How does bail-in actually work mechanically — what is the sequence of write-downs and conversions?

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AcadiFi · Accepted Answer

Bail-in is the process by which a resolution authority writes down or converts a failing bank's liabilities into equity to absorb losses and recapitalize the institution. The execu...

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**Write-down and conversion sequence (in order):**

1. **Common equity (CET1)** — fully written down first; existing shareholders are wiped out or severely diluted
2. **Additional Tier 1 (AT1/CoCos)** — written down or converted to equity at pre-specified triggers
3. **Tier 2 capital** — subordinated debt written down or converted
4. **Senior non-preferred / bail-in bonds** — the primary TLAC/MREL layer
5. **Senior unsecured debt** — if losses exhaust subordinated layers
6. **Uninsured deposits** (above guarantee limit) — last in the bail-in cascade, subject to depositor preference rules

\`\`\`mermaid
flowchart TB
    A[Resolution Authority Triggers Bail-In] --> B[Determine Total Loss Amount]
    B --> C[Write Down CET1 to Zero]
    C --> D[Write Down AT1 Instruments]
    D --> E[Write Down / Convert Tier 2]
    E --> F{Losses Absorbed?}
    F -->|No| G[Write Down Senior Non-Preferred]
    G --> H{Losses Absorbed?}
    H -->|No| I[Write Down Senior Unsecured]
    F -->|Yes| J[Recapitalize: Convert Remaining to New Equity]
    H -->|Yes| J
    I --> J
    J --> K[New Bank Entity Emerges]
\`\`\`

**Conversion ratio determination:**

The resolution authority sets conversion ratios to ensure that more senior creditors receive proportionally more equity than junior creditors — respecting the hierarchy. At Elmsford Capital Bank, a hypothetical resolution required absorbing $12B in losses:

- CET1 ($6B) → written down entirely
- AT1 ($2B) → written down entirely
- Tier 2 ($3B) → $2B written down, $1B converted at 1:1 ratio to new equity
- Senior bail-in bonds ($8B) → $2B written down, remainder converted at 1:1.5 ratio (receiving fewer shares per dollar)

The FRM exam emphasizes that bail-in must respect the no-creditor-worse-off (NCWO) principle — no creditor should receive less through bail-in than they would have in a hypothetical liquidation.

How does bail-in actually work mechanically — what is the sequence of write-downs and conversions?

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