Did An Obscure IMF Document Start A Global Bail-In Revolution?

by Daniel R. Amerman, CFA

When revolutions start, it's not uncommon for almost nobody to notice. It may take years or even decades before historians can look back, point a finger and say "that's where it really began."

An obscure International Monetary Fund "Staff Discussion Note" may have already started a "Bail-In" financial revolution that could transform the global investment world.

In this quite remarkable document, the staff discusses a world where risks to the global financial system have not gone away – but are worse than ever. As candidly discussed, the "SIFI" (systemically important financial institution) problem has not been improving, but instead has been getting worse than ever – and there doesn't appear to be any solution under existing contract law and bankruptcy law.

More risk than ever is concentrated in fewer financial institutions, while there is no way under existing law to unwind a failure of one of these institutions without risking triggering global financial chaos. Moreover, there is a deadly feedback loop between these "too-big-to-fail" institutions and sovereign governments. That is, as the IMF staff discusses, the bailing out of these massive institutions can bankrupt sovereign governments, and sovereign governments going bankrupt can wipe out the "too-big-to-fail" institutions.

So the IMF staff has come up with an audacious plan for how the globe can emerge from this seemingly impossible situation. The key word is "insurance".

The proposal is to take selected classes of investments, and retroactively decide that these assets aren't really assets at all. Indeed, the owners of these assets have – without realizing they've done it – agreed to provide insurance for the global financial system. So if a major crisis arises, the global financial system merely goes to these unknowing "insurance" providers and helps itself to their assets effectively, and the crisis is dealt with. It's a miracle solution!

Now there is the issue that some investors might actually object to this taking of their investment assets for the greater good of society. Which is exactly why the IMF staff recommends that this be done by way of statutory law, in a manner that overrides contract law – and is involuntary, with no investor permission needed. It would also be retroactive as needed, thus applying to people who already own these classes of investments.

After the bail-ins of the Cypriot banks and the Polish retirement system, the development of bail-in procedures is spreading rapidly around the world, including the EU, Canada and the United States.  What is fascinating and troubling - though perhaps not surprising - is how global politicians are in practice completely changing the "bail-in" concept, setting aside the IMF-proposed changes that could have forced genuine banking reforms and potentially increased global financial stability, and instead are creating a broader threat to investors.

Moody's Investors Service has already lowered the credit ratings of Morgan Stanley, Goldman Sachs, JP Morgan Chase and Bank of New York Mellon in anticipation of possible future bail-ins.  Moody's accompanying statement explained: "Rather than relying on public funds to bail out one of these institutions, we expect that bank holding company creditors will be bailed-in and thereby shoulder much of the burden to help recapitalize a failing bank."

A World At Risk

The IMF Staff Discussion Note is titled, "From Bail-Out To Bail-In: Mandatory Debt Restructuring Of Systemic Financial Institutions".  Originally released in 2012, it could be viewed as a source document for the global movement to bail-ins.  The note is available on the International Monetary Fund website, and a link for downloading the PDF is below:

http://www.imf.org/external/pubs/ft/sdn/2012/sdn1203.pdf

(The original discussion is well worth reading, and this analysis refers to particular document page numbers within it. Please note, as is often the case with PDF documents, that the page number in the actual document (which is what you will see if you print it out) is one off from the electronic PDF page number.)

One of the main questions explored in the document is just why the IMF believes that the world needs these major changes in the laws and how investments are treated.

While positive headlines abound in the media about rising stock markets and improving conditions, as it turns out, the International Monetary Fund staff sees a quite different picture. What they see are serious ongoing risks to the global financial order that are being caused by the major financial institutions around the world – which they refer to as SIFIs, otherwise known as "too-big-to-fail" institutions.

As covered on document page 4 (PDF page 5), there are three different ways in which the failure of even a single SIFI can imperil the entire global financial order.

The first major risk is "direct counterparty risk", with the SIFIs having an extraordinarily complex web of hundreds of trillions of dollars of interlocking commitments and contracts between themselves. The failure of a single SIFI could trigger a chain reaction of losses that would spread like dominoes, knocking down one SIFI after another – as well as other banks and investors around the world.

The second major risk is one of "liquidity". Since SIFIs rely heavily on borrowing, if the sources of their funds flee in the event of trouble, this would leave the SIFIs potentially insolvent unless they could quickly sell assets to cash out departing lenders, which would rapidly drive down prices, and with everyone selling assets together this could create a global "fire sale" on investments that's enough to crash the world's financial system in a matter of days.

The third major risk is one of "contagion", where the failure – or even looming failure – of one major institution introduces a psychology of panic into the marketplaces, which by itself is more enough to bring down the global financial order. After all, perception can and does create reality when it comes to financial markets.

Now all of these risks received a great deal of attention after the global banking system nearly went under in 2008, and in theory they were supposed to have been taken care of by restricting the ability of the SIFIs to take risks, and also by reducing the percentage of the world's financial assets that are held by the SIFIs.

However, as covered at the bottom of page 4 (PDF page 5) – this hasn't been working out in practice.

To the contrary, there has been an even greater consolidation of assets into these "too-big-to-fail" banks and financial institutions than there ever was before the crisis started. As a result, this has created "unsustainable public finances", where the extraordinary cost of conventional bail-outs potentially threatens the solvency of the nations themselves.  And such a sovereign insolvency could in turn trigger insolvency for the SIFIs. So again we have a toxic feedback loop between the SIFIs and the nations that must bail them out in the attempt to avert global financial collapse.

The IMF also identifies the related problem of a "shadow banking system" which also creates systemic risk, but is not subject to the same regulations as the formal banking system.

As discussed on page 8 of the document (PDF page 9), there are two other major problems with the global financial system that feed into these three major risks, making them far more dangerous.

One of them is that because these major financial institutions are generally exposed to a huge amount of risk in their derivatives holdings – which on a global basis dwarf the equity that they have – these derivatives in an insolvency situation could lead to a "disorderly unwinding" which could disrupt the financial markets. In other words, it could lead to a global financial meltdown – although the IMF staff uses a little more carefully chosen vocabulary.

The other core problem, as analyzed by the IMF staff, is that general corporate insolvency proceedings do not provide sufficient tools to manage the risks to financial stability when it comes to a SIFI failing. Which means that under existing law, there simply isn't the capability to manage this – except by bringing in massive amounts of public funds from already financially stressed sovereign states, which then risk triggering their own insolvencies, which then also risk triggering the insolvencies of other SIFIs in this toxic feedback loop.

Plainly put, the existing laws can't handle the problems that have been created by this intertwined world of "too-big-to-fail" institutions that continue to take massive financial risks for private gain, seemingly beyond the control of the sovereign nations, even as the sovereign nations dealing with their own financial problems increasingly lack the credible financial resources to massively bail-out these institutions without risking their own solvency.  So the bail-outs are unaffordable, but yet a failure to bail-out would lead to swift global financial chaos.

The Insurance Loophole

For an outside but rational investor, the solution might seem to be obvious. We didn't have this problem before the SIFIs – so get rid of these "too-big-to-fail" financial institutions. Break them up. Restrict their ability to take risks if the public is necessary as a backstop for them to take risks. Unlimited and unregulated risks are fine, but only those which their private investors / owners can actually afford to take. So that in the event of bad decisions leading to failure, the private investors may be wiped out, but no public backstop is needed.

And in doing so, the need for the public to bail-out these institutions would end, as would the toxic feedback loop between the SIFIs and the effectively bankrupt sovereign nations.

Now the IMF staff is aware of this obvious solution, but is very careful not to touch upon it, other than perhaps to implicitly say it just hasn't been working.

That is because the core of the problem is political. The SIFIs are simply too politically powerful for them to be broken up by the politicians of the sovereign developed nations. It's simply not politically practical for the governments to change the behavior of these institutions – even though they place the stability of the entire global financial system at risk on a daily basis.

So when considered from a practical political perspective, another solution needs to be found.

The alternative solution that the IMF document proposes is to use "bail-ins" instead of "bail-outs". My recent article titled, "Bail-ins & Taking Private Wealth", explains in further detail the concept of bail-ins, and how they're currently being used in the real world.

http://danielamerman.com/articles/2013/BailInC.html

One way of looking at a bail-in is that it is the opposite of a bail-out.  In the case of a bail-out, when there's an issue with a bank (or government, or government retirement system) not having enough assets available to meet the claims against it, funds are brought in from the general public, supposedly to serve the needs of the general public. 

With a bail-in, there is no bankruptcy, but assets are taken from selected investor classes, thereby reducing the claims against the corporation.  Solvency is therefore achieved and the needs of the general public are met, but without the general public having to actually pay for it.

Now while the IMF document uses the term "bail-ins", they also offer a quite different way of explaining the process, as shown on page 7 (PDF page 8). As stated, "the bail-in capital could be seen as a form of insurance (provided by creditors) against bank insolvency".

Now if we think through this approach – this way of finding completely new solutions for a system that otherwise lacks solutions, the implications are global, and they are extraordinary.

The way it works is that in the event of a potential financial meltdown, the government – or international organization – identifies particular investment types and classes of investors. These investors hold assets, and in some cases these assets are the liabilities (such as bonds) of the institution that is in trouble.

The government effectively says to these investors, "you may think that you own an asset, but what you've really done is you have underwritten an insurance policy. And if this institution in which you've invested your assets should run into financial difficulty, you have in fact pledged your assets to prevent the insolvency of the corporation, for the greater good of the global financial order".

Now the owner of the investment asset had no idea when they made the investment that they were doing this. They've never received an insurance premium for taking this risk. But nonetheless, a category of investment assets are retroactively declared to be insurance, and they can effectively absorb all the losses and keep the SIFI – or the government, or the public retirement system – solvent for the benefit of all.

Using Statutory Law To Override Contract Law

Now because the investors – whose assets are essentially funding the insurance that preserves the major financial institutions – didn't actually realize that what they were doing was pledging their assets to guarantee the payment on insurance claims, there's a case to be made that this could be a bit sticky from a contract law perspective. Given that this didn't appear anywhere in the prospectus.

Which brings us back to our previous discussion from page 8. One of the reasons for bail-ins in the first place is that using the current laws as written for traditional bankruptcy proceedings simply doesn't work to try to unwind one of these "too-big-to-fail" banks. Per the IMF staff it can't be done, as there's simply too much global risk and damage.

So there are three key paragraphs on page 12 (PDF page 13) that address this. The first one is that "there are compelling arguments in favor of an approach that minimizes the role of the courts". Keep those judges out of it in other words, as they might not do what they're supposed to do. Indeed, the IMF explicitly recommends not allowing the judiciary the ability to reverse this resolution, although it could be allowed to award damages in some instances.

Instead, it is more appropriate for the "decisions to be taken by the banking authorities". In other words, the very same regulators who failed to properly regulate the banks and allowed the disastrous situation to be created in the first place are the best possible experts resolve the crisis.

There's also the problem of getting creditor approval that might be required in a bankruptcy. The IMF document addresses this as well, stating that "the need for quick and decisive action in the interest of financial stability pleads against incorporating a procedure for creditor approval". Getting creditor approval can be a very messy part when going through a bankruptcy proceeding – therefore it's simply eliminated with the bail-in structure.

Perhaps most important of all is the bottom paragraph on page 12, which states that "bail-ins should be applied to existing debt as well as debt issued after the bail-in power is enacted".

In other words, this is retroactive when it comes to investment decisions. In theory, the IMF proposals are based on nations enacting bail-in legislation in advance, so investors are warned, and the yields on securities that are subject to bail-in should rise proportionately as the market evaluates the insurance premium that it should be receiving for providing this protection to other investors.

However, in the real world, as the IMF acknowledges, when you need the assets – you need the assets. So the government takes them, regardless of whether the investor had any idea at the time they made the investment that they would be subject to becoming "insurance" and having their assets effectively taken and converted into potentially worthless equity.

Theory Versus Practice

It should be noted that not everything in this IMF staff discussion note is bad, not by any means, and I encourage you to take the time to read the full discussion. There are numerous aspects that I think many free market-oriented investors would find to be quite appealing.

For example, as part of a bail-in, the bank management that made the bad decisions is expected to be fired.

Also, existing shareholders are supposed to bear the brunt of the loss, and in most cases see the entire value of their shares wiped out before other investors see their own claims involuntarily converted to insurance and equity.

And this is supposed to happen in a transparent manner in which investors understand exactly what they're getting into, before they make the investment. Given that investors then explicitly understand they are investing money that can be taken in a bail-in, the yields they receive should, in theory, fully reflect this.

The SIFIs are supposed to be required to hold a certain percentage of their liabilities in securities that are subject to bail-in, and the market rates they have to pay to attract investors for this effective "insurance" should act as a brake on their taking risky actions, which in practice banking authorities have been unable to prevent.

So in theory – if every essential aspect were enforced and if it were not retroactively applied to investors – the IMF proposal is a very interesting plan when it comes to both incentives and capitalization.  The new "insurance" debt may increase the real capitalization of the SIFI by two or three times, radically reducing the chances that a public bail-out would be needed.

Top management and boards of directors would face three new kinds of incentives to stop risking vast sums of public monies in the pursuit of private gain. First, they have to convince the market that risks are under control – and if not, the insurance premium component needed to sell the new securities will put a squeeze on profits that will bring on shareholder pressures for a change in management.

Second, management and boards lose the ability to negotiate, strike deals, take advantage of their insider connections with powerful politicians, or – to not put too fine of point on it – blackmail the public when they get into trouble.  Instead, there is no bankruptcy or negotiations, new management and a new board are brought in by the new owners, and former executives are left cleaning their desks out with little leverage.

Third, if they don't like that new incentive structure – they have powerful incentives to not become a SIFI or to stop being one.  They are then free to take whatever risks they so choose that are allowable for their type of organization – but without any public guarantees underwriting the risks they take (other than deposit insurance).

So there is a case to be made that if the exact structure were to be enacted, which includes various forms of investor protections as proposed in the IMF discussion note,  this could be a net positive for the stability of the global banking system, and an intriguing methodology for using the market to rein in excessive risks that are being taken by major banking institutions, which as a practical matter neither politicians and regulators have been able to do.

But that brings us back to the source of this problem in the first place, and why things have so far been working differently with bail-ins in practice than as proposed by the IMF in theory.

The core problem is one of politics.

The reason this situation exists in the first place is because of politics. And when it comes down to an acute financial crisis – politics continue to rule. So it might be naïve to expect that nations would use this framework the way in which the staff has proposed. Instead, political considerations are likely to rein supreme.

Which means that in the real world, bail-ins are likely to work in a quite different manner – exactly as has happened with the limited cases we've seen in the world so far. Cyprus didn't follow the IMF framework with its bank bail-ins.  Neither did Poland with its retirement system bail-in.  They just used the massive involuntary taking-from-private-sector-investors component in order to dodge bankruptcy.

Canada's proposal for bail-in rules is also quite troubling in this regard.  As can be seen on page 145 (PDF page 155) of the document (linked below), the language is all about the taking from private investors – but there is nothing about the specific securities covered, or the required percentages of "insurance" type securities relative to assets or equities, or the displacement of current shareholders and management.

http://www.budget.gc.ca/2013/doc/plan/budget2013-eng.pdf

Even more troubling are the rapid and major changes being made to the EU's bail-in legislation, as described in the November 13, 2013 Reuters article, "Plan To Raid Bank Creditors Could Shatter Europe's Calm".

"I hope that serious investors know what they are investing in," said Gunnar Hokmark, a member of the European Parliament who plays a central role in shaping the new law.

"Everything is to be seen as bail-in-able. Depositors are, in the end, bail-in-able. If anyone would be surprised by that, they have been away from the debate for quite a long time."

Originally pencilled in for 2018, these rules will be finalised and possibly accelerated by European Union countries and the bloc's parliament in the coming weeks.


http://uk.reuters.com/article/2013/11/13/eu-banks-crisis-idUKL5N0IX4LQ20131113

In other words, none of the "good stuff" is there when it comes to using market forces and incentives to cure the SIFI problem.  There just appears to be a new and massive source of involuntary funding from investors, which doesn't seem to disturb the cozy relationship between politicians, banking regulators, and the politically powerful senior banking executives.

Perhaps these missing components will be there if and when the actual regulations are issued?  We can only hope - but it sure doesn't look like it at this point.

What is rapidly emerging instead, in both Europe and North America, is an enabling mechanism for the taking of wealth from those who are judged to be able to bear the pain, so that the general population is bailed out without paying the cost, and in the real world – the politically powerful are still likely to be insulated.

Dysfunctional Global Finances & Governmental Interventions

Something else to keep in mind is that the banking institutions don't have a problem in isolation. Rather, as covered in the IMF document, their fate is closely interwoven with the sovereign governments. So we have a global financial system which remains at high risk, and if sufficiently stressed these institutions could still bring down the global financial order in a very short period of time, potentially even a few days. We know stress will come – we just don't know quite when and where.

Derivatives-led contagion and counterparty risk can still bring down the global financial system like a house of cards – absent powerful interventions.

The governments themselves are deeply in debt, the overall global economy continues to underperform, and many nations have far greater promises which have been made to their populations than they currently have the funds to pay, or are likely to have the funds in the future. So "stimulus" programs keep the global economies running, even as the debts continue to mount up.

And the leading source of government insolvencies over the long term is unfunded and unpayable government promises for retirement benefits.

So we have three separate but tightly interlocked components, with those being effectively bankrupt sovereign governments, effectively bankrupt public retirement systems, and a global system of major financial institutions who have entered into interlocking derivatives contracts, that are subject to collapse at any time when the next major financial stress hits the system.

All three are tightly interlocked; all three are dysfunctional. And the whole thing is held together by increasingly aggressive government interventions. Quantitative easing is of course a government intervention, and the "bail-ins" are another form of government intervention. These stresses grow worse each year as the populations of the United States, Europe and Japan continue to get a little bit older on average, even as the jobs for the young – that are needed to pay for those retirement promises – continue to fail to materialize.

This situation is entirely outside the current media message that the world is getting healthy again and these crises are receding in the rearview mirror. Instead they're escalating, and the system remains more at risk than ever, as covered in the IMF report.

However, despite five years of crisis – the financial order hasn't collapsed yet. And while it certainly could collapse at any time as a result of a political miscalculation, there's frankly no need for the global financial order to collapse. Indeed it could continue to exhibit a surprising stability over time – albeit a completely dysfunctional stability from the perspective of most savers and investors.

How do the governments of the world take this three-part combination of high risk and fragile banks, effectively insolvent governments, and effectively insolvent government retirement programs, and maintain them through time without triggering a collapse?

This is the central question. It is what I have been warning my readers about for some years now, and there are answers.

However, the answers don't lie within the "system as we know it".  Instead, what will be (and what is being) done is to change the "system", lest it be destroyed. Which means we should expect extraordinary changes when it comes to 1) the nature of the law, 2) the nature of money itself, and 3) the nature of investments.

While keeping those three categories of changes in mind, it is important to consider the two departments within the International Monetary Fund which cooperated in preparing this extraordinary document. They were the Legal Department, and the Monetary and Capital Market Department. In other words, the departments who deal with the 1) law, 2) money, and 3) investments.

The International Monetary Fund understands exactly how this process works, as does the Federal Reserve, as does United States Treasury department.

To maintain order within dysfunctional underlying economies and avoid financial collapse, the nature of money is changed, the nature of investments are changed, and the law itself is changed over time.

This isn't optional. If those are not done, the system collapses. And everything possible will be done – and is being done right now, in real time – by those currently in power just to avoid such a collapse.

Crucially, this process of changing the law, investments and money is not being done in a neutral or altruistic manner.  The difference between the IMF Staff Discussion Note, and EU parliament member Gunnar Hokmark's casual dismissal of the key provisions of that Note as being long-obsolete in the real political world is quite telling. 

Bail-Ins are no longer about reforming politically powerful banks using market-based principles – that concept was forced out early when economic theory met the reality of raw political power.  What is left is governments wielding a much bigger "stick" when it comes to the ability to take investor assets without restraint. 

Bail-Ins and quantitative easing aren't just about finding solutions to crisis that work for the equal benefit of us all.  Rather, let me suggest that a pervasive systemic crisis creates opportunities for the politically-driven redistribution of wealth for the benefit of powerful insiders, particularly when the nature of these redistributions is sufficiently complex to keep the average voter or investor from understanding what is happening.

Given this situation, there are few tasks that are more essential for investors over the coming years and decades, than understanding this close three-way relationship between: 1) the underlying dysfunctional economic fundamentals; 2) how those dysfunctions drive governmental interventions in the form of changing the law, money, and investments; and 3) the resulting market changes across multiple investment categories such as precious metals, real estate, stocks and bonds.