The European Union entered a brave new world of bank “bail-ins” at the start of 2016. Europe has wasted so much taxpayer money in bailing out banks in recent years that it is right to try to get investors to help foot the bill. However, the tough program carries big political risks.
The crucial new rule is that no bank can be bailed out with public money until creditors accounting for at least 8 percent of the lender’s liabilities have contributed. A bail-in typically means wiping out creditors’ investments, slashing their value or converting them into shares in the bank. Uninsured depositors could get caught, along with professional investors.
Moreover, within the eurozone, the national authorities will no longer be responsible for dealing with failed banks because the job has been transferred to the new Single Resolution Mechanism.
During the global financial crisis, bailouts were the normal way of shoring up failed banks. The European Commission approved 592 billion euros — $643 billion at the current exchange rate — of state aid to lenders between October 2008 and the end of 2012. This was justified on the grounds that if banks collapsed and depositors lost their money, there would be economic chaos.
The trouble was that bailing out banks caused government debt to balloon and contributed to the euro crisis — hence the idea that investors, not taxpayers, should have to help pay the cost of rescuing or closing down banks, which has been the norm in the United States since the Great Depression.
The theory is that shareholders should take the first hit because they know they are risking their money. If that isn’t enough to stabilize the bank, subordinated bondholders should step up because they too should know such investments are risky. Next in line are senior bondholders. Finally, there are the uninsured depositors, or specifically, in the European Union, uninsured depositors with more than €100,000 in their accounts. The smaller depositors should not be touched.
Unfortunately, bail-ins are harder in practice than in theory. A big test came during the Cypriot crisis of early 2013. The eurozone’s initial instinct was to tax all depositors, big and small, to fill the gap in bank balance sheets. Although that bad idea was abandoned, large depositors suffered heavy losses, helping cause a steep recession.
Other countries do not want to repeat the Cypriot experiment. No wonder that Italy and Portugal rushed to rescue some of their troubled banks before the tough new bail-in program started in January.
Not that Rome and Lisbon had a free hand in what to do. Since mid-2013, the European Commission, the executive arm of the European Union, has said that public money could be used to bail out lenders only if shareholders and subordinated bondholders shared the burden. Still, this was not as tough as the new 8 percent rule, which could require senior bondholders and uninsured depositors to take a hit too.
That said, applying the old rules caused a political rumpus. Italy used a new industry-funded bailout program to pump €3.6 billion into four small banks in November. The problem was that many of the subordinated bondholders who had to be bailed in were ordinary savers who had been sold these investments without appreciating their risk. One committed suicide.
The Italian government has faced a backlash. It has also been forced to create a compensation fund for investors who were mis-sold the bonds and is considering how to stop this from happening again.
In Portugal, the new leftist government lost its majority when its allies refused to back a €2.25 billion taxpayer-led rescue of Banco Internacional do Funchal, a midsize bank also known as Banif. The government survived only after the main opposition party abstained from voting on the budget, which contained the rescue.
It’s not clear exactly what would have happened if these banks had been rescued in 2016 instead, as there is some discretion in how to operate the new rules. Still, the worry is that if other banks get into trouble in the next few years and uninsured depositors face losses, as in Cyprus, the political repercussions will be even more severe than those in Italy and Portugal.
The European Union authorities, though, don’t have to just keep their fingers crossed. They could encourage banks to raise subordinated debt and other types of capital, faster than currently envisaged so that there is less risk that the 8 percent rule hits those lower in the pecking order.
Bail-ins are right in principle but aren’t an easy option. It would be a shame if the European Union’s bold experiment came unstuck.
Hugo Dixon writes a weekly column for Reuters Breakingviews. For more financial commentary, visit breakingviews.com.
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