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The term bailout became well known during the 2008 Great Financial Crisis (GFC) as governments around the world spent almost $1 trillion to rescue their banks from collapse. The term bail-in was coined after the crisis by bankers who wanted to assure the public that the biggest lenders could survive without any more taxpayer handouts. So bail-in is supposed to be the antidote to the bailout.

What’s a bail-in?

A bail-in forces investors into a bank’s bonds when a lender goes belly up.

Banks go belly-up when their shareholder equity is wiped out, which happens when loans or investments they’ve made go sour.

In return for taking a cut in the value of their bond, known as a writedown, creditors are usually given shares of the bank in a debt-for-equity swap.

The writedown is the equivalent of fresh capital and lets the bank continue functioning, at least for a while.

When you bail in the creditors, they become new shareholders of the bank while it goes through a resolution process similar to bankruptcy.

It’s less disruptive because the bank can continue functioning with the fresh capital from the creditors.

Although it was originally construed as part of a quick resolution mechanism, the term bail-in has come to cover every case of creditor loss-sharing when a bank gets in trouble.

The bail-in approach was invented in 2010 when executives at Credit Suisse Group AG proposed it as a mechanism to replace bailouts.

The U.S. and the European Union later included the concept in new laws.

What’s the case for bail-in?

Bankers and most regulators have long argued that banks can’t be put through a regular bankruptcy process because their assets lose value extremely fast.

A regulator-supervised resolution that keeps a bank running while winding it down could help prevent a loss of value.

Banks need continuous funding to maintain their assets and a bail-in provides fresh equity to help bridge the gap.

Creditors who are bailed in benefit if assets can be sold in an orderly fashion.

Putting bondholders on the hook is also supposed to reduce the moral hazard created by bailouts. A moral hazard is an idea that banks will take greater risks if they assume the government will step in should things go wrong.

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