For the past 8 years banks have had it rough. Partly they had themselves to blame, partly this is the result of lax (or light touch, or ‘growth oriented’ stimulative) government legislation and action. Anti-banking public opinion and the subsequent more stringent state aid rules and bail in requirements are currently preventing public sector measures that are needed to create short-term financial stability. Now in the news are Monte dei Paschi di Siena and Deutsche Bank, but similar stories have been available in the past across the EU, and at certain times in e.g. the USA and China. For troubled banks there do not appear to be voluntary private sector interventions, and forcefully ‘inviting’ stronger banks to buy their weaker brethren does not work because either the stronger banks are too strong relative to their supervisor, or too weak to bear the cross alone, or are themselves part of the weaker side of the system. Normally the state balance sheet would now be used to prop up the relevant bits of the financial infrastructure. Examples of such traditional public sector solutions for banks overwhelmed by non performing loans, sovereign/bank cross infection (now more often in the modus that new or old bad fiscal decisions and doubts about sovereign debts are infecting their banks in e.g. the UK, Italy and in Greece) would be e.g. nationalisation or a state aid loan at non-market rates or conditions. Even though such measures are often financially beneficial to the investing state in the long term, the potential for high-risk and especially the sheer amount of money needed for the initial public investment has influenced the introduction of barriers to public sector intervention. More specifically, any use of public funds now needs to be preceded by the bail-in of shareholders, junior bondholders and then senior creditors, such as current account holders above 100.000 euro. Creatively, Italy has introduced its Atlante/Atlas fund as a private sector alternative to state aid, but there are continuing doubts whether the Italian financial sector, based in an over-indebted country, is sturdy enough as a whole for the least weak institutions to help out their weakest colleagues.
Even though at least three of the legs of a banking union (EBA in the whole of the EU, and SRM and SSM in the Eurozone) are now in their operational phase, the responsibility for coming up with the funding for solutions appears to continue to be territorial. The SRM is still building up its funding, and it is no doubt difficult to determine when it should grasp the reins from the SSM and take control and responsibility for a concrete solution. In the mean time, local funds and savings account holders tend to be the biggest category of bail-inable creditors, once the more sophisticated financial sector investors have decided not to invest in shares or coco’s of a troubled bank, or are dumping such shares or bail-inable bonds at the first hint of trouble. In the case of amongst others Italy, this is a political issue as a recent bail-in showed that many of the bail-inable creditors are consumers and small and medium sized enterprises. Agreeing that the Single Resolution Board of the SRM takes charge, means accepting that these voters will suffer. These are the same taxpayers who were supposed to benefit from the fact that ‘taxpayer money’ should only be in play after bail-in had taken place (but instead suffer most). The least sophisticated players are the most likely investors in the bail-inable unsecured bank bonds that at the moment do not pay a credible risk premium in the central bank stimulated low interest environment. A territorial approach does not work in a rich but stretched country such as Italy, however, nor is the health of Italian banks of interest only to other Italian banks, the health of Deutsche or the smaller community banks only of interest to Germany, or the health of the UK financial system upon Brexit only of interest to other UK banks. The reputation and financial health of all banks in the Eurozone, in the EU, and perhaps even in the world are now soundly linked in our open financial system, with information, distrust and fear propagating quickly on the internet. This should make it in the joint interest of the member states and governments of other financial centres to stand together, but the aforementioned public opinion and a sovereign tradition of not helping each other across borders when there are solvency issues at banking groups of which the top holding is licensed elsewhere, are preventing this.
Nothing is, however, preventing banks and other key bits of the international financial infrastructure such as CCP’s to step up themselves. Regardless of whether Atlante/Atlas was voluntary or set up under political pressure, it would appear in the calculated self-interest of such institutions to create – as they did some decades or in some cases such as the UK centuries ago – a new central bank from their midst, to deal with this issue that no bank or member state can deal with unilaterally. Strong appearing financial groups can become weak almost overnight if the banking system is distrusted or an incident in one of their subsidiaries occurs (AIG, Citi, Deutsche, Unicredit, RBS, Fortis are examples that come to mind), so it would be in wise for both currently high ranking and for currently low ranking banks to participate in a new private sector bail-out structure that would be able, allowed and willing to act. And no doubt such a EU or worldwide private sector bail-out fund could count on a high rating, and a low tax environment, especially if it is set up as a charity instead of as a profit centre (perhaps with any profits allocated to help out bail-in victims, or to sponsor financial education of consumers and small enterprises). Taking action themselves, jointly, in the common interest but by voluntarily putting up their own money would not least also give a valid emotional argument for allowing them to set their own course again, instead of being regulated to the max as is the current regulatory trajectory for the still nominally ‘private’ sector activity of banking, and thus take control of their own destiny again by also picking up the tab if things go wrong.
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A new post-Brexit trade arrangement between the UK and the EU will be complex to negotiate, and likely to be made more complex by rejection trauma. From the point of view of long term economic growth, stable financial markets and cross border peaceful cooperation, there does not appear to be good news. Position papers like the Japanese give strong hints on what is needed, but also emphasize that the UK needs automatic access to the single market more than the EU needs access to UK markets. Even if the overall size of the European economy might shrink if London suffers, the transfer of even only some crumbs of its current business would mean additional local jobs in Amsterdam, Frankfurt or Paris, trumping any benefits of keeping the London financial markets alive.
So, how to turn it around, and make the shortsighted Brexit vote (costing UK voters jobs, subsidies and workers protection) and a lack of decisive political action from UK and EU legislators to avoid this course of action, into something that would benefit Europe as a whole?
One route that has not yet received sufficient attention is a renegotiated EEA (European Economic Area, consisting of the EU member states plus three non-EU member states). So far, the ‘Norway-option’ or EEA has only been mentioned as a halfway house, where the UK could seek temporary refuge under the current provisions of the EEA Treaty (if the EEA member states would be willing to allow this). Such refuge would allow continued access to the EU single market, as well as possibly to a range of existing trade agreements with third countries. However, like for the current non-EU EEA countries, there is a rather high price to pay for single market access via this route. The current EEA Treaty of 1993 (between the EU member states plus Norway, Liechtenstein and Iceland) allows access to the EU for the three in exchange for abiding fully by EU single market legislation and paying into the EU budget, on both of which they have no say at all. In essence they are being taxed without being represented (in exchange for single market access). For instance new banking requirements have to be accepted by the three countries in exactly the way they are agreed by the EU member states. This was kind of ok at the time, when for instance EU banking legislation was still relatively low key and required implementation by local legislators into local law, but more intrusive EU regulations and directives have de facto increased the transfer of Norwegian, Icelandic and Liechtenstein’ sovereignty to the EU. The Swiss were key drivers behind the negotiations for the 1993 EEA Treaty, but before it entered into force they opted out in a referendum. Swiss banks and stock exchanges, and other businesses for which there are no specific arrangements to access the EU suffer as a result. Norway, Liechtenstein and Iceland have gained access for their banks, but they suffer from having no vote in the council, no vote in parliament and no vote at EBA and ESMA.
The economic and political interests of the UK on the one hand and Switzerland, Norway, Iceland and Liechtenstein may thus well be aligned for a new treaty that keeps the EEA benefits, but adds a bit of balance to the sovereignty transfer. That is, if the UK can indeed convince Norway, Liechtenstein and Iceland that it can act decisively, and in their common interest instead of only its own (of which Iceland may need some convincing). They might do so, if a revamped EEA deal could bring back some of their sovereignty on single market issues, and there is not only a fair voting arrangement with the EU member states, but also amongst the non-EU member states of the revamped EEA. Arrangements on voting on new legislation could for example be based on the Eurozone ins and outs voting arrangements at EBA, though it would thus need to be drafted to ensure that the ‘outs’ are not dominated by any single non-EU EEA member state. Adding the economic and financial services heft of the UK and Switzerland onto the existing access to the single market of the non-EU EEA states, might sway the EU member states to add such a provision to the EEA Treaty.
One of the first things people note when they start viagra fast delivery like it adding Acai to their diet so as to get all the essential nutrients from it. Movie locations in California vary from cialis soft 20mg urban city setting to beautiful scenery of hills and beaches, all of which help in fighting cancer.No cycling: Traditional bike seats are leaf shaped with a nose at the front. As an added bonus, products like this tend to improve the over all well being of person. buying tadalafil tablets He said he didn’t know it well, which http://cute-n-tiny.com/cute-animals/cats-in-halloween-costumes/ purchase viagra no prescription I found hard to believe because I had seen him kick a wall harder than a donkey kicks a pervert. For the UK becoming part of a wider single market EEA renegotiation instead of being stuck in a bilateral post-Brexit negotiation would solve several EU/UK problems in one go. Gifts such as continued single market access, a say in financial services legislation and a more ‘sovereign’ vote on single market initiatives can more easily be granted to the joint non-EU EEA states than only to the UK. It would allow a path for the Swiss to opt in (solving their own internal referendum troubles on free movement of EU citizens), and perhaps even some of the other EU candidates that might be more acceptable to EU-voters as single market EEA candidates than as EU candidates. Last but not least it would allow the single market to remain intact and reduce negative fallout on joint external interests such as security and defence.
It would still require some hard choices on customs, taxes, security, the EFTA trade agreements and especially on passport free travel and migration. For instance the likely limitation cross border long term migration rights only to people in jobs or after retirement from a local job is a common electoral issue for both the Swiss and the British (following referenda in both countries). To gain or regain access to the single market with such a painful sacrifice for the EU member states, would require equally hurtful sacrifices of the Swiss and UK negotiators.
Which price for instance the UK wants to offer up first to Norway, Iceland and Liechtenstein, and then to the EU member states would be up to it to consider. Any offer would need to be of the level of the level of sacrifice in internal UK politics as e.g. exchanging the pound for the euro. Schengen accession and doing its share on burden sharing in finance or refugees would be a good starting point, as it would ease existing troubles with e.g. France on the Calais encampment. A prudential regime for wholesale markets, desirable from a macro-prudential point of view, could be another offer, building on the AIFMD regime for wholesale investment funds. Regardless of the exact result of mutually beneficial EEA renegotiations, this route would provide the UK with the opportunity to show again why it used to be the most influential and effective EU member state alongside France and Italy, before this influence was sacrificed on the altar of national short term electoral considerations. Changing the subject from post Brexit trade agreements to renegotiating the EEA would also provide EU negotiators with cover for granting favours to the UK, allow Switzerland a better entrance to the single market, and right an existing wrong in the EU/EEA of taxation without representation for Norway, Iceland and Liechtenstein.

Banking supervisors and legislators have opted firmly for the bail-in tool as a key part of crisis management at banks. According to the FSB, the EU competition authorities and the EU banking regulators, bail-in is the critical element in any scenario to resolve a bank that is in financial trouble. Before state aid can be dispensed, capital and the (newly reinvented tier 3 capital under another name) bail-inable debt capital requirement under the banking resolution and recovery directive needs to be written down in part or in full, or converted into shares. State aid includes any form of investment (equity or loans) at non-market terms, and includes the dispensation of money from the recently introduced resolution funds (because these funds are government controlled, even though they are funded by the banking sector). There have now been some minor try-outs of crisis management built around a bail-in at failing bank, for instance in Cyprus and Italy. In the absence of sufficient share capital, these try-outs have also involved bailing in depositors who had more than 100.000 euro (the deposit guarantee limit in the EU) entrusted to the failing bank, as well as bailing in consumers who unwittingly bought ‘saving certificates’ that turned out to be subordinated bonds (the term ‘subordinated’ means the same as the term ‘blah blah’ to many depositors).

If the state does not bear the risk, who does?

In Cyprus, the announcement of a bail-in of protected depositors caused social instability to the extent that bail-in enforcers backed down. In the final scenario, only the amount of deposits over 100.000 euro were bailed in. In Italy, the social repercussions of bailing in poor consumers who bought a subordinated piece of paper may well also lead to backtracking on the bail-in. A possible route would be by (ex post) declaring that selling subordinated bonds to consumers constitutes misselling, for which damages will need to be paid to the consumer (to the extent of the bailed-in amount, de facto annulling the bail-in). Though selling bonds or shares or subordinated deposits to only slightly financially aware retail investors did not seem to disturb anyone prior to the crisis, selling coco’s and similar paper already appears to be on the radar of conduct of business supervisors as most likely unsuitable for consumers. A high-risk investment in any bail-inable debt (under bail-in rules including senior unsecured debt, or savings exceeding 100.000 euro) may indeed well be prohibited as unsuitable for non-financially educated consumers and small companies (which can only be supported). These partial retrenchments of the scope of bail-in so far only concerned consumers, however, though both consumers and the financial system as a whole may also be harmed by bailing in claims on a failing bank held by of other banks, pension funds, insurers and so on. The likelihood of such damage to the financial system and directly or indirectly or to large groups of retail clients of bailed in financial institutions increases if a bail-in would ever need to be performed at a systemic bank.

Lacking impact assessment of the bail-in tool

Research on the consequences of a bail-in is still in its infancy. A detailed impact assessment appears to be lacking, with the main driver of bail-in legislation being that ‘the taxpayer’, whomever that may be, needs to be prevented from having to foot the bill of state intervention at systemic banks and other systemic financial institutions. Most likely, ‘the taxpayer’ is one of the consumers or companies (or public authorities), whose claim on the bank is being bailed in, or the beneficiary of pensions or insurance pay outs by pension funds and insurers whose claims on a failing bank are being bailed in. Whether concentrating this pain on the few entities with a direct link to the bank is fair or not is debatable, but it certainly will mean that these unhappy few will be less profitable companies, poorer consumers, and loss making financial investors, who will pay less taxes, buy less stuff and employ fewer people in the future. Tax income will thus likely be reduced, possibly to the same extent (or higher) than a more traditional form of state aid would amount to. This will almost certainly be the case after deducting future income from selling the ‘investment’ (now funded by state aid) in a failing bank, or by recouping emergency loans made to a formerly failing bank. The main effect of a bail-in requirement may well be that the pay out for crisis resolution is now channelled directly between investors end creditors/depositors and the bank, instead of via the sovereign balance sheet, though the net effect on both the balance sheet of the state and of retail clients and financial institution may be the same or worse.

What I personally would like to know, as guesswork is all we have now, is what would actually happen to the financial system and to the taxpayers if the bail-in tool would be applied to one of the bigger banks. I think this is also essential information for any banking supervisor or crisis manager such as the Eurozone Single Resolution Fund before they apply the bail-in tool to any systemic bank, to avoid creating financial instability. So far the tool has mainly been applied to minnows amongst the banks, and even there it has hurt. Can we ask EBA, the ESRB, the SRB, the ECB, the BIS and/or the FSB, to perform a stress scenario including a bail-in to each banking group that is deemed ‘systemic’?

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In such a stress scenario, a bail-in would be applied for instance after a year of severe losses that either were written down from equity or added to formal or informal sets of non-performing loans (the latter by banks that had no spare equity to write down, and by supervisors that wanted to avoid having to face the possibility of formally declaring a bank bankrupt on their watch). After such a prolonged deterioration of a banks’ health a full bail in is performed. In that case, how much would be bailed in of (1) public authorities investment (i.e. public shareholdings in banks such as SNS or RBS, as well as deposits by states and local authorities), (2) how much would be bailed in of loans or investment held by other banks (in the traditional domino-style financial instability scenario), (3) how much of loans and investments held by a pension fund/life insurer/investment fund, (4) how much of loan and investments by regular companies, and (5) how much of loans and investments by consumers. If this kind of information is not known in advance, then bailing in a systemic bank is just opening a black box of misery, similar to the repercussions of the unknown spread of risk in the financial system through securitisation bonds composed of bad quality US subprime mortgages, which were the starting point of the most recent financial crisis. The outcome of this first set of questions would only be first round effects (compounded if multiple banks would be subjected to the bail-in tool at the same time).

Second round effects

Once the information on the first set of questions on the above stress test is available, it would be interesting to assess whether those write downs would be concentrated in the uneducated part of the consumer pool, and at financially naive enterprises (and there is no reason to assume that industrial enterprises, restaurants, plumbers and bakers are financially educated enough to know that any surplus on their accounts over 100.000 euro would be bailed in, nor that most pension funds have the staff and expertise to monitor their banks). Equally, it would be interesting to investigate how many of the more educated and rich would have scampered away well before the bail-in once rumours of potential losses at a large bank would start to circulate. Lastly, it would be relevant to know the second round effects on tax income and economic growth, as well as on the pay-out (and thus taxable income) by pension funds and life insurers to retirees? And how would that over time (e.g. five years) compare to the more traditional scenario of a state funded bail-out, of which I would guess between 60 and 120 % is recouped after divestment of the bailed out systemic bank, or in the case of smaller banks: a liquidation scenario of a solvent but illiquid bank?

Final remarks

Introducing the bail-in tool in the crisis management of banks may well prove to be opportune. So far, however, there is mainly evidence to the contrary, with a loss of trust in banks and in banking regulators when consumers are bailed in. When systemic banks are bailed in, this may well turn out to lead to disproportional losses for the least financially educated. If in the future the claims of more educated parties are bailed in at failing systemic banks, this may lead to domino effects that lead to financial instability, and/or to bigger losses for ‘the taxpayer’ than under the more traditional state aid scenario. Until this is investigated, a bail-in at a larger bank may well trigger our next financial system crisis if that risk turns out to lie in unknown and vulnerable places. Further research is thus urgently needed.

Defaulting on your obligations is a clear event. You did not pay when you should, you did not show up when you promised you would, you did not deliver the assets for which you were paid. In financial contracts the list of clear-cut defaults is often expanded by contractually defined additional ‘events of default’. Such events of default could include many things that normal people would not call a default, such as reorganizing the group of which the obligor is part, or if the obligor suffers a credit rating decrease. Normally, these ‘events’ serve to enable the creditor to have a say in restructurings and such. This allows them to avoid their rights being eviscerated by e.g. removing cash out of the legal entity they have a future claim on.

Default reinvented

Banking legislators have also engaged in such reinvention of the term default as applicable to any credit obligation. The starting position is that there are consequences for the amount of financial buffers that a bank needs to hold for each claim on the obligor after it has not been paid for a certain number of days after they became due. Like the drafters of contractual ‘events of default’, legislators have tried to make the calculation of the required amount of financial buffers more forward looking, and include events when there are ‘just’ signs of possible future non-payment. For IRB banks this already happened in the old CRD after the introduction of the Basel II version of the capital accord. Under the new CRR, the forward-looking element also applies to banks that use the standardised models to calculate credit risk capital requirements.

The CRR requires supervisors and banks to treat obligors credit as ‘defaulted’ when there are early warning signs that indicate that the obligor is unlikely to pay in full. If such default as defined in the CRR and its predecessors happens, banks on the standardised approach need to hold more capital against some or even all the claims they have on the obligor (risk weighting them at a headline rate of 150% instead of at the risk weights that would apply on non-defaulted claims of e.g. 0% for sovereign bonds, 20% for unrated banks short term debt, 20% for highly rated banks long term debt, or 100% on unrated corporates; and equivalent changes in the calculation of the probability to default – PD – factor in IRB calculations). Such a default – as in a failure to pay a due claim by an obligor – does not yet trigger obligatory losses. Once losses are certain, they would have to be written down from the bank’s capital. Instead, a default only means that more capital needs to be held against the claim to buffer against unexpected losses. Only if events subsequently or simultaneously progress negatively and losses are relatively certain, such ‘expected loss’ needs to be fully deducted from the CRR-financial buffers. As can be expected, writing down losses is unpopular, but even having to increase financial buffers for a loan after a loan has already been granted can be costly, and thus unpopular with the banks. If the bank is important and thinly capitalised, it may even be unpopular with supervisors.

CRR examples

Luckily for less diligent banks, most of the situations that the CRR subsequently references as examples of ‘unlikeliness’ to pay in full are drafted to be dependent on their own action. If they for example act in a way that acknowledges that the debtor is in problems (for instance by applying for the bankruptcy of the obligor), they also need to increase their financial buffers. As long as the bank itself does not actually take action or draw conclusions, they can avoid triggering the obligation to acknowledge CRR-default until well after an actual default has occurred, namely until 90 days after the obligor has actually failed to pay. For IRB banks it can even be postponed until 180 days have passed without payment after a claim for interest or principal became due in the few member states that use a supervisory discretion to deal with apparently slow payment systems or for instance badly behaved debtors in the public sector. This national discretion expired for the smaller banks that use the standardised approach already in 2011, but the large IRB banks in countries with apparently slow payment traditions such as France and Great Britain can continue to treat slow payers – e.g. municipalities – as if they are solid obligors. Even if the stricter 90 days is applied, this still means that less diligent banks can escape increasing their financial buffers for at least 3 months after a claim became due. This is not very forward looking, unless the bank is proactive in managing its risky exposures and wants to pay attention – as is the CRR obligation – to indications of non-payment.

The indicators for unlikeliness to pay – as copied unchanged from the old IRB provisions in the CRD – include that the bank recognises a significant perceived decline in credit quality, sells (part of) the exposure at a relevant loss, agrees to a distressed restructuring with negative financial adjustments, asks for the bankruptcy (!) of the client, or if the client actually is bankrupt. This fine example of legislative prose means that according to legislators even a court proclaiming the bankruptcy of the debtor is only an indicator of unlikeliness to pay, and still only means that the exposure to the bankrupt client needs to be weighed at 150%, unless the bank itself determines that loss is certain and the exposure written down accordingly (after which they can risk weight the reduced value of the exposure at a lower risk weight again).

No consistency in application

Remarkably, as part of their monitoring EBA and the SSM supervisors have found that not all banks apply the rules in the same manner, and that the national interpretations (and application of the 180 days of non-payment of past due payments before being forced to acknowledge that the debtor may be troubled) lead to different capital levels for debt portfolios with the same risk profile. Some banks delay finding an event of default, and thus delay applying a higher risk weight or PD to the calculation for the minimum amount of capital they need to hold. Some government bodies are allowed some extra time by the local supervisors to pay their debts, even though the risk is the same or higher than in a similar debt just across the border in another member state. Some less principled banks could even opt to sell almost due bonds owed by a troubled debtor at (fire sale) market prices without formally acknowledging this as an indicator of default, to avoid having to consider whether the rest of the debt of that obligor in default when the debtor fails to fork over the repayment of the short dated bonds. CRR legislators were aware of the issue, but failed to reach a compromise on a solution. Instead, they have added to the existing definition an order to EBA the order to monitor the application of this definition, to come up by 2017 with a report on the 90 or 180 days past due issue, and (without a deadline) to provide non-binding guidelines on how default should be understood and applied by banks in the EU. The SSM has identified the 90/180 days issue as a major impediment to its working practices, and is aiming to pre-empt the 2017 EBA review for the Eurozone member states (of the couple of member state competent authorities that apply this leniency, only the UK supervisors would be able to continue to apply the supervisory discretion, as they will not be bound by the ECB choice on behalf of the Eurozone competent authorities).

As acknowledging the potential for default is core to preparing for recessions and asset based crisis at banks, it is good that EBA has already spent some of its scarce resources to find indicators on how a well set up bank that diligently monitors the credit quality of its debtors should be able to avoid its own future default by taking timely action should do this. Their consultation paper is not a perfect paper yet, but nonetheless it raises the standard for less diligent banks. It for instance implies more clearly that banks cannot limit themselves to the CRR examples of indicators, but actually should look for indicators that the obligor may perhaps not pay to determine whether it is unlikely to pay. Self evident as that sounds, it may be good to reinforce the main rule of heightening financial buffers when it becomes more likely that those are needed, not looking only at the badly written subsequent examples in the CRR provisions, that might lead to fatal delays to shore up buffers when e.g. your sovereign is failing, or when one of the major banks of your country is failing.

(Un)intended consequences?

The consultation paper also raises question, however. Was the spirit of these rules – to prepare for future write-downs by all types of obligors – applied in full in this manner by banks (and their supervisors) when the possibility of default was high in the last few years? For instance when the US government shut down, or when several Eurozone countries were (not yet sure that they would be) bailed out? It is unlikely that this was the case. A part explanation may be that for member states it may have been equally welcome to have optimistic banks that do not apply the indicators of unlikeliness to pay too diligently, and preferably not at all to the government itself, to large banks and to protected sectors. The consultation paper appears to ignore that the same rules should also be applied to these more sensitive types of obligors. The indicators mentioned appear most relevant if thinking of debt of households and loans to smaller companies. They lack clearly defined indicators derived from financial markets that would be much more relevant to larger obligors. The current references to market movements are vague, and thus fail to achieve harmonisation. It would be helpful to e.g. define a certain percentage of losses in share value over a relatively short period of time as a good indicator of potential default (which according to the draft guidelines now need only be considered when fair value in the profit or loss account needs to be reassessed under accounting rules). Rising CDS values would be another good and clear indicator, or high implicit interest rates of bonds traded in the secondary markets, as seen for instance when Fortis or RBS or AIG or Lehman failed, or when Greece defaulted on its original bonds by restructuring those bonds held by private sector banks, insurers, pension funds and consumers.

The macroprudential repercussions of banks being forced to start increase their financial buffers for larger numbers of small obligors or for the potential default of one or more systemically relevant obligors also do not appear to have been considered. Even though the lack of macroprudential awareness is a design flaw of the CRR-article, the guidelines could have helpfully added text on what to do when a systemically important private or public sector entity shows such signs, or if a specific industrial sector or the whole of the private sector in a member state starts to show signs of stress. In that case supervisors and central banks need to be informed of such signals, and in turn should be able to instruct banks to act both in line with their legal obligations to assess indicators of non-payment, but without doing systemic damage. For instance by orchestrating a joint response so that all banks prepare in the same manner (by acknowledging the potential for default of e.g. the USA under a political shutdown, Greece when the first bail-out appeared to be too optimistically structured, or any troubled bank about which rumours swirl in the financial markets). This same point applies to the proposed rules for keeping an obligor nominally in default – even it has started to pay again – to check that the default indicators have indeed permanently receded before allowing the bank to bring down the required level of capital again. As currently formulated, for instance the fact that the ECB accepts unsecured sovereign bonds of Greece again as collateral, or that a conditional new bail-out programme was politically agreed, would not have meant that the commercial banks of Greece could have brought down their increased capital levels for Greek sovereign debts. Such ECB actions are not mentioned as an indicator that all troubles are permanently over. That also applies to the question whether the USA can return to non-defaulted status quickly when a last minute deal on a budget or higher debt ceiling is agreed.

Perhaps a strict application of the law on systemically important obligors is not the intention of supervisors, and may not have been the intention of some members of the Council of the EU as co-legislator. The CRR definition of default nonetheless applies to all sorts of obligors, not only to those that are relatively irrelevant. A bank or supervisor that blatantly ignores indictors of default, and fails to increase the CRR-mandated minimum of capital in a timely manner sets itself up for liability. It thus may be good to give more clarity on the content of the legal obligation of banks and supervisors, instead of relying of regulatory forbearance and/or politically sensitive application of the CRR rules to avoid amongst others macroprudential consequences of a too strict or too late application of the definition of default.

Also see:

• Art. 110.4, 127, 178, 506 CRR 575/2013 and art. 101.5 CRD IV Directive 2013/36/EU.
• Art. 154.1 and 154.7, Annex VI part 1, chapter 10 (§61-65), Annex VII part 4, chapter 2.1 (§44-48) Recast Banking Directive 2006/48/EC (as replaced by the mentioned CRR provisions)
• EBA, Consultation paper, Guidelines on the application of the definition of default under Article 178 of Regulation (EU) 575/2013, EBA/CP/2015/15, 22 September 2015.
• ECB, Public consultation on a draft regulation of the European Central Bank on the exercise of options and discretions available in Union law, November 2015, article 4.
• EBA, overview of options and discretions.
• EBA, CEBS’s technical advice to the European Commission on options and national discretions, 17 October 2008, amongst other option 70, 113 and 151 (disclosure: at the time I was the chair of the relevant working group).
• EU Banking Supervision, Chapter 8

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The debate on whether insurers can be systemically important has taken a strange turn. After focusing on non-traditional and non-insurance activities at large international insurance groups, the scrutiny is now on whether or not to include reinsurance groups into the set of systemically important insurers. Lobbyists are rumored to have found the weakest link at the FSB (this time the USA) to stop reinsurers from being considered as systemically important. The arguments for this remain unclear. The main reinsurers are big, their clients depend on them, and if they have to liquidate their assets to afford a timely payout this would impact on the financial markets.

In the past, arguments appeared to focus on the expectation that the problems would be dampened by the structure of the insurance market. A regular insurer stands between them and policyholders, which would continue to be liable even if the reinsurer on which it relied fails. A traditional argument is also that reinsurance is more like traditional direct insurance instead of like non-traditional insurance activities such as derivatives investing. If such reasoning would be considered valid still, that would be shortsighted, but not unexpected. Reinsurers, insurers and the IAIS have a track record of downplaying potential contagion arising in the insurance sector, including in the reinsurance sector.

Reinsurers are not client-facing, that is true. And the policies they close are not structured as formal derivatives, but as insurance policies of a direct insurer against the materialization of a risk (in their case, that policyholders make claims at the direct insurer). If a reinsurer fails, the direct insurer is indeed left holding the bag. However, that direct insurer would have a huge gap in its capital and technical provisions. A reinsurance contract counts as risk mitigation for prudential supervision purposes at the direct insurer. If the reinsurer can pay out, it does indeed mitigate that risk by offering to pay all or part of the claim that arises from a policy written by a direct insurer (in exactly the way derivatives do if the triggering event occurs). The direct insurer subsequently does not need to hold financial buffers for potential claims that are no longer expected to land on its balance sheet as it is expected to be reimbursed in full by the reinsurer. For large reinsurers this (large) gap at the direct insurer it contracts with is multiplied across all the direct insurers it accepted premiums from. If one of them makes a disproportionally large claim, the reinsurer may no longer be able to honor its commitments to other direct insurers, making reinsurers the main potential channel for contagion in the insurance sector. As e.g. mortgage loans are built on required fire insurance and long-term pension payments from life insurance policies, this would impact on the banking sector too, providing another channel for systemic risks. Even if reinsurers can delay the pay-out by denying the validity of claims, that would just speed up the problems at the direct insurers and their clients, and would not dampen market expectations of asset sales by the reinsurer for an eventual pay-out.

The limited set of large reinsurers are thus a crucial underpinning of this sector of the financial market, similar to the role of central clearing parties (CCP) in securities trading, and ECB systems in Eurozone payment systems. The argument a non-client-facing entity is not systemic has been (and should be) eradicated from public policy thinking since the AIG London branch, LTCM and the Fannie Mae/Freddy Mac bail-outs. Even shareholders of large reinsurance companies like the subsidiaries of Berkshire Hathaway should actually see the benefit of better focus on and the acknowledgement of the importance of such key service providers. For one, it makes their investment in a reinsurance company less likely to suffer catastrophic damage. And if reinsurance would get a more explicit systemic role as a stimulated safety buffer for the wider insurance sector (like CCP’s and depositaries are for the securities markets), it would actually be a business opportunity. It would strengthen their hand against competitors from the hedge fund industry or (other) derivative writers. Even so, it would be more likely that shareholders and boards of reinsurance companies would actually admit that reinsurance is systemic, if the consequences of being deemed systemic were more focused on the business at hand. This is now not the case. The FSB and the committees that work for it (such as the IAIS) appear focused on just slapping an extra percentage on a yet to be developed solvency ratio for large worldwide operating insurers, in a move copied from the banking sector. The fact that it is not yet tested there as an effective tool to avoid or even mitigate a banking crisis does not seem to dampen regulatory ardor to roll it out to non-banks, but it may dampen the ardor of shareholders and boards to subject their reinsurance companies to it.

They have a point. To me it appears strange that the systemic surcharge on top of a debatable ratio calculation is now copied in other financial sectors as if it is a wonder formula. Especially if there is little or no experience with a solvency ratio in the insurance sector in the first place (where a first solvency ratio under the EU Solvency II directive is being rolled out only now). It is not guaranteed that a higher percentage for systemic insurers based on a totally new formula for calculating a ratio would withstand (fear of) the potential waves of destruction of a next crisis, nor that it would avoid the pitfall of being calibrated to the last crisis instead of to the next.

It may be better for the FSB and the (re)insurance industry instead to come up with a more measured response, focused on what is known to work in the specific financial sector at hand. For instance, CCP’s have a similar role in the securities sector both as a core service provider, risk mitigator for client facing securities firms, and – because they are trusted to handle this – risk aggregator as reinsurers have in the insurance sector. CCP’s developed homegrown techniques to be able to bear that risk, mainly by a system of collateral (margin), guarantee funds and novation and netting through which risk is minimized and spread. If reinsurers de facto are relied on in the insurance sector to play a risk-mitigating role and want to be trusted to be a risk aggregator, they should equally develop or expand risk-mitigating techniques. If reinsurers ask legislators to rely on the insurance they provide to direct insurers – which does appear to be part of their business model – they could embrace this role in a proactive manner by mitigating such aggregation/concentration risks. It should not be necessary to assume that each can withstand a multiple of risks arising at the same time, it should be certain. In other words: if reinsurers would like policyholders, direct insurers and supervisors to embrace a core role of reinsurers, it becomes more important that they are bankruptcy remote.

Learning from the CCP example and from what has worked well in the insurance sector, it might be good to take a second look at the benefits of solo supervision and the assets reserved for the calculated technical provisions (i.e. the calculated maximum potential pay-out under open policies). Instead of relying on untested new solvency ratios – even if they are calibrated to be higher for systemic entities – a better response to a systemic reality would be to rely on a combination of:

• more conservatively calculated technical provisions for the maximum potential pay-outs under the reinsurance contracts they have written;
• segregated assets for those;
• collateral rights held by the collective of (policy holding) direct insurers on those segregated assets;
• with a clear pay-out schedule that guarantees equal treatment of various current and future claims;
• and perhaps a mutual guarantee system if overwhelming claims arrive at a reinsurer.

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Also see:

• Buffett clout brought to bear in rules fight, FT 14 October 2015 (published under different title on ft.com on 13 October 2015).
• EU Banking Supervision, chapter 6.2, 6.5, 19.4 and 22.
• Are EU Banks Safe?, chapter 4.5.
• FSB, 2014 update of list of global systemically important insurers (G-SIIs), 6 November 2014.
• IAIS, Reinsurance and Financial Stability, 19 July 2012.

Increasing mortgage loan risk weights in a depressed property market is likely to be procyclical, as would reducing risk weights in booming property market. Strangely, this procyclicality appears to be acceptable under the contemplated EBA standards on adjusting risk weights due to financial stability considerations that are currently out for consultation. The draft binding rules do not specify when they should best be adjusted up, and when down, nor how to take into account such potential procyclical effects. Nothing in the proposed binding rules clarifies at which part of the cycle this lever should be used, which is a bit odd for nominally technical rules that have as their key ingredient that a specific lever can be used for financial stability considerations.

The EBA proposals do give a clue as to what information is relevant, but mainly leave the type of response to the supervisor itself. A supervisor eager to apply the law in a conservative manner is left scratching his head as to the optimum course and timing. A supervisor eager or under political or monetary policy pressure to boost a growing economy, or to stop a sliding property market, is free to do whatever it wants even if the longer term effects might be a less safe banking system. For example, the economies of many of the member states currently need a stimulus. Increasing house prices and office prices based on cheaper lending – if banks do not need to hold so much capital – could help provide such a stimulus. Even though bad lending practices and too low risk premiums and risk buffers for mortgage loans in the USA subprime sector actually kicked off the latest worldwide crisis, the solution to help growth in the short term could be to keep risk weights low, and to keep all options open for national legislators and supervisors. As a result of such pressures it is difficult to blame EBA and its voting members for building in this leeway. However, it does mean that the new binding rules are not very useful if a supervisor or financial stability regulator would like to be able to take measures to ensure the stability of the banking sector and/or the property market. The standards instead excel in less than clear guidance such as ‘Take into account housing market developments’, which kicks in a wide-open door, and says nothing on whether rising values or buyers interest should lead to an increase in risk weighting (and thus higher capital requirements), or to a decrease in risk weighting (and thus lower capital requirements).

This leaves aside that a discussion could be had on whether a higher risk weight would be best from a technical point of view in the upslope of a boom (to stop irrational exuberance, and build up capital buffers for the eventual decline in property values a few years hence and thus in an anticyclical manner), or on the downslope towards a trough (to increase the potential for bank capital being sufficient to deal with future losses in a value-declining property market, thus limiting the scope for banks to lend to potential new purchasers and forcing them to double down capital for existing and new downward developing mortgage loans, even though for the wider economy this would be procyclical). In this light, an analysis performed by supervisors on the basis of the lengthy data sets available over the boom period and the bust in immovable property markets in almost every member state could have been used to base these standards on an analysis of the costs and benefits of heightening and reducing risk weights in each national or regional property market in the period from e.g. 2000 until now. Indicating when Dutch, Spanish, Irish or any other national supervisor in hindsight would have wished that they used the existing risk weight-adjustment instrument either in a pro- or anticyclical manner during that period might lead to useful indicators as to when it should be used in the future with the best impact on wider financial stability as well as on the resilience provided by larger bank financial buffers.

A compromise solution could be to try to aim for the upper slopes of the boom for an increase, and reduce it when property prices have gone below reasonable long term values. At the bottom of the trough this would stimulate the housing market, especially if the expected losses on the housing portfolio have already been written down in full under a possibly wider definition of default and/or lower valuation of the collateral. Higher risk weights on the remaining fully covered mortgage loans would then no longer be necessary, if – and only if – the risk weight setter is able to correctly call when a boom is under way, or when a property market recession is entering irrationally depressed territory.

It would thus be helpful if the standards clarify whether their primary target is to stabilise the immovable property market in a certain market segment, or to stabilise the banks that lend in that area even if that means restricting loans to a already plummeting property market, or both. That would also help indicate whether there is a need to coordinate across financial sectors and across banks on the standardised and IRB approach (to ensure that banks, insurers, pension funds and other non-bank mortgage loan providers increase or decrease their exposure to the market segment involved in the same manner) which I would favour, or not (to ensure that the banks are safe by being able – to put it bluntly – to offload the risky and more costly exposure to the overheated property segment, even if that is to unsuspecting insurers or securitisation-investors such as pension funds).

This overall lack of clear indicators and purposes means that I am a bit reluctant to criticise the only clear benchmark that EBA does provide, which has been referenced in the draft standards and made more concrete in the impact assessment. According to it, loss expectations should be a key factor to determine how high the risk weights should be. It is a welcome clarification of intent, and something supervisors might be benchmarked to. However, though I applaud its inclusion, this specific benchmark does clarify two things that in view of pro and anti-cyclical thinking are a bit unwelcome. The first is that higher loss expectations are expected to be the trigger for an increase in risk weighting. As soon as market based loss expectations are made the determining factor, any irrationality in the market suddenly becomes less easy to deal with. This irrationality is part of the accepted market wisdom at that time, so if for ten years prices have gone up, no one ‘expects’ losses any more. Only once the bust period actually arrives, loss expectations suddenly swing up (sometimes to irrational heights in a panic). Increasing risk weights at that point in time will only strengthen the slide into the abyss. If risk weights instead are already up when loss expectations are still close to nil, then the lever could helpfully be used to lighten the load on the way down, helping to dampen the cycle. That does, however, require supervisors actually to take a stand against ‘the sky is the limit’ politicians and realtors, which as indicated above may not be their favoured role.

Second, the table appears to indicate that the lowest risk weights are appropriate in ‘normal’ times. If so, the lever of risk weights is unavailable during the entire trough of the cycle, meaning it has no dampening effect to get the market (and the banks’ capital requirements) into a mood that indicates light at the end of the tunnel. From a macroprudential point of view, that seems unhelpful. The lowest risk weights should be only in force at the ‘apex’ of the bust, so that the lever can be used both in the downswing and the upswing. No doubt this is more the role of the ESRB to point out, but strangely their role as providers of warnings and advisors on the cyclicality of draft-rules is not visibly reflected in the EBA draft standards.

In conclusion, it may be good to re-assess and clarify some of the key concepts, main goals and direction of adjustments in the draft binding rules before they enter into force. Building upon the experience in the past crisis with a ‘in hindsight’ analysis as to when and how this tool would have been most effective and efficient would be helpful. Both changes would help shelter banking supervisors from being put under pressure to sacrifice long term bank stability against short term political pressure for economic growth.

Also see:

• The separate comment on adjusting the mortgage risk weights
• EU Banking Supervision, chapter 6.2, 6.5, 8, 18.3, 21.2-21.4, and 22.5
• 124-126 CRR
• 128.2 sub d CRR
• 164-166 CRR
• EBA consultation paper EBA/CP/2015/12 of 6 July 2015 on determining higher risk-weights

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Banks that provide mortgage loans can be subject to more or less risk depending on for instance developments in house prices and house shortages in countries or cities. This means they need to hold more financial buffers or less financial buffers depending on the risk that the loan will not be repaid in full, which shift in prudential buffer demands in turn affects housing affordability for most buyers (and thus stimulates or dampens the housing market). EBA is now consulting on the ‘regulatory standards’ on varying the risk weighting for mortgage loans for both homes (residential property) and commercial properties such as shops and offices due to such financial stability considerations. The consultation paper is fostering this discussion very helpfully, but still has some severe shortcomings if it were to become law in this way, one of them is that it only deals with the increase of the risk weight, not with the decrease thereof, the effect of this information on the market, nor the changes in prices and risk over time. Another concern is the lack of clear rules on the timing these supervisory interventions in the financial cycle, which is the subject of a separate comment.

The headline risk rate for immovable property backed loans in the standardised approach to credit risk is that they should be risk weighted at 100%. This headline risk rate is, however, only used if some rather lenient criteria set by the CRR are not fulfilled. If sufficiently backed by qualifying homes, shops or offices the risk weight is sharply reduced (to 35 or 50 %). For the internal model based approach, there is an equivalent possibility to reduce or increase the LGD factor. The result is that banks normally only have to hold a reduced amount of financial buffers on residential and commercial types of mortgage loans. The only exception is if these criteria on the relative value of the collateral to the loan are found not to be fulfilled, and – and this is the subject of the consultation – when supervisors indicate that the reduction in perceived risk is not opportune at that moment in time, or even demand an additional slice of capital by increasing the risk weighting for commercial and residential mortgage loans to up to 150%.

Lets leave aside that the definitions of the terms used are as clear as tar (of the type of definition that residential property means a property that is a residence) and thus highly likely to be moulded not only to local practices but also to the lowest risk requirements. Lets also leave aside that if the supervisors set a high risk weight of 150%, it might be miraculously decided by the bank that the collateral is no longer sufficient, in which case the back-up risk weight of 100% will start to apply in accordance with the badly worded CRR provisions. Lets focus instead on the good intention that sometimes it would be good to require more capital, and sometimes less, for the good of the immovable property market and of the individual mortgage providers active in it.

The 150% risk weight is actually not new. It existed also in previous versions of the capital requirements directives, but was one of those territories that sounded good in theory but in practice were not used. In the depths of the subprime crisis, these levers gained new attention, and even a modicum of followers. For the standardised approach, some member states have now introduced stricter requirements on the lowest risk weighting, and some member states increased the risk weighting to 100% (none yet to the maximum of 150%). For the internal model based approach, only Norway (which is outside of the EU but covered by the CRR provisions under the EEA treaty) has used the possibility to increase the LGD factor in the internal model approach to credit risk (though other supervisors, however, may have done this too in an ad hoc manner as part of the model approval process). This is one of the macro/micro prudential levers that directly impact on the banks’ capital requirements for mortgage loans, and thus on the property market in specified regions (either in a whole country like Greece, or just in overheating segments such as London or Amsterdam). The weird thing is that the proposed regulation only addresses the ‘when should the requirement go up’ question, and ignores the equally important ‘when and how should the requirement go down’.

Even though this tool formally addresses only the capital position of individual banks, it applies to each domestic and foreign bank that is active in a specific property market, and thus will impact – intentionally it appears – on market prices in that area, by increasing or decreasing mortgage availability and interest rate levels. Hopefully, a similar restriction will apply to non-bank mortgage providers, though how this is ensured for specialised institutions or e.g. insurers is equally not addressed in the CRR or consultation paper. If the risk weight change might even potentially be a market-moving event, it is as important to give clarity on when the risk weight percentage or LGD should go down as on when it should go up. If this is not immediately clear from the new contemplated laws, the supervisor will join monetary authorities in their catch 22 of never being able to increase the interest rates if the only thing holding up market prices and holding back a recession is the fact that the market does not expect such an increase in interest rates. That the monetary interest rate dilemma relates also to bond and other financial instrument prices instead of – like this specific instance of mortgage loan risk weighting – only impacts on house prices and affordability does not really matter. If the risk weight is stuck at either a high or low value due to unclear criteria and potential market moving impact, it becomes useless as a macro economic and micro prudential lever.

In addition, the proposed rules should be clear on how supervisors should determine when the risk requirement goes up, but also how they clarify to the market when it certainly will go down again, and how gradual that decline will be. As market prices in the defined segment will be impacted – at least if they are intended to be useful – both by the decision to go up and by the decision to climb down (by reducing or increasing the exposure of the banks to that segment, and making new mortgage loans more expensive or cheaper) in a parallel to the insider information rules the obligatory decision-path and the communication plan of the supervisor involved should be very clear indeed. The consultation paper is silent on the communication plan that should have accompanied it, which is a serious defect on any issue that will and should impact overheating or collapsing housing markets.

To be fair, EBA’s drafting problems derive in part from unclear or one sided drafting of the CRR itself, which focuses solely on the going up variety, and ignores cross-sector and insider-information type concerns. Perhaps the attention of prudential supervisors and housing market organisations could have been better asked for and used at the time of drafting of the related CRR provision, which now contains pitfalls (what is the impact on the bank’s profitability, on their market share compared to other providers, why is there only a level playing field between banks on a specific approach, and not between banks on different approaches, and would a gradual build up and decrease not be better than the sharp cliffs now envisaged, and why do the increases not impact immediately on new mortgage loans, alongside a gradual build up for the existing mortgage loan portfolio?). And what should be the impact on the interest rates agreed in the existing loan portfolio, and is this a public policy concern (which it might well be if it impacts on the financial health of house owners), or is it an issue that can be left to banks (by introducing an additional component into their contractual interest rate calculation and adaptation).

In short, even within the boundaries of the sketchy provisions in the CRR, the consultation paper could be helpfully improved by filling in some of the blanks on adjusting these risk weight provisions both down and up, and on cross-sector cooperation as well as good communication. In an area as important as housing markets, leaving this to national discretion or to market participants may not be the best course. In addition, the related CRR provisions might be adjusted to improve their effectiveness.

Also see:

• The separate comment on timing these supervisory interventions
• Art. 124-126 CRR
• Art. 128.2 sub d CRR
• Art. 164-166 CRR
• EBA consultation paper EBA/CP/2015/12 of 6 July 2015 on determining higher risk-weights,
• EBA overview of notifications on 124 and on 164 CRR
• EBA Q&A 2014-1214
• EU Banking Supervision, chapter 6.2, 8, and 16.6.

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