The Next Time Banks Hit a Wall, Will Government Respond with “Bail Outs” or “Bail Ins”?

The banking sector is in great shape overall, both here and abroad, according to our Weiss Ratings data. There are always exceptions, and that’s why you should always check your bank’s safety rating with Weiss. But the fear and loathing we all felt in 2007-2009 is fading into history.

Still, the 10-year anniversaries of several major institutional failures are fast approaching. So that makes now a good time to ask: The next time banks hit a wall, how will the government respond – with “Bail Outs” or “Bail Ins”?

The term Bail Out became widely known back in the Great Recession because the U.S. government used taxpayer money to save banks and the economy from collapsing. They did this despite the fact much of the blame lay with the banks themselves.

Bad decisions by banks, mortgage companies, and rating agencies led to a massive accumulation of poor quality mortgage loans and financial instruments derived from them. Businesses were too greedy and too careless giving out loans to unqualified consumers who bought things they couldn’t afford.

In the end, the Senate passed a $700 billion bank Bail Out bill on October 3, 2008 to supply the failing banking industry with cash. Many other “Too-Big-To-Fail (TBTF)” companies also received our tax dollars to stay afloat.

But the problem with Bail Outs is that they encourage businesses to engage in risky transactions again, bringing us back to the edge of collapse in a never-ending cycle. That’s a problem called “moral hazard.”

The Dodd-Frank Act was put in place after the Great Recession to help ensure this doesn’t happen. Its main stance is that there will be no more Bail Outs for TBTF banks. While Dodd-Frank is currently being dismantled piece by piece by the Trump administration and major bank lobbyist groups, Bail Outs are still widely unpopular.

So how do we ensure that banks don’t go down the same dangerous path of lenient lending and unscrupulous investing? Well, there’s a concept floating around that could address the issue to some extent, but could also be devastating to your personal wealth. It’s called a Bail In.

With a Bail In, the financial institution isn’t rescued with taxpayer money. Instead, its creditors and depositors take massive losses or haircuts on their bonds and deposit balances.

Again, the idea is to reduce moral hazard. If bankers know they’ll have to do their best to dig themselves out of any holes they get into, maybe won’t dig them in the first place. But the concept is highly unpopular among depositors (and therefore, voters!), as it could wipe out or significantly reduce their savings.

At the height of recession, governments were too worried to even talk about Bail Ins because they were afraid that could cause or intensify bank runs. After all, if you hear that your bank might need a Bail In, your wisest move is to hurry up and yank your money out. But that drains the bank’s cash levels, putting it in even deeper jeopardy.

The bottom line is that we’re not sure what will happen if banks get themselves in a sticky financial situation again. Given the Dodd-Frank Act’s stance against bailing out TBTF banks, the previous strategy of propping up banks with taxpayer money might not be an option.

But in the end, someone has to pay the piper – and either Bail Outs or Bail Ins will cost taxpayers and savers immensely. One strategy uses your taxes to bring back banks in an indirect way, while the other literally takes your cash directly out to save institutions.

So even though things look fine now, be sure to stay on top of the latest bank regulatory developments and Ratings changes using our tools and articles.

Think Safety,

Remi Lukosiunas

Money and Banking Edition, By Remi Lukosiunas, Financial Analyst Remi Lukosiunas, a Financial Analyst, joined Weiss Ratings in 2014 with a financial services background in internal audit and the credit union industry. Remi conducts banking, credit union, insurance and investment research. He has also written extensively on stocks and investing using ratings as a guide. Remi is a graduate of Florida State University with a degree in multinational business.