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Failing or likely to fail?

Barely a year after its launch, a new European law that was supposed to put an end to bank bail-outs looks set to be failing already.

20 billion Euro. This is the total size of the cheque the Italian government is getting ready to sign, once again, to bail out Monte dei Paschi, the country’s third-largest bank, and possibly several other of the country’s ailing lenders. A drop in the ocean considering Italy’s public debt, which now stands at an eye-watering 2,224 billion Euro. And still, the bill would amount to some 334 EUR for every man, woman and child in the country. Ten years after the onset of the global financial crisis, taxpayer-funded bank bail‑outs could be back with a vengeance. How did this come to pass?

Since the beginning of 2016, a new European law ‒ the Bank Recovery and Resolution Directive ‒ has been in force to stop governments, once and for all, from bailing out big banks with taxpayers’ money arguing that they were “too big to fail”. The objective was clear: like any normal company, banks that fail should be liquidated. Banks that are too big to be liquidated in one fell swoop should be restructured and/or wound up at their investors’ expense, a process known as “resolution”. No longer should taxpayers foot the bill for bankers’ mistakes. If this sounded too good to be true, it probably was.

“The political appeal of protecting a large bank from being put into resolution is obvious.

The new law already had some exceptions built in, allowing politicians to protect a bank from being wound up if its demise was likely to cause serious problems for the wider economy. To qualify for a taxpayer-funded rescue – or “precautionary recapitalisation” – that bank would, however, need to be fundamentally healthy and able to prove that its need for government support is only temporary. Moreover, it was made explicit that public funds could not be used to cover losses that have already occurred or which are expected to crystallise in the near term. Now experts across Europe question whether Monte dei Paschi, which is now on its third state-funded bail-out (after 2009 and 2012), complies with these criteria. By contrast, the European Central Bank – which is responsible, together with the Single Resolution Board, for ordering the bank to be restructured or wound up – appears to be satisfied it does. It will be up to the European Commission now to judge whether the Italian government’s rescue plan complies with State Aid rules. Regardless of whether or not that plan will ultimately pass muster – it looks as if the EU’s new legal framework for dealing with failing banks has been deftly sidestepped at its first big test.

The political appeal of protecting a large bank from being put into resolution is obvious. Closing down banks that are no longer viable and forcing their losses on shareholders and creditors will never be popular with bankers, investors and politicians. It is particularly sensitive in countries, such as Italy, where ordinary citizens, savers and pensioners, hold large amounts of bank bonds. It should not be surprising in these circumstances if politicians are tempted to resort to bail-out as a simpler and politically more expedient option. For the taxpayer and the public at large, however, it is the wrong answer. As a general rule, all investors should be treated equally: if a bank fails it, not taxpayers, should bear the losses. Private investors who have been mis‑sold risky securities in the past should, of course, be entitled to compensation. The banking sector, which has been the beneficiary of this practice, should be obliged to set up, and contribute to, a dedicated fund which would be made available to cover the losses. But the plight of these investors should not be allowed to be instrumentalised by politicians and the banking industry to short-circuit the resolution framework and justify a return to bailing out banks.

“If banks are not allowed to fail, post-Crisis regulation certainly will have”

Equally worryingly, this precedent could pave the way for rehabilitating bail-outs on a wider scale, not limited only to the biggest banks. In recent years, European and international bodies have created an elaborate system for identifying banks which are thought to be “too big to fail”. So-called “systemically important” banks are subject to stricter supervision, both at the national and European level, and have to comply with higher capital requirements than their non-systemic peers. Ironically, Monte dei Paschi is the only one of the four Italian banks reportedly in line for a government hand-out that has been designated by the country’s financial supervisors as being systemically important. As with four even smaller banks, which were rescued by the Italian government in a similar manner at the end of 2015, proponents of the bail-out argue that any of these banks, “systemically important” or not, could trigger a nationwide banking crisis were they allowed to fail. Which amounts to saying that the legal framework built over recent years precisely to allow banks to fail in an orderly fashion has been for nought and the practice of designating banks as “systemically important” is equally pointless. If banks are not allowed to fail, post-Crisis regulation certainly will have.

Arguably, some of the problems in dealing with ailing banks could have been expected. The decision if and when a bank is placed into resolution, for instance, currently needs to be taken jointly by two different bodies, supervisory authority and resolution authority. To say that this process is not designed to deliver decisions rapidly and smoothly would be an understatement. It is known that supervisory authorities, in particular, tend to be reluctant to lose one of their charges. The fact that the criterion for triggering resolution – whether the bank is “failing or likely to fail” – is not linked to objective, quantitative thresholds but largely subject to regulators’ discretionary judgment, is not helping matters either. If EU legislators are indeed serious about closing down failing banks, they should prove their resolve by making that process faster and simpler.

Finally, the total bill of 20 billion Euro, if fully deployed, would add yet another percentage point to Italy’s already formidable public debt, which amounts to 133% of GDP. A level of debt that looks demanding already at a time of ultra-low interest rates and aggressive quantitative easing by the ECB could become daunting once interest rates rise. Moreover, a large part of this pile is held by the country’s fragile banking sector. What looked like a good idea at the time – under current EU rules banks do not have to put up any capital against their holdings of sovereign bonds but still earn the interest – has the potential to backfire spectacularly if the markets decided one day to mark down Italy’s credit rating. Visibly, the nexus between government and banks is far from broken. And taxpayers still have everything to lose.

Christian Stiefmueller, Senior Policy Analyst

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