Bail-in – there is still a lot to do

In a market economy, the following should go without saying: if banks run into problems, their shareholders and creditors will be liable, whereas the taxpayer will preferably be spared. But, given the experience of the previous years, this seems too good to be true. Even so, after the most recent resolution of the EU finance ministers on the rescuing and restructuring of banks, people have started to renew their hope for rules like this. After all, re-unifying ownership and liability would indeed be a major step towards individual responsibility and thus a sustainable solution to one of the Eurozone’s central challenges. Initially, individual responsibility was addressed by the no-bailout principle in the European treaties, even though, right from the start, investors did not see this as a realistic scenario. At a closer look, the re-kindled hope based on the new EU resolutions to change things will turn out to be delusive as well. This is due to various reasons.

First: The EU resolutions won’t become law before the year 2018. So what is going to happen until then? Another series of ad-hoc measures, as in the case of Cyprus, will hardly create trust and stability. Rather, it will continually raise the question which creditors should be tasked to the rescue of banks. If we differentiate between types of investments – i.e., national or foreign, institutional or private, small or big investors – a certain kind of arbitrariness might be the consequence. In this case, the respective investors would consider very carefully, if and how they were to provide capital for banks. This general sense of insecurity will last at least up to the year 2018.

Second: Instead of establishing clear rules, the EU resolutions have left several backdoors open, which means, said insecurity will last even longer than 2018. For example, if there is a risk of infection, national resolution authorities may exclude all or certain obligations from bail-ins. How this risk is precisely defined has not yet been clarified. This means, without clear rules, national intervention continues to be possible. But how are investors then going to assess a bank’s obligations? Their central demand will be to learn exactly under which conditions a bail-in can be expected. If these conditions were only dependent upon market prices, valuations would be as feasible as in the case of all other financial instruments. But if these conditions depend on the discretion of national resolution authorities, it will be impossible to conduct the valuations in question. The willingness to invest in this kind of capital might thus be low, even if national intervention, in principle, were to have a positive effect on creditors.

Third: The most important reason for the as yet largely missing bail-in for failed banks is that, in most cases, their creditors are other banks. Even if their bail-in is principally conceivable, it will lead immediately to the issue of risking contagion. But if banks stay as strongly interconnected as they currently are, every initiative will soon reach its limits, as well-meant as it might be. Hence, bail-ins will continue to fail as long as there is the threat of a contagion. Due to real or assumed worries over a systemic collapse, the taxpayer will be liable again. Therefore, it is vital to consider how the banking system should be financed in the future, and above all, how to create capital shares that cannot be held by other banks. Relevant suggestions can be found in the Liikanen Report.

All initiatives re-instating the principle of unifying property and liability should be welcome. This applies especially to the banking sector, where bail-ins have been the exception so far. However, the most recent resolutions of the EU finance ministers are insufficient. The rules are not timely enough, they are not free of political influence, and they do not have the necessary credibility. If the taxpayer is to be spared further burdens, more effort is required.

Banking and Finance

Financial Services

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