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The EU Commission’s Latest Proposals for Troubled Banks

by | July 11th, 2013 | 05:29 pm
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The European Commission took another step toward a banking union on July 10 when it published two new proposals for failing banks—a Single Resolution Mechanism (SRM) to help wind banks down and another to establish new rules for state aid to keep banks in the EU-28 afloat [pdf]. The first step got most of the headlines, but the second will likely have the most immediate economic effects.

As discussed earlier on RealTime, the European Commission has full executive power over state aid issues in the European Union. Hence its new rules are legally binding and can be enforced without permission of any member states. But with this step, the commission has changed the “rules of the bank rescue game” in the entire EU-28 and mandated that bank shareholders, junior bondholders, and hybrid capital holders be wiped out before any taxpayer money can be used. And this will be the law in the entire European Union in just a few weeks.

Of course, the commission’s willingness to use these new powers against bank shareholders, creditors, and—not least—state governments inclined to bail out their banks remains to be seen. But because the European Union and the commission’s powers are well-established and recognized, its latest action makes clear that the “bail-in principle” of imposing costs on creditors before taxpayers is being gradually rolled out in Europe, with national discretion limited to higher ranked creditors.

The commission lays out its rationale as follows. The new rules are needed to align disparate member states’ national bank rescue measures because “the integrity of the single market needs to be protected including through a strengthened State aid regime.”1 To “limit distortions of competition between banks and Member States in the single market and address moral hazard, aid [e.g., public money for a bank bailout] should be limited to the minimum necessary and an appropriate own contribution to restructuring costs should be provided by the aid beneficiary.”2 After August 1, the commission will demand that “before granting any kind of restructuring aid, be it a recapitalization or impaired asset measure [e.g., bridge or bad bank structure] to a bank, all capital generating measures, including the conversion of junior debt, should be exhausted.”3

A bank can opt out of these tough terms only if a country’s fundamental property rights are not respected or “if financial stability is put at risk.” But only the commission will decide when such exceptions can be made.4 It calls for “adequate burden-sharing”in which”losses are first absorbed by equity, contributions by hybrid capital holders and subordinated debt holders” and “hybrid capital and subordinated debt holders must contribute to reducing the capital shortfall to the maximum extent.”5 It would be up to the commission to define “hybrid capital.”

The single resolution measure (SRM) for banks to be dissolved rather than rescued is different because its proposal is subject to negotiations among member states and the European Parliament during the rest of 2013. The German government’s opposition to a centralized SRM is well-known. Germany believes a revision of the EU Treaty is required for these competencies to be transferred to the European level. Its stance guarantees tough negotiations on the matter.

The commission, as usual, takes an expansive approach to its powers, citing Article 114 in the EU Treaty, granting it power to replace member state measures in order to support the EU single market (and the previously adopted Single Supervisory Mechanism (SSM) for banks). Uniform resolution rules, the commission says, are intended to “restore the orderly functioning of EU banking markets,”and encourage free movement of capital and services while avoiding “significant distortion of competition, at least in those Member States which share the supervision of credit institutions at European level.”

While all 28 EU members must adhere to the new state aid rescue rules, not all will be part of the SRM.6 Only those accepting SSM supervision would be covered. The United Kingdom, Sweden, and other non-euro area members would thus not be part of the SRM, limiting its ability to overcome “banking sector competitive distortions.” The commission’s argument that the SSM/SRM is open for all members to join is legally adequate under Article 114, but this is sure to be contested by Germany and others.

Yet the commission has sought to alleviate some concerns regarding the SRM, especially among those member states that would resist any fiscal costs effectively imposed by the (unelected) commission in Brussels. A Single Bank Resolution Fund (SBRF) would succeed resolution funds at the member state level. Its size would be 1 percent of covered bank deposits in participating member states, or around €55 billion. It would be financed from risk-weighted levies paid by all banks in these states over 10 years. But if funds were needed more rapidly, the SBRF could charge covered banks on an emergency basis or borrow the money from the markets or the European Stability Mechanism against future levy revenues. In the latter case, this loan would be recovered from banks in the medium term to ensure the SRM’s fiscal neutrality. No explicit financing role for the ESM is foreseen.

The important political point is that the SBRF avoids direct fiscal costs for member states, except for a de facto new tax on banks. It may not be a fiscal cost, but surely it has fiscal implications for member states. Whether this will be politically acceptable to member state governments is uncertain, but its adoption should not be ruled out.

A politically intriguing element of the SBRF financing scheme is the proposed risk-weighting of banks’ contributions, based on a calculation of the risks of their liabilities, fund balances, and deposits. In effect, banks financed mostly by deposits would escape with low contributions to the fund. In addition, contributions would be based on the risks of a bank’s activities.Healthy banks facing “financial stability issues”could be exempted from contributions at the commission’s discretion.

Thus small German community banks (or Sparkassen), which are generally well-capitalized and also politically influential in Germany, would thus escape the bigger payments that the new fund would require from a large German institution like Deutsche Bank. Whether this escape clause will make the SBRF acceptable to these politically powerful German community banks remains to be seen.

The commission’s proposal is ambitious in other ways, especially by granting the commission authority to decide whether a bank is to be resolved. Indeed, the commission modestly argues that it “is the best placed among EU institutions to ensure that final decisions fully respect the principles underpinning the functioning of the EU and are consistent and equal across the Single Market.”It helps that other European institutions like the European Central Bank (ECB) or the European Banking Authority (EBA) have excused themselves from this politically explosive responsibility. But again, whether member states are ready to invest these powers in the commission is uncertain.

The commission also made a rhetorical bow to the recent Franco-German call for creation of Single Resolution Board [pdf] whose members would include representatives from the commission, the ECB, and various national authorities (e.g., both where a bank is headquartered and where it has subsidiaries). The board would oversee the resolution of a bank, which tools would be used, and the degree of funding from the SBRF. But the commission would retain the full final legal decision-making power. Once the commission has decided, the SRB would oversee implementation of how national resolution authorities execute and implement the resolution plan.

The commission is—no doubt deliberately—vague about the composition and activity of the SRB, but it notes that there will be an executive director and deputy-executive director appointed by the EU Council and approved by the European Parliament. With this structure, the SRB is designed to remain democratically accountable. In good European institutional fashion, the plans are for a highly complex multi-layered session framework (with distinctions made between plenary and executive SRB sessions) and layered voting weights. Another element of complexity allows for instances in which a bank is headquartered in an SRM member nation, but has subsidiaries in non-SRM member states.

Will this new kind of banking resolution “consultative Shura council” with ultimate decision power still residing with the caliph (i.e., the commission) be acceptable to member states? That question is pointed because the commission made a final nod to Germany and advanced the SRM proposals effective date to January 1, 2015.

Months of European political horse trading lies ahead over such specifics as the number of banks to be included, the size and funding mechanism of the SBRF, and the composition and powers of the SRB. The German elections will be over in September, and Berlin must then choose between an interim resolution framework with teeth, or the risk of another large banking crisis that would force ESM intervention again and expose Germany to more fiscal costs. In the end, a compromise not too different from the commission’s proposals seems likely toward the end of 2013.

Notes

1. Com (2013) 4119, page 5.

2. Com (2013) 4119, page 5.

3. Com (2013) 4119, page 6.

4. Of course the legal option is open for member states and private entities to subsequently file a case against the commission at the European Court of Justice.

5. Com (2013) 4119, page 11.

6. See also the more extensive discussion of this issue in Véron (2013:4ff) [pdf].