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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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.

A new component of the recovery and resolution framework for banks is the mandatory bail-in of shareholders and unsecured creditors that will become mandatory across the EU at the latest in 2016. The bail-in of creditors has been introduced to avoid having member states (ultimately at the expense of its taxpayers) chipping in to bail out a bank that is too important for its economy to let fail. As a policy choice this is understandable, even if much of the initial investment in bailing out a failing bank is normally recouped when the bank or its assets are sold at a later point in time (unless the public sector owner manages the bank for other public policy reasons than recouping its investment).

For subsets of depositors/investors at banks the new mandatory bail-in at the behest of resolution authorities requires a new mind-set in risk management. Specifically this applies to those depositors holding funds at the bank that are not protected under the applicable depositor guarantee system, such as companies or individuals keeping more than 100.000 euro at the bank, or (from 2019) those that bought bonds issued by the bank.

The new rules aim to the public budget, while continuing to protect small depositors, and anyone with a secured claim on the bank (such as central banks). Really new in this line-up is the protection of the public budget, or as politicians/legislators name it: ‘the taxpayer’. Increasing the protection for the public budget does mean that the losses will have to be suffered by someone else, in this case the ‘senior unsecured creditors’ that used to rely on (1) implicit government support for large banks, (2) good banking supervision that would fail and liquidate the bank when it was still solvent enough to pay back each senior unsecured creditor after the liquidation process, or (3) for bondholders that qualify as consumers or small companies on the explicit deposit guarantee system for bond portfolios up to 100.000 euro. These are all in the process of being removed, as senior unsecured creditors will no longer be protected under any of them but instead will be forcibly bailed in when there are signs that the bank might be in trouble. The thinking is probably that very wealthy individuals will ultimately bear these costs, but in practice the impact is more likely to be suffered by pension funds, insurers, banks, investment funds that hold cash at the bank in their current accounts, have bonds or own shares issued by the bank, or have to replenish deposit guarantee systems that have to cough up the cash under a bail-in. And by the consumers and companies dependent on them of course.

Though the commitments to the pension fund of the employees of the failing bank are protected, any debts to other pension funds or insurance companies are fair game. Regulators can still opt – in an optional and thus non-dependable manner – to exclude bail-inable creditors at the moment of the bail-in if they for instance fear unrest. This might benefit certain senior creditors, but will only increase the burden on the remaining senior creditors that do not get this benefit from the resolution authorities (for instance because they are based in another member state, or are too small to start a crisis if they in turn fail due to writing down the money they had entrusted to the bank).

For bonds, the exclusion from deposit guarantee protection and accompanying bail-in-ability may be somewhat defendable (in spite of the potential financial instability risks of writing down bank bond values), as long as the right risk premium is paid by the bank for this risk. I understand that after downgrades of bank bonds by rating agencies in anticipation of the bail-in instrument, the (ultra low) interest rates on unsecured senior debt have shown an increase in the risk premium paid to investors in such bonds. It is doubtful whether that risk premium is enough to compensate for the de facto highly increased risk that bank supervisors will deem a bank to be potentially in trouble and potentially to cause financial instability, and ‘rescuing’ the bank by increasing its capital by writing down or converting these bonds. This can and perhaps should be judged part of normal risk management at the institutions investing in such bonds. It could be a conscious assessment by a well-trained lender that the likelihood of such an event is sufficiently low per bank in a diversified portfolio of bank bonds that even at the current low interest rates the small add-on constitutes an acceptable risk premium. Perhaps. For non-deposit protected consumers and non-financial companies that invest spare cash in bank bonds after the deposit insurance expires for bank bonds in 2019 it is unlikely to be as well prepared for.

A risk perhaps less well understood is that any cash held at any bank on a savings/payment/current account (to the extent it exceeds the coverage by the deposit guarantee system or collateral, and thus also constitutes a so-called senior unsecured credit) is subject to the same write down or conversion as unsecured bonds are. For instance, if a pension funds uses one single bank to collect the liquidity needed to make out the monthly payments to its pensioners, it is in fact making a high risk investment in the bank. This high risk materialises if the banks’ supervisor and resolution authority decide that the time for failing the bank has come before the order for the transfer to pensioners has been given. The bank will in that case re-open the next Monday as usual, but the cash needed by the pension fund to make the payment to pensioners will no longer be available as such cash was bailed-in. The supervisor/resolution authority may or may not give an exemption to the bail-in, but this would increase the burden for others (and is certainly not a right of the pension fund).

The main dependable exception is if the bank gives collateral to the owner of the cash, in the example to the pension fund. Senior unsecured debt is bail-inable, but secured debt is excluded. This is for instance the case with central bank loans that will be collateralized by sovereign bonds or other acceptable collateral. Other examples are for funds owed in the clearing and settlement process, or in the case of bonds so-called pfandbriefe and other covered bonds (that are secured by specific assets of the bank). Small pension funds and small insurers will normally not have the market power or political power to ensure such security is given to them for payment accounts. If they do not get it, they may be wise to spread their cash holdings over a wide range of banks in order to avoid potentially losing all their cash in one go. They could also seek insurance e.g. via derivatives on the potential that a bank will fail, but that may be costly, and it would need to be certain that the writer of that derivative/insurance is not itself linked to or exposed to the bank that is failing.

Should the shares in a bank, bonds issued by a bank, and savings held at a bank by an institutional investor be bailed in, this may have an impact on its own obligations to pay out. An investment fund will be worth less (and so will the pro rata investments by its investors, and the investors in such investors), which may or may not have been understood by those investing via such a fund. At an insurance company or pension fund it may mean that premiums will need to be increased, or payouts reduced. Though their clients may not always be taxpayers in the country where the bank was based, they will definitely be taxpayers somewhere. Taxpayers will thus still bear the costs directly or indirectly via their pension funds, investment funds and insurance firms. The main change is that this burden will only to a lesser extent arrive via state budgets (which will still contract due to lower tax receipt as a result of the losses suffered by banks, insurers, and individual taxpayers, as well as via bailed-in cash held by municipalities, provinces and other state bodies at the bank). The main advantage is the public relations benefit that the burden will not go via the state budget immediately, and that the costs – if pension funds, insurers etcetera have limited their risks via risk management – will be spread out over time and many consumers. Small increases in premiums or limits to payments are less noticeable than a big headline number of initial investment by the state in a traditional bailout. Saving the taxpayer by bailing taxpayers in (directly or indirectly) does, however, appear to be logically impossible.

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– Recital 1, 5, 8, 31, 67 and art 44, 47, 48, 108, 109 and 130 BRRD directive 2014/59/EU

– Recital 5 and 6 Recast Banking Directive 2006/48/EC (part of the previous version of the CRD)

– Art 27 SRB regulation 806/2014

– Art 1.1 and 1.4 of the currently applicable Deposit guarantee directive 1994/19/EC, and Recital 47 and art 5, 20 and 21 Deposit guarantee directive 2014/49/EU (of which 5.1 sub k on excluding bonds will be applicable from July 2019)

– Italy/Romanelli, EU Court of Justice 11 February 1999, Case C-366/97, §13-15.

– EU Banking Supervision, chapter 4.4, 18 and 19

– Are EU Banks Safe?, chapter 3