A second Greek bailout and the temporary respite on bond markets following the European Central Bank’s trillion euro loans has given the member states’ finance ministers the opportunity to switch their attention from failing states to failing banks. Long-awaited proposals on bank resolution, put on ice last year as banking and sovereign tensions engulfed Italy and Spain, are now in the final stages, with officials saying that the banking industry has come around to the idea that shareholders and creditors should be first to pay in the event of a future bankruptcy, an option known as a bail-in.

“The industry in general has changed its position and it’s now much more close to the idea that bail-in is really a useful instrument,” said European Central Bank Vice-president Vitor Constancio. The bail-in - the opposite of taxpayer-funded bailouts - encountered opposition when it was first mooted in 2010 as part of a wide-ranging proposal on bank resolution. It essentially gives regulators the power to write down shares and debts or convert debts into shares to keep a bank in business or contribute to the costs of a wind-down, a last-ditch effort to avoid state cash injections.

“Because of the vital role played by banks, and in the absence of effective resolution regimes, authorities have often had to put up taxpayers’ money to restore trust and avoid a domino effect of failing banks from seriously damaging the real economy,” the European Commission said in a discussion paper presented to the member states’ finance ministers, on 31 March in Copenhagen (see Europolitics4397).

The paper contains a detailed explanation of the Commission’s thinking on the bail-in, which has raised fears among some analysts and the industry that asking investors - particularly senior creditors - to take losses will hamper banks’ ability to fund themselves in the markets in future. The Commission is putting the final touches to its proposals to detail how, when and what debts will be ‘bailed in’. “There needs to be clarity around trigger points,” said one EU official, “as well as the scope and who you take first”. The Commission suggests bailing in eligible debts once a bank is “failing or likely to fail,” ie if it breaches or is likely to breach minimum capital requirements, default on its debts or require a state bailout. Shares would be first to be written down, followed by debts, which can include everything except very short-term liabilities (of less than a month), covered deposits, secured liabilities (except where the collateral securing them is worth less than the debt) and tax, wage and supplier obligations. Long-term liabilities (of more than a year in maturity) would be written down before the short-term, while derivatives cleared through clearing houses could be given preferential treatment and written down after other debts.

There are moves to introduce a 10% minimum threshold for ‘bail-inable’ liabilities to ensure banks do not switch all of their liabilities into other instruments to avoid write-downs in future crises. The Commission is also looking into delaying the bail-in provision to make sure banks have uninterrupted access to funding in the markets. Fitch ratings agency has said this should be delayed until 2019, when EU banks are expected to have raised their capital requirements to the top level of 13%. There are also talks on introducing ‘grandfathering clauses’ for debt issued before the proposal takes effect and transitional periods for building up ‘bail-inable’ liabilities.

RESOLUTION FUNDS

Officials say that there is “a very strong consensus that the time for bail-in has arrived,” admitting that sharper divisions have now arisen over moves to create special resolution funds to deal with bank failures - and more importantly, which funds should pay for failures of a cross-border bank. “The easiest way of solving the problems of burden-sharing in resolving cross-border banking is to have from the start a European resolution fund,” says the ECB’s Constancio. However, France is the only EU country to come out in favour of such a fund - although it is widely supported by MEPs - with other countries, including the UK, Sweden and Finland, preferring to deal with the problem via tougher capital requirements. “Capital requirements keep coming back,” said Danish Finance Minister Margrethe Vestager, who chaired last week’s talks in Copenhagen. “It’s not only about financial resolution alone - capital requirements will be important as well.”

BAILOUT

There is also the issue of government funding, which is not being ruled out in the resolution proposals. Analysts say that banks’ ability to attract market funding is eased by the fact that they have the implicit backing of governments, a link which Internal Market Commissioner Michel Barnier is keen to break.

Bank resolution explained

What is it? A new framework to ensure taxpayers are no longer first in line to pay for ailing banks. A communication from the Commission in 2010 outlined new requirements for banks to create living wills to map future wind-downs and resolution funds to cover potential future costs. Under the proposal, regulators would be handed expansive new powers to limit bank exposures, increase reporting, restrict trading and even parachute in interim managers during future crises.

And the bail-in? This is one of the tools open to regulators after all other measures have been exhausted. It involves the writing down of debts or conversion of debts to shares (debt to equity swaps) to raise capital for an ailing or failing bank.

Why has it taken so long? Market stress prevented the Commission from releasing the proposal last year, with fears that moves to haircut senior bondholders would make investors jittery about buying bank bonds. The time is now ripe, officials say, after the relative calm spell on financial markets following the ECB’s long-term refinancing operations and the Greek bailout.