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October 21, 2010

Calello: From Bail-Outs to Bail-Ins

A proposal coauthored by Paul Calello '87, head of Credit Suisse's investment bank, to recapitalize failing banks with shareholders' and creditors' money is gaining momentum in Europe.


Paul Calello ’87, head of Credit Suisse’s investment bank and a member of the School’s Board of Overseers, coauthored a proposal to recapitalize failing banks with shareholders’ and creditors’ money that is gaining momentum in Europe.

Drawing on corporate restructurings, a so-called “bail-in” would involve recapitalizing a failing bank by looking first to its own capital base rather than the state.

Calello and Wilson Ervin, a senior adviser at Credit Suisse, represented Credit Suisse at the eleventh-hour meetings hosted by the New York Fed in September 2008 as regulators and bank CEOs tried to save Lehman Brothers. They introduced the bail-in course of action in a January 28, 2010, article in The Economist. “A bail-in during the course of that weekend could have allowed Lehman to continue operating and forestalled much of the investor panic that froze markets and deepened the recession,” Calello and Ervin wrote.

The authors detail how a bail-in could have saved Lehman Brothers: “First, the concerns over valuation could have been addressed by writing assets down by $25 billion, roughly wiping out existing shareholders,” Calello and Ervin wrote. “Second, to recapitalize the bank, preferred-stock and subordinated-debt investors would have converted their approximately $25 billion of existing holdings in return for 50 percent of the equity in the new Lehman. Holders of Lehman’s $120 billion of senior unsecured debt would have converted 15 percent of their positions, and received the other 50 percent of the new equity.”

“The remaining 85 percent of senior unsecured debt would have been unaffected, as would the bank’s secured creditors and its customers and counterparties. The bank’s previous shareholders would have received warrants that would have value only if the new company rebounded. Existing management would have been replaced after a brief transition period.”

The authors argue that bail-ins should form part of a broader recovery and resolution package that would improve the financial system’s health and avoid the use of public funds. Bail-ins would also neutralize “too big to fail,” which many believe incentivizes banks to take excessive risk.

“The core idea — to convert the debt held in financial institutions into equity quickly, without using taxpayer dollars — is both powerful and innovative, and may ultimately be part of a critical shift in how governments and regulators approach the resolution of failing banks,” said Dean Glenn Hubbard, the Russell L. Carson Professor of Finance and Economics.

The concept has since been discussed in such publications as the Financial Times, Euroweek, and Seeking Alpha. Furthermore, regulators in Europe — where there is no cross-border FDIC scheme in place — have expressed interest. Recently, the Basel Committee on Banking Supervision used the term in a public statement for the first time and the Association for Financial Markets in Europe published a report on bail-ins. According to Euroweek, the Financial Stability Board also appears to endorse the concept, which will likely be examined at the G20 summit in Seoul next month.

Calello and Ervin answered questions about the proposal on The Economist’s Free Exchange blog.