Asset owners and other institutional investors face new risk-mitigating regulations directed at strengthening the stability of the financial system to avoid a crisis like the collapse of 2008, the aftermath of which continues to reverberate in the markets, the economy and policymaking.
The new regulations call for “bail-ins,” new approaches to financing recovery of troubled financial institutions.
Regulators across the globe have embraced them as powerful tools for resolving insolvency issues while maintaining the stability of the financial system, and also to replace the too-big-to-fail practices of governmental bailouts.
The new regulations likely will affect the prices of the stocks and bonds of all financial institutions of sufficient size to affect financial stability.
Under bail-ins, regulators trying to liquidate or reorganize a failing financial institution that poses significant risk to the stability of the financial system have authority, at their discretion, to reduce or even wipe out the equity holdings of shareholders and to convert debt held by investors into new equity, or write down the obligations entirely as well as changing management.
In either case, shareholders and debt-holders could face huge losses.
Putting the cost of failure onto investors is the way the equity and debt markets should function, but the prospect of a government bailout, as in 2008, has distorted that function for large financial firms.
Institutional shareholders and debt-holders should welcome bail-ins, which bring more discipline to the market and address the moral hazard of reliance on too-big-to-fail bailouts.
Investors expect a return on their investments and, accordingly, must bear the risks, but now they must recognize that the risk of investing in these systemically important institutions will change as a result of the new resolution tool.
In a research paper presented in December at a European Central Bank conference, Christos Hadjiemmanuil, visiting professor, department of law, London School of Economics, noted “that markets price the specific risk of large financial firms more now than before the global financial crisis ... an indication that market perceptions of the probability of bailouts have changed (possibly also due to the insistence of recent legislative instruments on orderly resolution and bail-in).”
Bail-ins put the risk for financial institution failure on investors, where it belongs, instead of on taxpayers through a government-engineered bailout. The new regulatory tool gives asset owners and other institutional investors more predictability on which to model returns and risks, and identify the potential consequences of bail-ins. They need to understand how to manage bail-ins' ramifications.
As a result, portfolio management, diversification, risk management as well as corporate governance oversight become even more critical for institutional investors.
With these new rules, shareholders and debtholders as well as the managements and boards, should no longer presume government bailouts to rescue a failing financial institutions that might present risk to the financial systems.
The European Union's rules on bail-ins became effective Jan. 1. Canada's proposed federal budget, tabled in the House of Commons March 22, would “implement a bail-in regime that would reinforce that bank shareholders and creditors are responsible for the bank's risks, not taxpayers.”
The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 includes a framework for authorizing government intervention to recapitalize or liquidate financial institution's equity and debt capital to prevent instability in the financial system and to reduce the need for a taxpayer bailout.
The bail-in regulations generally cover large commercial banks and investment banks, and U.S. regulators have included large insurance companies in the identification of systemically important financial institutions.
Regulators would trigger bail-ins when no private-sector resolution can restore an institution back to financial health. The question remains whether the bail-in tool will generate sufficient financial resources to recapitalize an institution without creating instability in the system, although some rules such as those in the EU call for contributions from other financial institutions in relations to their size.
Corporate governance becomes a more crucial tool for shareholders to hold boards of directors and management accountable for risk oversight, but it's not easy to get a majority of shareholders on the same page for increased accountability and risk management.
In September, despite opposition by major pension funds, Bank of America Corp. shareholders ratified a corporate bylaw amendment giving the institution's board of directors the discretion to determine its leadership structure, allowing it to combine the roles of chairman and CEO.
In calling for a separation, asset owners noted that since Brian T. Moynihan, chairman, was also named CEO in 2010, the company has failed important financial stress tests designed by the Federal Reserve System. But the vote was 63% in favor of the company's policy.
As a result of the new rules, investors might confront more volatility of equity and debt securities of financial institutions considered to be heading toward bail-in, as some attempt to sell to eliminate any risk, or others double-down to increase potential return, accepting greater risk.
Bail-in rules make it more important for the Financial Stability Oversight Council, whose makeup includes financial system regulators, to be more transparent and frequent in its reporting on financial institution health, and the identification of systemically important financial institutions.
Uncertainty in markets can make raising capital more difficult for a financial institution, challenging any resilience and making government action inevitable.
Unlike bail-ins, a public-sector tool, another tool that was developed in the event of a crisis is a private-sector approach called contingent convertible bonds that banks sell to strengthen their balance sheets.
The approach is a way banks can address a problem of raising capital during times of stress when investors are disinclined to provide additional financing. If an issuing bank breaches preset financial triggers, it can cancel the contingent convertible debt coupon or convert the debt into equity, diluting equity holders, or even write off the debt. Mixed regulatory signals from the European Central Bank and the European Banking Authority has put CoCos at risk for more volatility.
Even more than this contingent debt approach, bail-ins are designed to protect taxpayers from bearing the brunt of financing bailouts to rescue failing financial institutions and restoring financial system stability. Investors must realize they have that risk and adjust their investment decision. n
