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VoxEU Column Financial Regulation and Banking

New ICMB/CEPR Report: Bail-ins and Bank Resolution in Europe

Failed financial firms should not be bailed out by the taxpayers. Europe, unfortunately, has a weak track record of following this principle of good governance and sound economic policy. The banking union, with its new approach to supervision and resolution, is meant to improve this matter. This column introduces a new Geneva Special Report on the World Economy which reviews the resolution side of the banking union. 

Nine years since the Global Crisis of 2008 and two and a half years after the launch the banking union in November 2014, some European countries are still struggling with significant banking problems. The total amount of non-performing loans (NPLs) in the EU is around €1 trillion and its allocation is far from equal. The rates of non-performance range from less than 5% in strong countries to 16% in Italy, 20% in Portugal, and 45% in Greece and Cyprus (EBA 2016). More than a third of EU countries have NPL ratios above 10%. These non-performing legacy assets present a challenge for the newly created banking union.

This column introduces the 4th Special Report in the Geneva Reports on the World Economy series.


Download the new report here:

Bail-ins and Bank Resolution in Europe: A Progress Report


Schoenmaker and Véron (2016) conclude that the Single Supervisory Mechanism (SSM) is "effective, tough and fair": cross-border banking groups are now supervised by a Joint Supervisory Team (JST); supervision is more intrusive, and less vulnerable to political intervention; and there is no evidence of special treatment for any particular institutions. However, the SSM lacks transparency and little to no information is provided to the public about the supervised banks. In addition, the SSM has not yet created a single banking market in the EU, and in some cases might even contribute to cross-border fragmentation.1

Between 2006 and 2008, several US financial institutions either failed or had to be rescued with public funds.2 Most of the interventions of the US Treasury for the financial sector were funded by the Troubled Asset Relief Program (TARP), which reached over 6% of GDP in the fourth quarter of 2008 alone. In Europe, all member states of the EU, with the exception of Romania, provided support to their financial institutions (Petrovic and Tutsch 2009). Between October 2008 and 31 December 2012, the European Commission approved €3.6 trillion of state aid measures to financial institutions, of which €1.6 trillion was effectively used. Member states thereby provided €591.9 billion (or 4.6% of EU GDP in 2012) of capital support (recapitalisation and asset relief measures) to the financial sector.3

The debate regarding the justification of the bailouts is unlikely to ever be settled because it is almost impossible to assess the systemic consequences that disorderly failures would have had on the financial system and the broad economy. What is clear, however, is that citizens around the world do not want to be presented with a ‘too big to fail’ dilemma again. The job of regulators is therefore to make the system safer, and to create a process whereby systemically important financial institutions (SIFIs) can fail in an orderly manner. To preserve public finance ex post and market discipline ex ante, the guiding principle of the post-crisis financial regulations is that no private financial institution should be viewed by markets as being too important to be allowed to fail. Another issue in resolution is the distinction between individual bank failure and systemic crises. Avgouelas and Goodhart (2014) discuss the shortcomings of the bail-in regime, and argue that bail-out would still be necessary in extreme cases.

With these goals in mind, we review the EU resolution framework and discuss the desirability and feasibility of bail-ins as opposed to bailouts (Philippon and Salord 2017). Banking resolution involves difficult trade-offs between creditors and taxpayers, between market discipline and financial stability, and between sovereign solvency and political risk. Allocating losses to private creditors improves incentives and protects taxpayers, but it can fall disproportionately on some investors and create short-term financial instability

We start by comparing the US and EU frameworks for dealing with troubled banks. In the US, the Dodd-Frank Act is split between Title 1 (oversight of large financial institutions) and Title 2 (new resolution powers). The EU regime includes state aid rules and the Bank Recovery and Resolution Directive (BRRD). The main objective of the BRRD is to provide a framework whereby financial firms can be repaired or resolved without public money. It has become an important building block of the banking union. The US and EU frameworks have much in common, from their emphasis on financial stability to the resolution powers of the administrative authorities. There are also some significant differences, such as the lack of a restructuring option in the US or the uncertainty surrounding the precautionary recapitalisation measure in the EU. A major issue in the EU is the fact that the BRRD has been phased-in before the completion of other critical features of the banking union, such as a European deposit insurance scheme (EDIS) or the minimum requirement for own funds and eligible liabilities (MREL).

We then review the track record of Europe in matters of bank resolution, based on recent cases of public supports for banks, as summarised in the following table:

Table 1 Haircuts and burden sharing

Note: The first three columns show the haircut rates for equity (Eq), junior debt (JuD) and senior debt (SeD). The next three columns are scaled by assets. Public recap is the sum of all the capital injections by the public authorities. For assets and debt guarantees, we start from the face value. We then use the CDS spread of the bank at that time. We assume that it pays 200 basis points for the insurance, and that the insurance lasts for three years. When CDS spreads are not available we input the average in our sample, which is 969 basis points. The total recapitalisation need is the sum of the recapitalisation, guarantees, and the losses by private investors (shareholders, junior and senior debt holders, and, in the case of Laiki, depositors). For Bankia, we take the public recapitalisation to be 18 billions, as in Duble (2013) and World Bank (2016), although we note that one could also include previous public capital injections (see Appendix). PSI is the ratio of private haircuts, including shareholders, over total recapitalisation needs, including the value of government guarantees.

We find that European taxpayers have covered more than two-thirds of the cost of resolving and/or recapitalising distressed banks. The goal of the new framework (i.e. BRRD and state aid) is to increase effective private sector involvement, in particular via bail-ins. This would be a significant improvement. For instance, we find that if private investors had effectively contributed up to 8% of assets, this would have halved the taxpayers’ burden. Cyprus represents an example of a country where, for various reasons, investors bore the brunt of the resolution costs. In that respect, the macroeconomic performance of Cyprus since 2013 is encouraging, although high levels of non-performing loans remain a challenge. Finally, recent issues with Italian banks show that credibility of the bail-in option requires effective supervision of who is exposed to losses in case of bail-in.

The third part of our report focuses on policy recommendations. Although much improved relative to the pre-crisis period, we argue that excessive forbearance is still an issue and we recommend improvements in the governance of the Single Supervisory Mechanism, its coordination with the Single Resolution Board, and the design of stress tests, as well as the monitoring of exposures to bail-inable instruments. Europe also needs to address important cross-border issues in terms of resolution planning, liquidity and capital. Finally, in our report we propose some changes to improve the predictability of resolution for financial contracts.

Overall, we are cautiously optimistic about the future of bail-in in Europe. The main issue is the transition from the old regime to the new resolution framework. For several years to come, the new resolution tools will have to be applied to balance sheets that are not quite ready for it. This is bound to create bitter legal and political fights. But the evidence suggests that bail-in can work – in fact, it is already producing significant changes in some dimensions – and with the help of hard-headed policymakers, it can become credible and effective.

References

Acharya, V and M Richardson (eds) (2009), Restoring Financial Stability: How to Repair a Failed System, Oxford: Wiley.

Acharya, V, M Richardson, S van Nieuwerburgh and L White (2011), Guaranteed to Fail: Fannie Mae, Freddie Mac, and the Debacle of Mortgage Finance, Princeton, NJ: Princeton University Press.

Avgouelas, E and C Goodhart (2014), “A Critical Evaluation of Bail-ins as Bank Recapitalisation Mechanisms”, CEPR Discussion Paper No. 10065.

Dübel, H-J (2013), "The Capital Structure of Banks and Practice of Bank Restructuring", Center for Financial Studies Working Paper No. 2013/04, Frankfurt am Main.

European Banking Authority (EBA) (2016), Risk Assessment of the European Banking System, London.

Martin, P and T Philippon (forthcoming), “Inspecting the Mechanism: Leverage and the Great Recession in the Eurozone”, American Economic Review.

Petrovic, A and R Tutsch (2009), “National Rescue Measures in Response to the Current Financial Crisis”, ECB Legal Working Paper Series No. 8.

Philippon, T and A Salord (2017), Bail-ins and Bank Resolution in Europe: A Progress Report, Geneva Special Report on the World Economy 4, ICMB and CEPR Press.

Schoenmaker, D and N Véron (eds) (2016), European Banking Supervision: The First Eighteen Months, Blueprint Series No. 25, Brussels: Bruegel.

World Bank (2016), Bank Resolution and “Bail-in” in the EU: Selected Case Studies Pre and Post BRRD, Financial Sector Advisory Center, Washington, DC.

Endnotes

[1] For example, the SSM has not put an end to the high home bias towards domestic sovereign debt in many banks’ bond portfolios, and has not approved many cross-border acquisitions.

[2] For a summary of the US financial crisis, see Acharya and Richardson (2009) and Acharya et al. (2011).

[3] European Commission Press Release IP/13/1301, 20 December 2013. For a comprehensive analysis of the Eurozone crisis, see Martin and Philippon (forthcoming).

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