With the Italian bank Monte dei Paschi di Siena (MPS) being bailed out by the Italian taxpayer, push comes to shove: Are post-crisis reforms working? First and foremost, this concerns the innovative resolution instrument of ‘bail-in’. While the successful resolution of Banco Popular stirred hope at first, the Italian government’s handling of Veneto Banca, Banca Popolare di Vicenza (together: ‘V&V’) and MPS throws serious doubt on the consistent application of bail-in as set out in a recent Bloomberg article.
The European strand of the financial crisis is being brought back to the center stage of financial regulation. Unlike in the financial crisis of 2008/2009, however, there are strong forces arguing against state intervention today: European law requires creditors of a systemically relevant bank in the vicinity of insolvency to be ‘bailed-in’ – that is, having their claims written off or converted into an equity stake. In MPS’ case, around 40% of this ‘bail-inable’ debt is held by small retail investors, which puts strong political pressure on the Italian government to inject state funds.
Hence, the far-fetched exemption to the bail-in concept, a ‘precautionary recapitalisation’ is used to inject taxpayer funds by way of Art. 18 IV d SRM-Regulation/ 32 IV d BRRD (see Philipp Lassahn's post on Regulation-Y blog). In the case of V&V, the Italian government was allowed to – in effect – circumvent the European rules by resorting to national insolvency law, which does not prevent the bail-out of senior creditors.
1. Bail-in as a self-commitment device – a credible bail-out alternative?
Anything that comes close to circumventing bail-in is, however, a very dangerous undertaking.
And herein lies the danger resulting from the MPS crisis: it shows that resorting to the bail-out option is still possible if necessary for the preservation of financial stability (Article 32(4.d) BRRD).
Even a single precedent renders void the genius that is idea behind it. As posited here, bail-in should first and foremost be understood as a device to commit future governments/authorities not to bail-out creditors, eliminating the funding subsidy enjoyed by financial institutions that are deemed ‘too big to fail’.
Bail-in rules seek to do away with the menace of socially costly bank insolvencies in the first place. They seek an ‘internal resolution’ by way of writing down liabilities or converting them into equity, thus avoiding balance sheet insolvency.
But are bail-in powers likely to be exerted when push comes to shove, that is, even in times of extreme financial stress? Standard & Poors seems to be very doubtful in this regard. Enforcement of bail-in rules relies heavily on how the extreme political and economic pressure on all participants in a very short window of time is expected to be handled (‘until Asia opens’). The more discretion is given to authorities in these kinds of situations, the more susceptible to external pressures the actual decision-makers, namely politicians who would rather play it safe and not risk a crisis or regulators prone to industry lobbying, will be. In essence, this touches the very core of the bail-in’s credibility, given that situations of severe financial stress by all means constitute realistic cases of application.
The mere public discussion about the feasibility of bail-in surrounding MPS shows, however, that enforcement of bail-in is up in the air. In order to conceptualize how governments’ discretion can be reduced without doing away with the necessary flexibility altogether, one aspect warrants closer inspection: How do regulators come to a decision over conversion?
2. Calibrating conversion: Getting to No
In general, we can distinguish two models of bail-in decision making. First, is the one in which a resolution authority has the right to write off the bank’s liabilities (regulatory bail-in alternative). Second, regulators can require financial institutions to issue a specific level of debt in advance of any deterioration in the bank's balance sheet which will automatically convert into equity (contingent convertible debt). The decision over a future conversion is thus made ex ante (‘internal insolvency’) by the contracting parties in conjunction with the relevant authorities. This is the idea underlying the Financial Stability Board's TLAC (Total Loss Absorbency Capital) or the EU’s MREL (Minimum Requirement for Own Funds and Eligible Liabilities) requirements.
If other fragile financial institutions are holding these claims, however, bail-in could trigger contagion effects. This, in turn, would render the application of bail-in by regulators less likely in the first place. Consequently, authorities should pay attention to who holds the ‘bail-inable’ debt.
Concerning the point of time, it seems preferable to have relatively easily triggered and regular conversions. This will reduce the impact on the financial system as a whole and external pressures on authorities to resort to bail-outs.
3. The law in action: Now is the time – the MPS case
Coming back to MPS, the Italian regulator (in collaboration with the supervisor ECB and the European Commission as state aid watchdog) is now making use of the ‘precautionary recapitalisation’ exception. This does substantially impair bail-in’s self-commitment function by implicitly opening up discretion. Setting another precedent against bail-in lowers the burden for future authorities, even in potentially benign situations and in turn raises expectations that public money will be used again.
For policymakers, the way to go from here should be to further restrict the relevant authorities’ discretion vis-à-vis bail-in and close the loopholes. As long as the law ‘on the books’ still allows for undue discretion or wholesale circumvention, bail-in powers have to be made credible by enforcing them ‘in action’. In June, Europe seemed to be on the right track with respect to Banco Popular. With V&V and MPS, two excellent opportunities to showcase bail-in’s feasibility were missed.
An earlier version of this post appeared on Regulation-Y, a project by a group of students and academics associated with Oxford University, Bucerius Law School and Harvard Law School. By way of offering a platform for fresh and non-conformist thought and debate, the project seeks to promote the formation of an international community of young researchers, students and all others involved with and interested in financial regulation.