Systemic banks must have the capacity to replenish capital, up to minimum regulatory standards, even if all capital – of all tiers – has been completely burned through. 8 It’s a game changer because it hardwires the recapitalisation of failing banks. Bailedin debt holders become, very quickly, the proud new owners of the bank. Case study evidence is striking. Rapid recapitalisation of failed banks speeds economic recovery. It cuts the long-term costs of systemic bank failure in half. But resolution through bail-in is more than a fire extinguisher. It’s a non-flammable coating of the banking system too. It helps to prevent bank failures in the first place. Unsurprisingly, the evidence is that when debt holders face the consequences of failure, banks take fewer risks. International estimates suggest that the removal of the heads-I-win-tails-you-lose ‘too big to fail’ subsidy cuts the risk of failure by a third. As you know, the removal of that subsidy isn’t a pipedream. Rating agencies are already removing “state support” uplifts from bank debt ratings. 9 And yes, it will raise  7  This is very similar to estimates of Miles et al (2012), who find the effect of increasing capital from 3% of total assets to 6% of total assets to be around 6% of GDP. 8  The Bank of England, as UK resolution authority, is now consulting on proposals to implement that principle in the UK for all systemic banks, as it must do under the European Bank Recovery and Resolution Directive.
But one of them pays interest of 5% a year, the other one only 2%. [9] Let’s  Page 7  also imagine that you can put funds somewhere without any risk and earn interest of 1%, and that the Solvency II rules say that for assets with the credit rating of these bonds we have to allow 0.5% per year to cover the risk of things going wrong. Now under the existing rules, for the bond paying 2% the insurer treats 0.5% as the MA – this is the 2% interest on the bond, less the 1% risk-free rate and the 0.5% allowance for things going wrong. The insurer will bring all of that interest due in the future, so 0.5% for each year, forward to today and count it as shareholders’ capital. For the 5% bond, the insurer does exactly the same: although the bond pays so much more interest than the 2% bond, the insurer uses the same riskfree rate (1%) and allowance for things going wrong (0.5%). As a result the insurer books as capital up-front the entirety of the 3.5% (5% less 1.5%), so a much bigger amount than for the 2% bond. Some stakeholders think we shouldn’t allow this at all, even for the 2% bond. We don’t agree with that position, but we do think we need to ask: are we entirely confident that all of that extra return on the 5% bond can safely be considered risk-free and banked as capital up-front?