In 2006, my housing association decided to renew the window frames in our 50 apartments. We arranged for all the local permits, found a supplier with a solid reputation, placed the order and made a down payment of 3,000 euro per apartment. Then the supplier went bankrupt. As we had banked on its solid reputation, we had accepted that the supplier did not partake in the sector’s guarantee fund so we were not reimbursed and had to take our place in the line with other creditors. First of course came back payments, followed by taxes and social security premium. Next in line were other creditors (including us) followed by subordinate loans and finally the owners. I have no idea where payments stopped, but we were never reimbursed.
In 2008, the financial crisis came to the surface with the bankruptcy of Lehman Brothers, quickly followed by the Irish banking crisis and the bankruptcy of the Icelandic savings banks. To save Irish banks from bankruptcies, the Irish government issued an unlimited banking guarantee. Other countries followed suit in an unprecedented movement to save banks from bankruptcies.
Even if banks exercise a public function in the payment system and even if banks are more interconnected with other parts of the economy than industrial companies, these rescue operations defy the pattern to get through a bankruptcy that my housing association learned the hard way. The bank rescue saved bank owners first and creditors – bondholders and savers – second and did so at the expense of the taxpayers who were now running the largest risks of losses. In economic terms this provides a typical example of moral hazard – banks knowing that they will be saved anyway have an incentive to accept large risks.
But if the authorities do nonetheless want to save banks, there is an alternative for the public buying or guaranteeing of banking debts, namely swapping bonds of these beleaguered banks into shares. This is a double-edged sword which both increases assets and decreases liabilities strengthening banks’ balance sheets. This strategy is widely debated in economic policy forums as a means to prevent bankruptcies and moral hazard. See e.g. these two websites.
What may be good economic policy, however, may not be possible legally. Previous suggestions to transfer bonds into equity ran into legal objections as current bondholders argued that they did not buy convertible bonds (which do have a provision to be turned into equity). Forcing them to transfer bonds in equity would be a breach of contract which they would fight. This is typically a civil law argument. But banks have been rescued from bankruptcy, in which case bond holders would have received nothing, because banks exercise public functions and their behaviour has large external effects – their actions do have large consequences for the economy as a whole. Lawyers and lawmakers should, therefore, make great efforts to go beyond the interests of private banking and design and discuss ways to force bondholders into cooperation in rescuing banks from bankruptcy.