The EU-turn on Banks

Perhaps establishing common, clear directionsfor EU bankresolution will help prevent some policy confusion. Photo by Ward/Fox Photos/Getty Images.

Thursday, European finance ministers drafted a plan they think will prevent massive taxpayer-funded bailouts for good—or at least reduce the likelihood for now. With this new measure, EU leaders have likely brought some positives but taken a few steps of debatable merit. However, any of the proposal’s terms likely don’t impact investors too much for now—partly since the plan’s implementation goal is a ways away.

Starting in 2018, if an EU bank fails, it will be required to “bail in” shareholders, junior bondholders, senior bondholders, large corporations with over €100,000 deposited and small and medium-sized businesses (SMEs) or individuals with over €100,000—in that order—to cover at least 8% of its liabilities. Notably, depositors with €100,000 or less will remain protected.

Once savers and investors have contributed their 8% or more, the bank may seek help from the state, via national resolution funds, created through bank levies, equaling 1.3% of a nation’s insured deposits. However, to use these national funds, countries will first require permission from Brussels—and they can’t contribute more than 5% of liabilities unless the bank’s creditors are “wiped out.”

Only after all that can the bank seek help from the European Stability Mechanism (ESM)—a last resort. And even then, the ESM most likely lends to the national government, rather than the bank, adding to states’ sovereign debt loads. Under these rules, ESM funds will likely remain untouched—despite EU leaders’ declaration of intent to allow direct bank recapitalizations from the fund a year ago.

If this plan sounds familiar, you’re on to something. With this proposal, the EU has U-turned on its assurances Cyprus’s bailout wouldn’t be a blueprint for future bank failures. This plan’s eerily reminiscent of Cyprus’s bailout terms: dinging creditors and large depositors while protecting depositors with €100,000 and under.

This plan could reduce schizophrenic bailout resolutions like we saw in the US after the 2008 financial crisis—when the interbank funding markets froze after troubled banks couldn’t possibly handicap the government’s next move. Common bail-in rules could be somewhat beneficial by removing some uncertainty. Also, that EU finance ministers are proactively looking for a solution to bank failures before they happen, not finding a last minute solution, gives markets plenty of times to digest the information and investors plenty of time to prepare—roughly five years, in fact. Hence, the brightest silver lining: The very delayed phase-in likely greatly mitigates capital markets risks.

That’s the good. The bad is specifically exposing large depositors and bank investors to risk in one country wasn’t a great plan in the first place and was wrought with unintended consequences. Treating depositors as investors seemingly misunderstands the risk/return tradeoff. Extrapolating the same plan to all EU banks likely only creates more unintended consequences with farther reach. For instance, businesses and other large depositors likely look elsewhere to save their cash reserves, rather than accept increased risk they could lose their savings. Or spread out their savings. Or turn to money markets or other vehicles. Bond markets may not exactly smile on bank funding either, particularly if a firm encounters difficulty.

As a result, banks could have less cash on their balance sheets and may need to de-lever or rely more on wholesale financing to meet capital requirements—banks’ overall funding requirements would likely rise. With less funding, banks have a harder time staying profitable, hindering their ability to make loans and offer attractive interest rates to savers—painful for everybody. This would be especially hard on smaller banks with fewer resources. Hence (another unintended consequence), bigger, usually safer, banks likely get even bigger as large depositors seek out less risky financial institutions.

Next up, the new measures go to the European Parliament for debate, and legislators could adjust some provisions before passage (assuming they’re passed—never a certainty). This bears watching over the months ahead, as does the potential for EU officials to make further adjustments before the 2018 implementation.