What Is a Bail-In?

A bail-in occurs when an institution's creditors must forgive some of its debt to save it from collapse. It may be used as an alternative to a bail-out during times of financial crisis.

Learn how bail-ins differ from bail-outs and how they work.

Definition and Example of a Bail-In

Most people are familiar with the concept of a bail-out following the global economic crisis, when many governments were forced to rescue private institutions. But there's another term, called a "bail-in," that can be used as an alternative to a bail-out, which has become increasingly unpopular.

In a bail-in, a bank or other institution's creditors must write off a portion of its debts to save it from insolvency. An example is the rescue deal for the biggest banks in Cyprus in 2013, which required shareholders and creditors to take on some of the costs.

How Does a Bail-In Work?

With a bail-in, a failing bank's creditors are forced to bear some of the burden by having a portion of their debt written off. The new approach became especially popular during the European sovereign debt crisis.

For example, in 2013, bondholders in Cyprus banks and depositors with more than 100,000 euros in their accounts were forced to write off a portion of their holdings.

Unlike bail-outs, which transfer risk from the bank to the taxpayer, bail-ins eliminate some of the risk for taxpayers by forcing the bank's creditors to share in the burden. They're especially useful when the debt is overwhelming in proportion to the government's ability to cover it, as was the case in Cyprus—the bill would have been 50% of that country's gross domestic product (GDP).

Bail-Outs vs. Bail-Ins

Bail-outs occur when outside investors, such as a government, rescue a borrower by injecting money to help make debt payments.

For example, U.S. taxpayers provided capital to many major U.S. banks during the 2008 economic crisis to help them meet their debt payments and remain in business rather than being liquidated to creditors. This helped save the companies from bankruptcy, with taxpayers assuming the risks associated with their inability to repay the loans.

Bail-outs are designed to keep creditors happy and interest rates low, while bail-ins are ideal in situations where bail-outs are politically difficult or impossible, and creditors aren't keen on the idea of a liquidation event.

An Alternative to Bail-Outs

Most regulators had thought that there were only two options for troubled institutions in 2008: taxpayer bail-outs or a systemic collapse of the banking system. Bail-ins soon became an attractive third option to recapitalize troubled institutions from within, by having creditors agree to roll their short-term claims over or engage in a restructuring. The result is a stronger financial institution that isn't indebted to governments or external influencers—only its own creditors.

Similar strategies have been used in the airline industry to keep them running throughout bankruptcy proceedings and other turmoil. In these scenarios, the companies were able to reduce the payments to creditors in exchange for equity in the reorganized company, effectively enabling the lenders to save some of their investment, and the companies to stay afloat. The airlines would then benefit from the reduced debt load, and their equities—including those issued to debt holders—would increase in value.

Interestingly, bail-ins can complement bail-outs in some cases. Successfully bailing-in some creditors alleviates some financial strain, while securing additional financing from others helps to reassure the market that the entity will remain solvent.

The Future of Bail-Ins

The use of bail-ins in Cyprus' banking crisis has led to concerns that the strategy would be used more often by countries when dealing with financial crises. After all, politicians can avoid the thorny political issues associated with taxpayer bail-outs while containing the risks associated with letting a bank failure lead to systemic financial destabilization.

The risk, of course, is that the bond markets will react negatively. Bail-ins becoming more popular could increase risks for bondholders and therefore increase the yield that they demand to lend money to these institutions. These higher interest rates could hurt equities and end up costing more over the long term than a one-time recapitalization by making future capital much more expensive.

In the end, many economists agree that the world is likely to see a combination of these strategies in the future. With Cyprus having set a precedent, other countries now have a template for the actions and an idea of what will result.