EU Commission Document on Bank Resolution Framework

The European Commission has released a “working document” that “seeks views on the technical details of a possible EU framework for the management of failing credit institutions and an appropriate class of investment firms.” There’s a press release here and an FAQ here.

The document contains a lot of sensible proposals that would lead to a common future European approach to dealing with failing banks, in contrast to the chaotic and disorganised approach that was seen during 2008-2009.

There’s plenty in the document worth discussing but, given the particular focus of this blog, it is clear that the most interesting aspect of the document is the annex starting on page 86 titled “Debt writedown as an additional resolution tool”.  It’s worth reading in whole but here’s the basic idea:

Thus, to provide additional flexibility and to ensure that any write down power is sufficient to deliver the policy objectives, this consultation outlines two possible models for additional write down powers. Building on the minimum powers above, the first ‘comprehensive’ approach aims to make a broad range of senior creditors face the real risk associated with bank failure. The second ‘targeted’ approach aims to create a more focused tool for resolving in particular, institutions which have been assessed as likely to prove difficult to resolve with traditional resolution tools at a time of fast moving idiosyncratic or systemic crisis.

Resolution authorities could be given a statutory power, exercisable when an institution meets the trigger conditions for entry into resolution, to write off all equity, and either write off subordinated debt or convert it into an equity claim. However, in some cases this will not be sufficient to ensure that an institution in difficulty returns to viability so as to maintain market and creditor confidence when the markets next open. (For example, RBS’ balance sheet at the end of 2007 contained £38bn in subordinated liabilities, while losses before tax in 2008 amd 2009 amounted to around £43bn.

As is de rigeur these days the Commission argues that “Such a power would only apply to new debt issued (or existing debt contracts renewed or rolled over) after entry into force of the power.”  In other words, existing European senior bank debt cannot take a haircut in this way.

However, the problem with this argument, as well its sovereign cousin (the idea that only post-2013 sovereign debt will be open to restructuring) is that it is subject to what economists call time inconsistency. As described by Wikipedia, “time inconsistency describes a situation where a decision-maker’s preferences change over time in such a way that what is preferred at one point in time is inconsistent with what is preferred at another point in time.”

Today, Europe has lots of troubled banks and some troubled sovereigns. Ideally, the powers that  be would like financial markets to not worry about being defaulted on and to keep lending to these banks and sovereigns. No agreed EU resolution regime for banks or sovereigns is in place, so the authorities would like to reassure current lenders that they will be safe when such a regime is put in place and that it is future lenders who will take the hit.

However, when the future arrives, it becomes the present and future senior bank bond investors will consider a regime in which only they are subject to a resolution regime involving selective haircuts as totally unacceptable.

The time-inconsistency of the current sovereign debt proposals are clearly recognised by sovereign bond markets, which are pricing current Irish and Greek government bonds at yields that clearly indicate the likelihood of default. For banks that are already in trouble, it seems unlikely that these proposals will really comfort bond investors that they are genuinely safe from getting haircut by a future resolution regime.

Mody on Institutional Change

Writing in today’s Irish Times, Ashoka Mody argues for the need to introduce a special resolution regime for banks as well as “fiscal benchmarks and supporting rules, along with a technical voice in the form of “fiscal councils” to evaluate budgetary risks.”

Mr. Mody is assistant director in the European department of the International Monetary Fund and has lead the IMF’s article for team that has visited Ireland in recent years. While Mody’s senior IMF status makes him worth listening to, it’s also worth noting that he has a considerable research record as an economist including this interesting work on the effects of budgetary institutions.

Resolution Regime

Colm McCarthy makes a strong case for a bank resolution regime in today’s Sunday Business Post (article here).   If I understand intent of the argument correctly, however, Colm is proposing the regime as a critical element of a new regulatory system for the long term.  He is not proposing it as a means of imposing loss sharing on existing creditors.    Looking to the longer term, he argues that a resolution regime will make it possible to withdraw the guarantee.  

The wide-ranging guarantee of bank liabilities announced at the end of September 2008 runs out in little more than six months. Assuming that the banks have been recapitalised by then, the government can minimise subsequent risk of exchequer cost through getting out of the guarantee business as quickly as possible.

Bank resolution legislation – clarifying the power of the authorities to ensure that all providers of risk capital share quickly and appropriately the losses incurred by failed banks – is an important component in the state’s exit strategy from the banking collapse.

I believe the more pressing issue is to have a resolution regime in place for the period after the current guarantee expires and before existing subordinated bonds mature.  If the banks are insolvent, or at least incapable of reaching minimum capital adequacy requirements on their own, there should be a willingness to impose these losses on creditors, most likely as part of the debt-equity swap long advocated by Karl Whelan.