Why Bail-in Fails – A Critical Look at a Key Feature of the European Banking Union

Event

Chancellor Day Hall NCDH 202, 3644 rue Peel, Montreal, QC, H3A 1W9, CA

In collaboration with the European Centre of Excellence, we welcome Tobias Tröger, Fellow of the Center for Financial Studies, and Chair of Private Law, Trade and Business Law, Jurisprudence at Goethe-University Frankfurt am Main.

Abstract

A key lesson for policymakers after the financial crisis was to reduce the likelihood of bank bailouts using taxpayers’ funds. Bailing out banks not only stresses public finances – it also undermines market discipline, produces moral hazard and thus incentivizes banks to take on more risk. All in all, a vicious circle. Policymakers thus looked for ways to ensure that failing banks can be recapitalized without tapping public coffers. As a result, the bail-in tool, codified in the Bank Reorganization and Resolution Directive compels holders of bank equity and debt to bear the brunt of the losses the ailing institution incurred. Yet, having proper resolution tools doesn’t guarantee their time-consistent application. Hence, lawmakers undertook to tie their hands. To strengthen the compelled private sector loss-participation, the BRRD stipulates in a somewhat entangled manner that in general a bail-in of debtholders needs to provide at least 8% of the resolved bank’s total liabilities before additional sources, such as resolution financing mechanisms or treasury funds can be used for bank recapitalizations.

Clearly, a systemic crisis that involves the whole financial sector requires widespread recapitalizations to ensure stability. Bailing in bank-investors during periods of systemic stress will be a shock and awe-strategy that will wreak havoc on markets and does anything but restore confidence in the continuous and proper functioning of the financial system. Legislators have foreseen this possibility and thus provided an exception to the rule: in order to avoid widespread panic and to ensure the safety and soundness of the financial system, resolution authorities can institute a precatory recapitalization outside of the BRRD framework in order to fill gaps in banks capital endowment that were revealed in stress-tests.

However, many theoretically sound concepts of banking policy reveal their ugly traits when implemented in the midst of a political melee. In fact, there is one key issue here that was brought to the fore by the recent struggle over the fate debtholders in Italy’s Monte dei Paschi di Siena: the notion of financial stability and systemic risk in the banking sector is very blurry and leaves plenty of room for interpretation. This provides a gateway for politicians who deem it easier to sell yet another bail-out to their electorate than a bail-in of certain parts of their constituency. In the current context, the rhetoric that stresses the BRRD’s “flexibility” comes to no surprise from politicians and central bankers with a known inclination for bail-outs. To be sure, this is not a problem of the periphery. European banks, particularly major universal banks in large Member States already lack profitability and are further squeezed by the competition from fin-techs, but they are major employers of highly skilled labor. Downsizing the sector in overbanked Europe thus raises concerns which accounts for many politicians’ proclivity to tacitly subsidize the sector which can be regarded as the 21st-century coal and steel industry. Indeed, any perception that bail-in is only cheap talk and will not be applied in a stringent manner will immediately lower dull market-discipline. Instead, financing costs for banks will be more favorable as implicit government guarantees are reinstated. As a result, achieving the key policy goal of the BRRD is imperiled.