EU enters brave new world of bank bail-ins

January 4, 2016

The author is a Reuters Breakingviews guest columnist. The opinions expressed are his own.

The European Union entered a brave new world of bank “bail-ins” at the start of 2016. Europe has wasted so much taxpayers’ money on bailing out bust banks in recent years that it is right to try to get investors to help foot the bills in future. However, the tough new regime carries big political risks.

The key new rule is that no bank can be bailed out with public money until creditors accounting for at least 8 percent of the lender’s liabilities have stumped up. So-called bail-ins typically mean wiping out creditors’ investments, slashing their value or converting them into shares in the bank. Uninsured depositors could get caught along with professional investors.

Moreover, within the euro zone, national authorities will no longer be responsible for dealing with bust banks as this job has just been transferred to the new Single Resolution Mechanism.

During the global financial crisis, bailouts were the normal way of shoring up bust banks. The European Commission approved 592 billion euros of state aid to lenders between October 2008 and the end of 2012. This was justified on the grounds that if banks collapsed and depositors lost their money there would be economic chaos.

The trouble was that bailing out banks caused government debt to balloon and contributed to the euro crisis. Hence the idea that investors, not taxpayers, should have to help pay the cost of rescuing or closing down banks – the norm in the United States since the Great Depression.

The theory is that shareholders should take the first hit because they know they are risking their money. If that isn’t enough to stabilise the bank, subordinated bondholders should step up because they too should know such investments are risky. Next in line are senior bondholders and, finally, uninsured depositors – which, in the EU, means those with more than 100,000 euros in their accounts. The small depositors should not be touched.

Unfortunately, bail-ins are harder in practice than in theory. A big test came during the Cypriot crisis of early 2013. The euro zone’s initial instinct was to tax all depositors, big and small, to fill the gap in bank balance sheets. Although that bad idea was abandoned, large depositors suffered swingeing losses, helping cause a steep recession.

Other countries do not want to repeat the Cypriot experiment. No wonder Italy and Portugal rushed to rescue some of their troubled banks before the tough new regime kicked in at the start of January.

Not that Rome and Lisbon had a free hand over what to do. Since mid-2013, the commission has said public money could only be used to bail out lenders if shareholders and subordinated bondholders shared the burden. Still, this was not as tough as the new 8 percent rule, which could require senior bondholders and uninsured depositors to take a hit too.

That said, applying even the old rules has caused a political rumpus. Italy used a new industry-funded bailout scheme to pump 3.6 billion euros into four small banks in November. The problem was that many of the subordinated bondholders who had to be bailed in were ordinary savers who had been sold these investments without appreciating their risk. One committed suicide.

The government has faced a backlash. It has also been forced to create a compensation fund for investors who were mis-sold the bonds and is considering how to stop this happening again.

Meanwhile, in Portugal, the new leftist government lost its majority when its allies refused to back a 2.25 billion euro taxpayer-led rescue of Banif, a mid-sized bank. The government only survived after the opposition abstained.

It’s not clear exactly what would have happened if these banks had been rescued in 2016 instead, as there is some discretion over how to operate the new rules. Still, the worry is that if other banks get into trouble in the next few years and uninsured depositors face haircuts as in Cyprus, the political repercussions will be even more severe than those experienced in Italy and Portugal. That could bring the new regime into disrepute. The first case will set an important precedent, says Nicolas Veron of Bruegel, the Brussels-based think tank.

The EU authorities, though, don’t have to just keep their fingers crossed. They could encourage banks to raise enough subordinated debt and other types of capital so that there’s less risk that the 8 percent rule hits those lower in the pecking order.

Lenders don’t have to get to that level until 2020, which means there is a four-year gap when things could go wrong. Accelerating the timetable should be considered when the commission reviews the rules this year. With interest rates low, now could be a good time to raise capital.

Bail-ins are right in principle, but aren’t an easy option. It would be a shame if the EU’s bold experiment comes unstuck.

(Hugo Dixon is actively invol

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