Bank bailouts during periodic financial crises aim to stop financial panic and restore the stability of the financial system. Even if they are undesirable, future bank bailouts are unavoidable due to political and political economy reasons, whether or not they are regulated or economically efficient. In a new book, I build on existing literature to examine the different bank bailout and resolution techniques and tools through carefully selected case studies from the U.S., the E.U., the U.K., Spain, and Hungary. The pros and cons of the different legal and regulatory options are identified in order to reconstruct a regulatory framework that might better serve countries in future financial crises.

While the U.S. government recovered every cent of the money spent on bank rescue measures, with interest, the E.U.’s post-2008 bank bailouts led to a sovereign debt crisis by 2011 that contributed to the political, social, and economic tensions there. This striking difference was due to better methods of bailing out banks in the U.S. than in the E.U. My book recognizes that the E.U. had fewer options than the U.S. because the European bank failures were mostly insolvency-induced rather than illiquidity-induced, as in the U.S., and because of the limited monetary policy tools of the E.U. in contrast with the practically unlimited monetary policy options of the U.S.[1] This limitation amplified the importance of choosing bank-bailout methods in the E.U.

Building upon the post-2008 legal-regulatory developments in the jurisdictions selected for analysis, one can see the penetration of “banking bailout law” provisions into other areas, including constitutional law, bankruptcy law, banking law, investment law, deposit insurance, consumer protection, monetary policy, and fiscal policy-related laws. The preventive leg of this developing body of law has developed a lot over the past 10 years but is not capable of eliminating future bank bailouts, because cyclical and severe financial crises are unavoidable, and governments never remain inactive in those crises. The other, crisis-management leg of this law is underdeveloped, especially in the U.S. but also in the E.U., because of the strong anti-bailout approach of the post-2008 era, which profoundly affected both the 2010 Dodd-Frank Act and the 2014 Bank Recovery and Resolution Directive (BRRD). The recognition of bank bailout law enables a more coherent theory and understanding of the very phenomenon of bank bailouts, and it will result in more successful future bailouts.

The conclusions reached in my book are based on robust empirical evidence available in the selected jurisdictions. The book systematizes the selected bank bailout cases and their methods based on a variety of criteria, including those derived from the Bagehot Dictum (i.e. lending early, freely, at a penalty rate, against good collateral, to solvent banks).[2] There are three measures of success: (1) repayment in full, (2) positive effect on financial stability, regarding both the financial institution and the financial system, and (3) relatively short time-frame The case studies confirm that bank bailouts are not always successful, and that methods make a difference. The book identifies the patterns and concludes that there are (1) successful bailouts, (2) bailouts that should not be allowed, and (3) bailouts that represent long-term burdens on the public budget, making their success dubious at best.

Chief Findings

The existing literature has not effectively identified how to do a bank bailout successfully. The issue was first raised by Walter Bagehot in 1873, and revisited by, among others, Adam J. Levitin following the 2008 crisis.[3] Ten years later, I analyze in my book the known bank bailout cases in the selected jurisdictions to tackle this issue from a comparative perspective.

I identify three main bank bailout approaches from the analyzed cases: A government acted as lender-of-last-resort, as guarantor-of-last-resort, or as investor-of-last-resort.[4] In most cases, the government combined these approaches, and the first two (lending and guaranteeing) almost always went hand in hand. Within the investor-of-last-resort solutions, the government either invested in bonds and became a controlling or non-controlling owner of the rescued entity or invested in equity. The bailout of state-owned or subsidized or controlled entities (such as Fannie Mae and Freddie Mac) represented a specific sub-type. State ownership or control increased the probability of future bank bailouts.

Most cases in the E.U. resulted in nationalization and controlling ownership rights for the state. By contrast, in those cases where the U.S. government became temporary owner of the rescued entity (see the Troubled Asset Relief Program), it obtained non-voting preferred shares in order to keep the state intervention at a minimum, allow it to  exit the transaction as soon as possible, and keep private investors more involved. Another notable difference was that the U.S. bank bailouts addressed illiquidity while the E.U. and its member states acted slowly and then bailed out insolvent banks.

Both illiquidity and insolvency-induced bailouts may be economically successful, but insolvency-induced bailouts are more complicated and contested because of their long-term adverse effect on public finances. Insolvency-induced bailouts require a complete restructuring of the failing entity (see the Fannie Mae, Freddie Mac, AIG, or the Lloyds Bank or Royal Bank of Scotland bailouts in the U.K.). Insolvency-induced bailouts should only be allowed when many banks become insolvent simultaneously in a financial crisis, and the collapse of the financial system is a realistic risk, and when the state is the owner of the failing bank and so would realize losses in any event.

The cases analyzed in my book confirm that system-wide bank bailout schemes have some advantages over individual bank bailouts, such as fewer antitrust concerns, more effective tackling of systemic issues, and faster response. Yet both individual bailouts and bailout schemes can be successful. In the U.K. and in Spain, the government first set up bank bailout schemes, but because  the schemes were not effective, were forced to bail out (through nationalization) some of the biggest banks in order to avoid systemic instability. There are also successful and unsuccessful examples of individual bailouts.

A shared characteristic of the current U.S. and European regimes is a strong anti-bailout stance in their respective laws that seems to contradict the view of most scholars that bank bailouts are unavoidable in crises. In the U.S., there is a bailout prohibition in the 2010 Dodd-Frank Act, whereas in the E.U., despite the strong anti-bailout message of the 2014 BRRD, some provisions of the directive itself, as well as the 2016 Kotnik decision, allow bank bailouts following the exhaustion of bank resolution tools, such as the bail-in.[5]

My book concludes that the obligatory imposition of the bail-in by the 2014 BRRD is not viable. This seems to have been confirmed by the 2016-2017 bank rescue measures in Italy, where bailouts rather than bail-ins were used due to financial stability concerns. A bail-in can function well as a complementary tool (as in the U.S. by the FDIC), especially if it is negotiated (as in the U.K.) rather than imposed. But, as a foundation and obligatory element of bank resolution, it sends the wrong message to investors. Even if the 2014 BRRD’s details are well-designed, because of its flawed underlying principle (i.e. prioritizing the protection of taxpayer money over investor confidence, especially in a financial crisis), its effectiveness is questionable.

As for the crisis-management aspect of the developing bank bailout law, the E.U.’s legal-regulatory model is fundamentally different from the U.S.’s ad hoc and ex post evaluation-based model, with the E.U. having developed a systemwide and ex ante insurance regime, the European Stability Mechanism (ESM) and the Single Resolution Fund. Yet both the U.S. and the E.U. will resort to bank bailouts in a future financial crisis because the preventive tools do not provide solutions for all cases.

My book concludes with two principal recommendations: (1) the U.S. should put more emphasis on restoring its sovereign debt to sustainable levels, and (2) the E.U. should significantly simplify and further integrate its legal-regulatory framework.

ENDNOTES

[1] Neel Kashkari, “60 Minutes”, CBS (March 22, 2020) (“…there is an infinite amount of cash in the Federal Reserve. We will do whatever we need to do to make sure there’s enough cash in the banking system.”), at https://www.cbsnews.com/news/coronavirus-and-economy-best-and-worst-case-scenarios-60-minutes-2020-03-22/.

[2] BAGEHOT, W, LOMBARD STREET: A DESCRIPTION OF THE MONEY MARKET, 334 (Henry S. King & Co, 3rd ed., London, 1873).

[3] Levitin, A J, In Defense of Bailouts, 99 Geo. L.J. 435-514 (2011).

[4] See for example, Tucker, P, The lender of last resort and modern central banking: principles and reconstruction, BIS Papers No 79 Re-thinking the lender of last resort, Monetary and Economic Department, 10-42 (Sept. 2014); Judge, K, Guarantor of Last Resort, TEX. L. REV., Vol. 97 Iss. 4 (March 2019); for an institutionalized approach see Manns, J, Building Better Bailouts: The Case for a Long-Term Investment Approach, 63 FLA. L. REV. 1349 (2011).

[5] Curia judgment (Grand Chamber), Case C-526/14, Tadej Kotnik and Others v Državni zbor Republike Slovenije, Request for a preliminary ruling (judgment No ECLI:EU:C:2016:570) (July 19, 2016).

This post comes to us from Virág Blazsek, an attorney at the United Nations Joint Staff Pension Fund’s Office of Investment Management in New York. It is based on her new book, Banking Bailout Law, available here. The views expressed herein do not necessarily reflect the positions of the United Nations. The author wishes to thank Professor Emeritus Arthur E. Wilmarth, Jr. of the George Washington University School of Law for his helpful comments.