Bail-in: Limits and work in progress

Giorgio Barba Navaretti, Giacomo Calzolari, Alberto Pozzolo 12 December 2016

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The balancing act between making shareholders and creditors liable for failing banks and preserving financial stability is pretty daunting. It is a tough trade-off between fairness (investors and creditors should pay if they make wrong choices, not tax payers) and avoiding the disruption of vital economic functions. The regulatory framework on banks’ resolution has struggled to solve this balancing act for decades and the problem seems exacerbated since the outburst of the financial crisis.

When the crisis burst, it took almost everyone quite by surprise. Then, survival was the only possible option – taxpayers paid. The fiscal cost of the recapitalisation and asset relief of 22 large European banks and 13 large US banks amounted to €298 billion and $US205 billion respectively, and the cash injections to UK banks were up to £133 billion (Shoenmaker 2016, Cunliffe 2016).

Since then, the obsessive focus of the regulatory framework has been to restore fairness, and, as much as possible, make investors careful and liable.

To this end there have been two responses to the growing sentiment that banks were generating private profits but social losses. The first was designing a clear framework for how to deal with ailing banks. Resolution authorities and rules have since been set up, especially for large banks. The Orderly Liquidation Authority (OLA) in the US and the Bank Recovery and Resolution Directive in Europe now provide a regulatory framework for orderly resolution. Meanwhile, the FDIC in the US, the Single Resolution Mechanism in the Eurozone, and national resolution authorities in non-Eurozone EU countries now oversee and manage the implementation of such rules.

The second response has been making sure that losses and costs of adjustments in bank crises are borne by private investors and creditors (potentially all holders of junior liabilities) rather than by tax payers. The principle of bail-in, as opposed to bailout, was introduced – resolution of banks has to be carried out by bailing-in (i.e. by imposing losses on) private investors. To reduce uncertainty and to make sure that resolutions based on private funds were not disruptive, large buffers were imposed on banks.

Apart from the prudential capital buffers, eligible liabilities for loss absorption and the hierarchy of such liabilities are being identified. In particular, the Total Loss Absorption Capital and the Minimum Requirements of own funds and Eligible Liabilities (MREL), introduced, respectively, by the Financial Stability Board and by the EC, define such requirements. On top of this, resolution funds have been set up, financed by banking contributions. Namely, in the Eurozone, a Single Resolution Fund is being funded, envisaging a ten year building up process of mutualisation among member countries (funds initially national).

This reform of resolution mechanisms is a necessary and required step to reduce moral hazard in banking and the risk of systemic instability. We fully share the principle of investor- and creditor-financed resolutions to support critical banking functions (Cunliffe 2016). Efforts are underway to identify adequate buffers of bail-in-able liabilities and their hierarchy, and these are important steps forward to increase the resilience of the banking system and to reduce uncertainty regarding the implicit risk of banks’ liabilities. Also, the fact that a Single Resolution Mechanism is now in place in the banking union is an essential and inevitable step towards dealing with the cross-border nature of systemic and idiosyncratic events.

However, the principle of bail-in, although powerful and intrinsically fair, requires a series of warranting conditions for its effective functioning. Especially in the EU, the present framework is still incomplete and its design has considerable limitations. In particular, there are no explicit provisions for a fiscal backstop to private interventions. Private liability buffers and resolution funds may not be sufficient under systemic distress. At the same time, the extent of the required private intervention before public funds can be activated, and the extremely restrictive provisions for the emergency use of public funds before this limit is reached make the boundaries between private bail-in and public bailout apparently clear, but in fact not fully credible and hard to identify.

These restrictive provisions tie the hands of policymakers and put a heavy weight on the shoulders of private investors, some of whom may still be completely unaware of these subtleties, especially at the new framework’s inception. Under stress, this may magnify the fragility of the system, rather than enhance its resilience, amplifying the potential systemic impact of minor idiosyncratic events (Hadjemmanouil 2016).

At present, we find especially challenging the requirement of addressing non-performing loans of European banks by strictly private means. The narrow path identified by the resolution framework and the limited amount of available private resources constrain this process to potentially disruptive missteps. Avgouleas and Goodhart (2016) bring forward an interesting proposal to constitute an Asset Management Company in the Eurozone to find a mutualised solution to the non-performing loans problem.

Restrictive provisions on the use of public funds are especially problematic at the establishment phase of the resolution mechanism. This is because, in this phase the hierarchy of bail-in of different financial instruments will not yet have been clearly defined. It further will not be consistent across jurisdictions and, therefore, markets will be unable to figure out the effective implicit risk of the assets that they hold. As argued by Cunliffe (2016) and Enria (2016), the definition of senior unsecured debt that can be used as MREL must be clear and well known in advance to be an effective ex ante deterrent for excessive risk-taking and to allow an ex post fair allocation of realised losses. Together with the obvious uncertainties and asymmetries in information haunting banks’ resolutions, this may hamper the implementation of an effective and smooth bail-in process.

In this context, the new Proposal for a Directive amending the resolution framework, issued a few days ago by the European Commission, does indeed address some of these shortcomings, for example by defining a pattern of harmonisation in the national rules on the hierarchy of liabilities (European Commission 2016a, 2106b).

Moreover, for the Eurozone, a fully effective resolution framework does require important steps forward in the mutualisation of banking risks. A clearly identifiable mutualised fiscal backstop is a necessary but still missing ingredient of the resolution architecture. Equally necessary is the approval and implementation of a European Deposit Insurance scheme.

The presence of large and systemic pan-European banks further complicates the job. The limited mutualisation and size of the resolution fund and the inconsistencies in national insolvency regimes are even more blatant when addressing the cross-border dimension of large groups. Several issues concerning cross-border banking are still incompletely addressed in the European architecture. The optimal design of resolution plans (so called ‘living wills’) is a very complex exercise, which requires building experience, and strong cooperation between the Single Resolution Board and national resolution authorities. This is especially important given that resolution plans are based on the ‘multiple point of entry’ approach – the only one applicable in the short term, given the current structure of large banking groups in Europe – rather than the ‘single point of entry’ approach, which is probably a superior long-run solution.

An effective implementation of the bail-in principle requires clearly identifying its limits. This, in turn, implies defining transparent and credible triggers for activating mutualised fiscal backstops and interventions with public funds when bank runs and systemic crisis are likely. A fully safe banking system will always require the backing of taxpayer money. Pretending that taxpayer money shall never be used is not the most effective way of making its use least likely. Fairness by itself can strengthen, but not fully restore safety. An effective bail-in regime requires that the option of bailout is not ruled out by assumption, but that it is made clear when and under what circumstances it may be credibly activated.

Editors’ note: This column is derived from the editorial of the latest issue of European Economy.

References

Avgouleas, E and C Goodhart (2015) “Critical reflections on bank bail-ins”, Journal of Financial Regulation, 3-29.

Avgouleas E and C Goodhart (2016) “An anatomy of bank bail-ins: Why the Eurozone needs a fiscal backstop for the banking sector”, European Economy. Banks regulation and the Real Sector, 2.

Cunliffe, J (2016) “Ending too-big-to-fail: How best to deal with failed large banks”, European Economy. Banks regulation and the Real Sector, 2.

Hadjiemmanuil, C (2016) ”Limits on state-funded bailouts in the EU bank resolution regime”, European Economy. Banks regulation and the Real Sector, 2.

Enria, A (2016) “From bank bail-outs to bail-in: Progress and open issues”, Speech given at Regent’s University - London, 13 April.

European Commission (2016a) “Proposal for a Directive amending Directi 2014/59/EU of the European Parliament and the Council on Loss Absorption and Recapitalisation Capacityof credit Institutions and Investment Firms” .

European Commission (2016b) 2016/063 “Proposal for a Directive amending Directi 2014/59/EU of the European Parliament and the Council as regards the Ranking of Unsecured Debt Instruments in Insolvency Hierarchy”.

Schoenmaker D (2016) “Resolution of international banks: Can smaller countries cope?”, CEPR Discussion Paper No. 11600.

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Topics:  EU policies Financial regulation and banking

Tags:  bailout, bail-in, EU, financial crises, financial stability, eurozone, bank regulation

Professor of Economics at the University of Milan and Scientific Director of the Centro Studi Luca d’Agliano

Professor of Economics, Bologna University ; Research Fellow CEPR

Professor of Economics at the University of Molise

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