Europe's Cypriot Solution for Failing Banks

by Jacob Funk Kirkegaard | December 13, 2013

The European Council and European Parliament have reached a political agreement on how to deal with banking failures. The new rules — known as the Bank Recovery and Resolution Directive (BRRD) — make clear that the treatment of Cypriot banks earlier in 2013 set a precedent. A final round of testy negotiations among member states and the European Parliament next week will determine the design of the euro area’s new single resolution mechanism (SRM) for failing banks. The key points of the agreement are as follows:

National rescue and resolution funds for insolvent institutions are to be created by 2025. Each member state will establish a fund to help a bank recover or be liquidated. The fund is to be worth 1 percent of covered deposits in the country, half the 2 percent level at the Deposit Insurance Fund (DIF) of the Federal Deposit Insurance Corporation (FDIC) in the United States, which has the dual purpose of (1) protecting the depositors of insured banks, and (2) funding the resolution of failed banks.

The national funds are to be financed gradually by the banking industry until 2025, with access to public funds during the transition period, raising the possibility of the process becoming politicized. In the event of a bank failure, the resolution fund is allowed to inject up to 5 percent of the failed bank’s capital. Thus national governments could be liable for this part of the costs of winding down a bank. Until 2025, therefore, a relatively larger part of the costs of rescuing or winding down a European bank will reside with the national governments.

An additional complication arises for the period before 2025 in the euro area, as political difficulties surround the ability and capacity of a national resolution fund in one country to help rescue a bank in another country. It is hard to see cross-border transfers happening without political conditionality imposed on the country receiving assistance in this period. After 2025, when only “industry funds” are at stake, the political issues related to national taxpayer funds crossing euro area borders disappear. Euro area politicians, therefore, must agree to integrate national euro area resolution funds into a single industry-funded euro area resolution fund by 2025 at the latest.

Mandatory bail-ins begin in 2016. Mandatory bail-ins — forcing costs equivalent to 8 percent of bank capital on creditors, shareholders, and junior and senior unsecured bondholders — are to be imposed before any taxpayer money can be utilized. Deposits under €100,000 will be exempt and preferential treatment will be given to deposits of residents and small and medium enterprises above €100,000.

As discussed earlier, mandatory bail-ins reduce the exposure of taxpayers to all but the most total bank collapses. Had such rules been in place earlier, they would have dramatically reduced government bank bailout costs for Ireland and Spain. This part of the BRRD alone dramatically improves Europe’s banking rules.

After the mandatory bail-in of 8 percent of bank capital, national governments will be permitted to use their national resolution fund cash to inject another 5 percent of bank assets into failing banks.

EU governments can request that the European Commission exempt some creditors from bail-in requirements in exceptional cases. Doing so would merely shift the 8 percent in mandatory losses in a failing bank onto other private creditors, however. Governments — with Commission blessing — thus would get the power to allocate losses among private creditors but not to limit these losses.

Exceptional circumstances, moreover, are envisioned to allow the use of certain government tools, such as “precautionary recapitalization” by public money. (Such a step might entail nationalization, or at least making the government a major shareholder.) But government ownership of an insolvent bank would still not be possible until the minimum bail-in costs have been imposed on shareholders and creditors. Exceptional circumstances like another systemic banking crisis may invite larger European government capital injections into an entire banking system but still not shield private bank creditors in Europe from losses.

Had such rules been in place in the United States in 2008-09, when the US Treasury demanded that leading banks accept additional capital from the Troubled Asset Relief Program (TARP) to stabilize the banking system, it could only have done so after haircuts imposed on each receiving bank.

Needless to say, such repercussions go well beyond any market stigma from having to take government money for affected banks. Healthier banks in any country affected by a systemic banking crisis would most likely fight the imposition of such government stabilization tools.

Some potential problems are evident for the European Banking Authority (EBA), the rule-making body of European banking regulators tasked with drafting the fine print of how exceptional circumstances are to be handled. In a future European systemic crisis event, necessitating government capital injections in virtually all large banks, the requirement of haircuts for creditors could destabilize the system by penalizing healthy as well as ailing banks. Unless solid and well-capitalized banks can show they have absolutely no need for new capital, a vicious circle might evolve, producing a general crisis for the European banking system, as creditors flee all banks to avoid the costs imposed on them. The EBA will need to specify that exceptions from mandatory bail-ins are possible for healthier banks in such situations.

The cap of 5 percent of bank assets on any contribution from resolution fund money to a single failing bank opens the question about what happens in cases where bank losses exceed the combined 13 percent of bank capital in mandatory bail-ins and potential contributions from resolution funds. Presumably, the yet-to-be-created new euro area SRM and national governments outside the euro area would decide. They could simply bail in more creditors and impose losses onto large uninsured depositors, as happened in Cyprus. Or they could inject public funds to cover losses greater than 13 percent of bank capital. Presumably in noneuro members, the national government would retain flexibility in deciding what and how much taxpayer funds to inject. In the euro area, this would be in the hands of the (still to be agreed) SRM, which would not be able to demand that a euro area government inject national taxpayer money to cover losses in excess of 13 percent of total bank capital. A national euro area government might be willing and able to do so, of course, though it would not be required.

This matters, as euro area countries after November 2014, when the European Central Bank (ECB) takes over as bank regulator, have access to the European Stability Mechanism (ESM) for additional financing. This, however, is available only after all available creditors have been bailed in and the 5 percent contribution from the resolution fund has been exhausted. In such cases, whether the ESM provides a bilateral loan to the national euro area country in question (like in Spain in 2012) or directly injects new capital into the failing bank, the requesting national government would be subject to political conditionality. This poses an obvious political obstacle for any ESM application being made, as a number of national euro area parliaments would have to approve it, including the German Bundestag.

How a failing euro area bank with losses beyond 13 percent of bank assets is resolved might, therefore, be difficult to decide quickly, as recently requested by the ECB’s Jörg Asmussen. It will often require the political willingness of a national government to apply to the ESM. Ironically, that might require the very financial market volatility that the BRRD and SRM are supposed to avoid.

Overall, with the BRRD, the link between national governments and their banks’ balance sheets in the euro area will not be completely broken. Though the mandatory 8 percent bail-in and 5 percent potential contributions from a banking industry financed resolution fund will deal with the financial fallout from most future banking failures and protect taxpayers. But beyond 13 percent of bank capital, national governments themselves will potentially remain on the hook. Only if a government is willing to submit to ESM political conditionality will direct bank recapitalization from the ESM be possible.

None of these mechanisms will prevent future systemic banking crises or allow for them to be dealt with on auto pilot over a weekend. Not even fully integrated countries like the United States or the United Kingdom were able to deal with their crises without a new political settlement in 2008. It remains unreasonable and unrealistic to demand that Europe’s banking union be capable of this in the future. The best that can be hoped for is to make crises less frequent and harmful.

The BRRD is not perfect, but it will be helpful on both accounts. Mandatory bail-ins should make bank shareholders and creditors demand that bank managements run their institutions soundly. Second, as bail-in and taxpayer losses are negatively correlated, the BRRD will lower the risk that a European government goes bust following a banking crisis, especially after 2025. And third, it does go some distance in severing the link between governments and banks. Combined with the conditional access to the ESM, which would not be capped at the currently envisioned €60 billion, there is now more clarity on what happens if a very large euro area bank collapses.

Copyright © 2013 the Peterson Institute.