This article appears in the May edition of the Financial Post Magazine. Visit the iTunes store to download the iPad edition of this month?s issue.
The questions started coming the day after the budget, in emails and tweets, with the conspiratorial tone and sound-alike phrasing of people who have been haunting Internet comment boards: Have you seen this? Can they be serious? Is the Harper government about to seize our bank deposits, JUST LIKE IN CYPRUS?
Eventually their queries were picked up and amplified by media commentators who ought to know better. But the answer, as the government belatedly clarified, is no. When the budget described the government?s proposed ?bail-in? regime for ?systemically important banks? ? a policy it has openly discussed for months, if not years ? as involving the forced conversion of ?certain bank liabilities? into regulatory capital, it did not have in mind depositors? money.
The whole discussion is ridiculously hypothetical, but what it really means is this: In the event a bank runs into trouble, some of its ?unsecured market debt? ? bonds and other debt instruments, set aside in advance and sold with this possibility clearly advertised ? will be converted into equity.
The idea is not just to spare the taxpayer from bailing out failing banks, but to discourage the very sort of risky behaviour that might get a bank into trouble in the first place. Creditors, shareholders and bank management would be on notice that there would be no government rescue in the event their bets turned bad.
The budget is quite explicit about this. The days when large banks could act on the assumption that their importance to the economy would immunize them from the consequences of their own mistakes ? an unstated, informal policy known as ?too big to fail? ? are over. The new policy, it said, in tandem with higher capital requirements and other measures enacted nationally and globally after the financial crisis, ?will limit the unfair advantage that could be gained by Canada?s systemically important banks through the mistaken belief by investors and other market participants that these institutions are ?too big to fail.? ? Note that word: mistaken.
This is very good news. ?Too big to fail? has been a major contributor to the instability of the world financial system, leading bank creditors to systematically underprice risk, with the biggest risk-takers the biggest beneficiaries. In effect, governments around the world have been subsidizing recklessness. Not surprisingly, that?s what they got. Taking away this ill-designed safety net would be a major achievement.
In fact, the banks would still very likely not be allowed to fail, as such. The point of the bail-in regime is to keep them viable, if possible. But there?s no doubt that whatever emerged from such a forced recapitalization would be a very different entity. Senior management would be gone, and everyone would have to take the proverbial haircuts. Everyone, that is, except depositors. In the case of insured deposits, all is well and good. That?s the point of deposit insurance, after all:?to protect small depositors from losing their life savings, for their sake, but also to prevent needless bank runs by panicky depositors acting on rumour.
But there?s also an element of moral hazard in this. We?ve just been discussing how the possibility of loss is a useful incentive to be more careful about where you put your money. Although insured deposits are sacrosanct (that?s what really got people up in arms in Cyprus: an early version of the bank rescue plan that proposed taxing even insured depositors), it?s not clear why uninsured deposits ? those over $100,000 ? should be off limits. Before the comment boards are set ablaze again: What do people imagine would happen to those deposits if a bank was simply allowed to collapse?
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