It appears that many of the advanced economies of the world have adopted, or are looking at adopting, a bank “bail in” approach, according to Ellen Brown in the Huffington Post. The article was written sometime back and I came round to thinking of this issue when wondering about the functioning of banks vs. investment banks. The following article neatly summarizes the matter (with external links and reading material).

The difference between a bail out and bail in is that the external regulator provides liquidity to a distressed financial company in a bail out while depositor funds are used to maintain liquidity in a bail in. Under most laws, depositors have a claim of credit at a bank with the bank owning the money and that is what makes it legal for the banks to engage in “fractional reserve” banking, holding on to some of the deposits while loaning out the rest or engaging in some venture to earn a profit (regardless of the risk).

Let’s play the scenario out, in slow motion. If I, as a depositor, have a claim of credit with a bank, that makes the bank indebted to me. If the bank loses my money (“investing”; I use quotes because I see derivatives as a fancier form of gambling) why should I be liable for it and not the bank’s shareholders? If I am likely to be held liable, where is my share of the profits for shouldering some of the risk (of the bank failing)? Shouldn’t bank stability be a new sub-industry within the actuarial field and not just within the regulators’ offices?

Bank bondholders are different. Since the contract drawn up with them is explicitly that of a debtor-creditor, the funds from a bond sale can be readily used to refinance a bank. In return, the bondholders receive some payout once the bond matures.

With depositors, the understanding is that banks are looked at as saying, “We will hold your money for you, just deposit a certain amount with us,” while customers are under the impression that they can get access to their money when they need it. There is no mention anywhere of a transfer of business risk and/or profit sharing. So unless there are changes to banking legislation and the ensuing contracts, there may be class action lawsuits filed by angry depositors.

If you think this will scare away a large number of depositors (which might very well cause the financial system to freeze due to lack of liquidity AGAIN!) you could be right. So if they stand to lose something, why should they not stand to gain something? Why not offer the depositors a share of the profits made by the bank considering how much is deposited with the bank and how much of the deposits are used by the bank to make a profit? Does that sound like a similar scheme? That’s only because it is. It is how all hedge funds and investment vehicles operate. With a small difference, the depositors not only have an investment, they hold equity in the bank. This is different from:

• bondholders in that bondholders relinquish their equity stake when the bond matures and the payment is made and
• fund investors in that the deposits are easily liquefied when required.

A potential positive effect could be that finance will once again be used to serve the economy instead of the economy coming to be held hostage to finance (particularly “hot money”). [Paraphrased from Robert Reich’s “Supercapitalism”.]

I say potential because if the depositors get swept along by the “cheerleading” crowd (as with the sub-prime loans and derivatives before everything went bust) then economic meltdown¹ won’t be far behind. However, recovery won’t be that drawn out as the debt overhead will be considerably lower and far more easily contained compared to the current scenario.

Such a bail in structure will also lower, or at least slow the growth of, the growing inequalities in a free market economy². A bail in regime like this though will meet stiff resistance, primarily from the banks as they will not be able to leverage anything close to the ratios observed prior to the last financial crisis.

Given the governments’ administrative environments, I’ll place my bets on the depositors and their money being used to save the bank in case of bank insolvency without letting the depositors have a claim to any operating profit.

Update (13th Dec 2015): It seems this idea is being actively pursued in different places of the globe.

¹While going through this, I realized that the type of currency (fiat, fixed, gold exchangeable) used will impact the extent and duration of the recession.

²I realize I should elaborate on how this option will be a better answer to the scourge of inequality than even “employee stock ownership plan”.