Bank's other major concern is to ensure that bailed-in banks remain open for business and that payments to individuals and companies continue to flow. It is also important that depositors can access their savings, even during bank runs such as that seen at Northern Rock in mid-September 2008.

The Bank's new rules will require banks to burn through 8% of their liabilities before going cap-in-hand to the State for help. Royal Bank of Scotland, which got a £45.2 billion bailout in October 2008, would not have reached this 8% threshold at the time of its near-collapse, largely because its balance sheet had swelled to a gigantic £2.4 trillion (larger than the entire UK economy).

Only in extreme cases - where bail-ins, asset sales and customer transfers have proved inadequate to stabilise a bank - would public money be used to bail-out a firm. Initially, these last-resort bailouts will come from a resolution fund of £2.6 billion, which will be funded by the current bank levy and is equal to 1% of UK savers' deposits.

Sir Jon Cunliffe, the Bank's Deputy Governor for Financial Stability, said: "The Bank seeks to ensure that firms, whether large or small, can fail without causing the type of disruption that the United Kingdom experienced in the recent financial crisis and without exposing taxpayers to loss."

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Good news for taxpayers, bad news for owners and creditors

Clearly, reducing the risk of taxpayer bailouts during future banking crises is welcome. However, in order to reduce future risk to UK taxpayers, the Bank of England has loaded more risk into the laps of bank bondholders and, even more so, bank shareholders.

Under the Bank's new regime, shareholder wipe-outs could well be a much more likely event. What's more, a failing bank's unsecured creditors would share the losses by seeing their claims written down. Similarly, dealings in a bank's debt would be frozen, with bondholders later given tradeable certificates in place of their bonds.

That said, the Bank of England claims that, under its new regime, shareholders and creditors would not be worse off than they would be if a failed bank entered insolvency. Even so, with the biggest banks having assets and liabilities in the trillions of pounds, winding up a big bank will remain a messy and drawn-out affair.

Safer British banking

When the UK enters its next financial crisis, we will have a defined framework for dealing with failing financial institutions. It's high time that we had robust rules and better forward planning to cope with the next emergency. While bank shareholders and bondholders may grumble about this new framework, orderly bank failures, greater financial stability and the end of Too Big To Fail are worthwhile goals.

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