A Temporary Bail-In to Stabilize Weak Eurozone Banks

The European Central Bank (ECB) has proposed that taxpayers will “temporarily” bail out solvent but undercapitalized banks. They will temporarily provide the needed capital until private-sector investors can step in and replace the public funds. However, temporary bailouts create perverse incentives for regulators and investors and, too easily, become permanent.

There is a better market-based alternative to a bailout. If the capital shortfall is temporary, there is no need for taxpayer funds. The bank’s junior and even senior debt holders can provide the interim capital. The bank’s debt holders will be temporarily bailed in and their claims temporarily converted to equity.

Once new capital is raised from the private sector, the former debt holders will have the option of retaining their shares or reconverting their shares back to their original debt claims. If the funds are truly needed only temporarily, the bank’s debt holders will be only temporarily bailed in. A temporary bail-in of creditors will create stabilizing incentives and pressure banks to raise the needed capital quickly.

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