Through the summer of 2012 there have been increasing calls for the adoption of a ‘banking union’ in the Eurozone. The single aspect of this that is now becoming clearer is that the supervision of all cross-border banks headquartered in the Eurozone and of all banks therein in receipt of officially financed capitalisation should come under the supervision of the ECB. Whether that supervisory oversight should extend to all banks headquartered in the Eurozone, and the relationships between the ECB supervisory staff (yet to be assembled) and the European Banking Authority (EBA), on the one hand, and the supervisory staffs in member states (often, but not in all cases, in national central banks), on the other hand, has yet to be decided. Meanwhile, the British and Swedish authorities are not prepared to cede or share supervisory control over their own banks to the ECB. Nor is this necessary for achieving the purposes of banking union within the Eurozone, so the latter will be the relevant regional framework.
One of the problems that a banking union might help to remedy is a tendency for national regulatory authorities to be too soft on or to be partially captured by their own national champion banks – institutions that often have strong political links and lobbying capacities. Another problem has been that such national champions, especially when cross-border, have become too large relative to the size of their domestic exchequer. If such banks should become insolvent, the cost of rescue can become so large as to endanger the fiscal solvency of the state (as in the cases of Iceland, Ireland, and Spain). One of the main purposes of a banking union is to loosen the links between national banks and nation states whereby weakness in the one can imperil the other. A third problem is that – as the experiences of Dexia, Fortis, and the Icelandic banks have shown us – sharing the loss burden of a cross-border international bank through ex-post negotiation has been fraught with difficulties.
If a banking union is to help in resolving such problems, the ECB must have the ability to close down the operations of a failing bank expeditiously. It must do so in a manner that does not place an excessive fiscal burden on the home state, while allocating any residual burden of loss arising from the failure of a cross-border bank in an agreed distribution amongst the participating countries. Banks do fail from time to time; even ‘narrow banks’, which are supposed to be perfectly safe, can fail (as a consequence of fraud for instance, or a loss from ‘safe’ assets). Good supervision should make failure less common, but cannot prevent it altogether. Since the supervisor is responsible to the polity, which has delegated its powers, the supervisor also has responsibility for trying to minimise, or at least to reduce, the externalities and costs of bank resolution in the event of failure. Thus if responsibility for bank supervision is to be shifted to the federal Eurozone level, by the same token the management (and financing) of failing bank resolution should also pass to the same federal, Eurozone level.
Of course, the hope is to shift the costs of bank failures from the taxpayer onto other shoulders, to the banks themselves, or to their creditors. But attempts to shift the burden, particularly in the midst of a general financial crisis, can lead to severe and unhappy consequences. The remaining banks will be too weak to support an additional impost, and placing the burden on a failing bank’s creditors may have contagious consequences for other banks’ funding costs and financing abilities.
So, at least in the short run, and in the middle of a crisis, there may be little or no alternative except to resort to the taxpayer to recapitalise, or otherwise to bear the burden, of resolving a failing bank (or indeed of a failing banking system).
Resort to the taxpayer?
Whereas there has been general agreement within the Eurozone to transfer supervisory powers to the ECB, there has as yet been no equivalent agreement on the concomitant issue of handling and financing bank resolution. It remains, for example, unresolved whether any recapitalisation of Spain’s banks by the European Stability Mechanism (ESM) would ultimately remain the liability of the Spanish government (the ESM being eventually repaid by it), or would be shared out among the participating countries according to the key for the ESM’s financing (which is the same formula as used for putting up capital for the ECB), or in line with some other formula. Thus, one other possibility that has been considered is that the home country should have responsibility for the eventual repayment of half of the cost of resolution/recapitalisation, and half remaining with the ESM or Eurozone resolution fund and financed according to the ECB formula.
With this in mind none of the above proposals touch on, or deal with, the cross-border aspects of a banking failure. What if a bank, headquartered in a small country, say Belgium, failed because of losses in a large subsidiary in another, larger, country, say France? That subsidiary would have come under the supervisory control of the ECB and of both the Belgian and French supervisory authorities. Is it then really to be the case that the burden for refinancing should fall only on Belgium and/or on the participating Eurozone countries according to the same overall formula, with no special burden on France?
Failures occur primarily because of losses incurred on bank assets (write-offs and non-performing-loans) rather than runs triggered by some random event, and the main perceived benefit of banks in each country comes from the extension of loans to its citizens. So, as Dirk Schoenmaker and I have already proposed, a sensible division of burden sharing would be to relate the relative cost to the distribution of assets on the bank’s books at some time prior to the failure (see Goodhart and Schoenmaker 2009). There would need to be a large enough lead-time to prevent last minute rebooking of assets between countries. There would still be arguments. What if the bad assets were mostly concentrated in one country, while in another the bank held only safe, ‘riskless’ assets? Should it therefore be the distribution of total assets or of risk-weighted assets? However, ex-post renegotiations between sovereign states are rarely productive, or amicable (as evidenced in the cases of Dexia and Fortis). One does need an ex ante rule; and the locational distribution of bank assets seems to us as good as can be otherwise found. That said, there has been virtually no discussion, nor any progress yet on this front.
Resort to the banks
There is a widespread perception that the financial crisis was caused, in some large part, by bad behaviour by banks and bankers. Thus there is enthusiasm for making those same banks and bankers pay for the direct costs of resolving and recapitalising the banks. Moreover, this is seen as shifting the burden, relatively painlessly, onto the appropriate shoulders and away from taxpayers. Making the banks pay for banking resolution is an integral part of the Dodd-Frank Act proposals for resolution, and will almost certainly be the means of financing a resolution fund in the Eurozone, and possibly in the wider EU.
Requiring such funding from banks is not, however, without its costs to the wider economy. In so far as banks are thereby taxed, intermediation via banks becomes more expensive, thus meaning finance will become diverted into other channels, which may well be less efficient and just as liable to crises and breakdowns. Banks will pass on much of the tax, dependent on market structure, to other creditors in the guise of lower interest rates, higher charges and fewer services to depositors, and higher rates and charges to borrowers. In short, bank spreads between deposit and lending rates would rise.
Then there is the question of the mechanism whereby the tax might be levied. If the tax to refinance the cost of bank resolution were to be imposed ex post after the event to recoup the prior resolution expenditures, it would fall on the ‘good guys’ – those banks that were prudent enough to have avoided failure, at a time in the immediate aftermath of a crisis when they, and the whole system, would tend to be abnormally weak. While the tax could still be levied in proportion to risk characteristics, i.e. in relation to capital adequacy, liquidity or leverage, so as to influence behaviour and thus the likelihood of the next crisis, the fact that it would be imposed ex post (and so will have had no behavioural effect on the prior crisis) suggests that it would be levied pro rata on deposits, and/or short-dated liabilities. A perennial problem with the imposition of financial penalties (taxes) on banks is that there is no generally agreed definition of risk, so such imposts tend to be imposed pro rata.
If such imposts were to be imposed ex ante, in advance of a crisis, they could perhaps be more closely calibrated to penalise behaviour more likely to lead to calls to use such an insurance fund. They would then have a double purpose, both as a regulatory device to encourage good behaviour as well as a means of funding future needs for recapitalisation. Again, however, there are problems. The main one is that in setting the premia in advance one has little idea, apart from the historical record, of the likely future date or scale of the next crisis, and therefore of the size of premia that would be needed. A second argument is often made that any insurance leads to ‘moral hazard’. Perhaps in particular that having contributed to such an ex ante fund any bank, however badly run or in whatever state, might feel that it would have a moral right to be recapitalised – and perhaps even have its shareholders bailed out –rather than be liquidated or taken into temporary public ownership.
Be that as it may, economists tend to argue for ex ante imposts, primarily for the chance of aligning bankers’ incentives more closely with social welfare. Bankers, on the other hand, and their lawyers(?), usually prefer the ex post mechanism. Perhaps because arguments about the appropriate delineation of any such impost are then more clear-cut. As may be imagined, bankers normally win any such argument. Taxes on banks, levied in order to recoup past official expenditures on recapitalisation, therefore tend to be levied ex post along pro rata lines.
Resort to other bank creditors
Even if imposts on banks should be levied, so as ultimately to meet the costs of the resolution of failing bank(s), they cannot be used to defray the immediate up-front costs of recapitalisation or liquidation. For this purpose there is another current suggestion, which is to replace taxpayer funding by calls on (unsecured) bondholders, either in the form of conditional convertible (Coco) bonds, (which can either be in high trigger, ‘going concern’, or low trigger, ‘gone concern’, format, (depending on whether they transform into equity well before, or at the point when bankruptcy is reached)), or bail-inable unsecured bonds, of various levels of seniority. Low trigger Cocos and bail-inable bonds have several characteristics in common.
Moreover, bondholders have chosen to invest in the bank, and have presumably done ‘due diligence’, whereas the taxpayer will generally have no connection with the bank. The bondholder will often be a rich financial institution such as a hedge fund. There was anger in Ireland for example, when senior unsecured bondholders were repaid in full, leaving the burden on the taxpayers. But without specific legal priority for depositors or bail-inable terms on issue, senior unsecured bond-holders rank pari-passu with uninsured depositors. When Iceland repaid all Icelandic depositors, but not the senior unsecured bondholders, the latter sued. The case failed in the Icelandic courts (surprise, surprise), but has been appealed to the European Court of Justice, where as of August 2012, it remains to be decided.
If the Irish government had decided to make unsecured senior bondholders junior to uninsured depositors, and thereby impose losses on them, it would have led existing and potential bond-holders in other Eurozone countries to expect similar treatment. Such contagion would very likely have virtually closed off, or made much more expensive, an important long-maturity funding channel for banks in most other Eurozone countries. In view of the difficulties and high cost of such bank funding that was already in effect, the ECB is reputed to have placed great pressure on the Irish government not to penalise senior unsecured bank bondholders.
Imposing penalties on senior unsecured bondholders, but not on uninsured depositors, would have represented a change in relative legal status ex post facto. But giving all depositors (Cross-border? Foreign currency?) priority, and/or making a subset of bond or Coco holders bail-inable from the start, would be an ex ante way of shifting the burden of resolution. Even so it would, one expects, have adverse consequences for bank funding costs. If the expected alternative source of recapitalisation funding was expected to be the taxpayer, why would bank management want to issue higher cost bail-inable bonds? Probably the only way to get banks to issue them would be to make them a partial alternative to pure equity for regulatory, capital adequacy purposes.
Even then, when banks start to fail in a crisis, the costs of rolling over or issuing new bail-inable bonds would probably rise steeply. If banks either have to raise additional equity- type, debt at unpropitious times, or cut back on leverage and new loans, by raising spreads and toughening up on collateral, they will choose to do the latter, as now. Potential investors can walk away from bank equity and bail-inable bonds; taxpayers cannot opt out. The implication is that reliance on taxpayers in a crisis may well be a cheaper way of maintaining an existing banking system in place, rather than putting the squeeze on bank investors. But then maybe the public, and several commentators, see a case for encouraging a sharp reduction in the relative size of the banking/financial system.
While some of the investors in unsecured bank bonds will have been rich individuals and hedge funds, probably a considerably larger proportion will be held by pension funds and insurance companies. It is always the public who bear the burden of taxation one way or another. Taxation can, if so wanted, be made sufficiently progressive to make the burden fall on the shoulders of the rich, more so than imposing the costs on bail-inable bondholders. In some part the present enthusiasm for imposing the costs on bail-inable bondholders is a reflection of ‘the grass is always greener on the other side’ syndrome. When pension funds and pensioners get hit by losses in bail-inable bonds, the tone may change.
Ultimately the case for bail-inable bonds is that it introduces a market mechanism, in place of a government dirigiste control mechanism. And ultimately the case against is that this new market mechanism may prove considerably more expensive in a crisis.
When should a bank go into resolution?
Whatever the mechanism for resolving a bank, the sooner that is done, the less the likely burden that will have to be subsequently met.
Author’s note: This paper first appeared in the October 2012 edition of the Butterworths Journal of International Banking & Financial Law.
Goodhart, Charles and Dirk Schoenmaker (2009), “Fiscal Burden Sharing in Cross-Border Banking Crises”, International Journal of Central Banking.