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.

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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