July 8, 2016    3 minute read

Banks Bail-In: When The Cure Is Worse Than The Disease

No Panacea    July 8, 2016    3 minute read

Banks Bail-In: When The Cure Is Worse Than The Disease

From the beginning of 2016, the Bank Recovery and Resolution Directive (BRRD) introduced the bail-in as the new principal tool to help European banks and financial institutions that face serious difficulties or bankruptcy. A bail-in occurs when the shareholders, creditors and depositors are forced to bear the burden of rescuing the bank by having a portion of their holdings written off. This process involves helping the bank “from the inside” and is in this sense opposed to the more traditional bailout, where external parties (i.e. the government) directly inject liquidity to help the bank make debt payments. The bail-in is deemed to be a fair tool in crisis management as it protects taxpayers and prevents the moral hazard problems and the risky initiatives fueled by bailouts.

Recently, the European banking sector has been hit very hard by the very low (even negative in certain cases) interests rates. As banks profit from the interest rate margin (the difference between the rate at which they lend and the one at which they can borrow), lower interest rates mean lower revenues and lower profitability. And this is a problem that all European banks face. Then, there are country-specific problems: the two most worrying examples are the critical exposure of German banks (especially Deutsche Bank) to derivatives and the enormous amount of non-performing loans (NPLs) that characterise Italian banks’ balance sheets.

The New Rule

In this context, the BRRD bail-in requirement has been introduced, in an auspicious attempt to bring stability. However, we could say that so far it has done nothing except adding uncertainty to an already troublesome sector. Financial markets have not accepted the new regulatory framework as the performances of the main European banks show. The Euro Stoxx Bank Index has lost 31% of its value during the first six months (Italian banks were the worst, losing half of their cap in the same period), and more specifically 18% only after June 23rd after the Brexit turmoil exacerbated the investors’ negative expectations towards the sector.

Financial markets don’t like the new bail-in rule because it brings uncertainty: indeed, markets do not know what to expect in case of an emergency, what institutions are required to intervene and what are the tools in the hands of the EU to prevent systemic risk. Markets seem instead to be reassured when governments are capable of “stepping in”, through the provision of guarantees or the injection of liquidity into the system.

Unfortunately, this is now forbidden by the BRRD, unless there is some rule bending: as a matter of fact, there are some explicit cases cited by the BRRD where the bail-in rule does not apply and government intervention is thus allowed. The Italian government is currently considering intervening to protect some banks (especially Monte dei Paschi di Siena) whose balance sheets would be devastated by an adjustment of NPLs from book values to market value. This public intervention might be allowed by Bruxelles in light of the peculiarity: indeed these banks might require a recapitalization after the results of the stress tests conducted by the European banking Authority, whose results are to be published in late July.

To sum up, at the first practical test (represented by the potential crisis of Italian banks) since its introduction, the bail-in rule might be circumvented. Evidently, if the most effective use of the rule is obtained by bending the rule itself, it might not be the best course after all.

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