Definition of bail-in
Bonds are a form of debt and as such, they rank higher than equity. This gives them a better claim to get their money back when business turns sour since the owners - equity holders - have an obligation to repay their creditors.
Following the financial crisis, when governments injected hundreds of billions into banks, most bondholders were left untouched - even those holding subordinated, or junior, debt, which is theoretically designed to bear losses in times of stress.
The result was anger, particularly in Brussels, and a desire to make bondholders - who after all helped lend the money that allowed banks to lend imprudently - share the burden in future by making them forfeit part of their investment to "bail in" a bank before taxpayers are called up on to bail it out.
In theory, this will force them to be more careful with their investments and protect the taxpayer from a re-run of the recent crisis.
A bail-in takes place before a bankruptcy and under current proposals, regulators would have the power to impose losses on bondholders while leaving untouched other creditors of similar stature, such as derivatives counterparties. By quickly addressing the problems of sickly institutions, they would also help stabilise the financial system by removing uncertainty.
Bail-in regimes have unnerved bondholders because they are not traditional bankruptcies, which have strict rules and a court-supervised process that mean creditors are ranked in order of repayment precedence, and those in each group must be treated equally. Bondholders and many bank executives warn that such moves could have negative consequences for the wider economy.
Banks finance much of their lending through bonds. Bond holders are likely to require more interest if they are at risk of losing money to a bail in. If banks’ borrowing costs rise, that could in turn be priced into the costs of mortgages and other loans. Regulatory efforts to protect taxpayers could unintentionally expose them to a permanent rise in the cost of credit.
The US has already put in place bail-in-like powers as part of the Dodd-Frank financial reform act passed last year. The law includes a resolution scheme that gives regulators the ability to impose losses on bondholders while ensuring the critical parts of the bank can keep running.
Employees would be paid, the lights would stay on and derivatives contracts would not have to be instantly unwound, one of the areas that caused market confusion when Lehman Brothers collapsed in September 2008.