Putting Capitalism Back Into Banking

Free-market in life, nationalized in death. This is the paradigm that has haunted bank regulators, central banks, governments and taxpayers world-wide since financial institutions started to fail in 2008 and public money was used to rescue them. The implicit societal contract in the banking business is that public-sector authorities will stand behind banks during the inevitable, periodic crises of confidence. In return, financial institutions will serve as a vital mechanism for allocating credit and capital throughout the economy.

This contract works when credit is flowing and economies are growing. But when financial institutions suffer dramatic failures of judgment and risk management, the agreement loses social and political support. Banks are vilified as having little to do with the so-called "real economy" of their home countries, and taxpayers resent the use of public funds to keep these institutions afloat. Today, in much of the world, we are in exactly this state of affairs.

Economists tell us that when something is subsidized, you get too much of it. Trading activities at giant commercial-banking groups were until recently triply subsidized: by capital requirements that were set far too low, by transfers of cheap deposit-based funding between their retail and investment-banking arms, and by implicit governmental guarantees.

Two of these problems are at least partially addressed. The new Basel regulations dramatically increase the capital required to support risky trading operations. And both external and internal funding have become more expensive across the banking industry. But governments' implicit guarantees remain, in some ways even stronger than before.

There is an emerging international consensus that the answer to this problem lies in adapting bankruptcy arrangements that are common in other industries to the banking sector—that is, to ensure that a bank's creditors, and its bondholders in particular, are genuinely at risk if the institution fails. But due to the speed with which banks can be destabilized in a crisis, the classic bankruptcy process is not totally suitable for banks.

Instead, a massively expedited approach is required, but one based on the same principle: that a bank's shareholders pay first for its losses, creditors pay next, and taxpayers don't pay. Too often in recent bank failures, this hierarchy has been perverted.

This "bail-in" approach—in contrast to the "bailout" it seeks to avoid—involves a bank's creditors in its restructuring by imposing writedowns or haircuts, or by converting their debt into equity. These techniques are familiar in the world of corporate restructuring.

Because today's large global banks operate through multiple entities in multiple jurisdictions, however, the danger of an uncontrolled restructuring process is high unless there is international coordination.

That is why the so-called "single point of entry" approach is increasingly gaining favor. This means bailing-in creditors at the highest point of the banking group, which is placed under the control of the home resolution authority for the duration of the process. The fresh capital that is created then gets channeled through the restructured bank's corporate structure to where it is needed.

The U.S. Federal Deposit Insurance Corporation and the Bank of England advocated this approach in a joint publication late last year. Finma, Switzerland's financial regulator and resolution authority, is also a strong supporter, for two principal reasons.

First, one of the greatest fears currently expressed about the global banking industry is that if regulators fail to coordinate and cooperate, the industry will retreat behind national borders. Without a synchronized approach to supervision, internationally active banks will become the exception, and the benefits of globalized markets will fall away.

This retreat is very often provoked by national authorities' fears that they will be left with the bill after the failure of a complex global institution that they do not oversee. The best antidote to these fears is the establishment of a clear process for restructuring international banks, with clear responsibilities and a clear chance of success.

Second, the bail-in approach restores discipline to the decision to invest or deposit money in banks. Institutional investors should not have the impression that senior bank debt—let alone subordinated or hybrid debt—is essentially risk-free paper with enhanced yields. Depositors should not believe that they will in any circumstance be made good on amounts that exceed the level of deposit insurance. Depositors should also become sensitive to the fact that there is no free lunch in banking: If they are earning excessive returns on their deposits, it is because they are taking on excessive risks.

Swiss legislation already equips Finma with the tools to execute a bail-in if the restructuring of a large, global Swiss bank were ever needed. Developing contingency plans in close cooperation with other bank regulators has given us some comfort that we can avoid uncontrolled international reactions if problems ever arise.

Our view is that authorities in all major financial jurisdictions should be aiming to have such powers in place, and to make genuine progress on having their banks build up stocks of automatically convertible capital and/or other debt clearly subject to bail-in. That would allow investors to begin to understand how this new paradigm could apply to their investments, and to price them accordingly.

There are a host of detailed issues underlying this general concept, however. And one thing is clear: We are not there yet.

There may be a touch of "coals to Newcastle" irony in public servants endeavoring to bring a healthy dose of capitalism back to the capitalists. But that is how we can return banks to what they should always have been: free-market in life, free-market in death.

Mr. Raaflaub is CEO of Finma, the Swiss Financial Market Supervisory Authority, where Mr. Branson is head of the banks division and deputy CEO.