Bail-in Securities and the Current Equity Market Turmoil
The current equity market slide is being led by European banks and stems in large part from market concerns over their newly issued bail-in securities. Bail-in securities begin life as a five-year bond that converts into equity when bank capital falls below a certain threshold. At higher thresholds these bonds stop paying interest or become perpetual, which is the current concern of equity market investors. Deutsche Bank's €1.75 billion bail-in security is now trading below 75 cents on the euro, its lowest level, and a 19 percent fall this year. The current market turmoil over these securities was predicted in an earlier PIIE Policy Brief, Why Bail-in Securities Are Fools' Gold.
Regulators put their faith in these new instruments as a way to save banks without the need for taxpayer-funded bailouts. They have intentionally included bail-in securities as regulatory capital alongside equity, and because such securities are cheaper to issue from the perspective of shareholders, banks have issued around $100 billion bail-in securities already. They had planned to issue far more in lieu of raising more equity finance.
In 2014 regulators and others raved that bail-in securities issued by banks would save the financial system. But all that glitters is not gold. One of the main concerns critics raised was that regulators had not thought through who should own these instruments. Because banks and retail investors couldn't buy them, and life insurers and pension funds shouldn't, they would end up being owned by hedge funds, as has occurred. Hedge funds have to watch short-term performance: They love these securities in the good times when they offer a slightly better yield than safer assets, and scramble to be the first to sell them at the faintest whiff of trouble.
As predicted, the plummeting prices of bail-in securities have been interpreted by the wider markets as the best indicator of the trouble banks are in, forcing some to cut back their exposure to the banks in a self-fulfilling prophesy. Investor losses and shock have triggered wider risk aversion and have led to the sale of other bail-in securities and risk assets like equities. Bail-in securities are not only fools' gold, but they bring forward a crisis, not prevent it. Old-fashioned remedies, such as extra equity capital at banks and less maturity mismatches across the financial sector, would be more effective at protecting the economy and the taxpayer.