With the financial crisis, member States took over massive debts originated in the financial sector to save a number of large banks with public funds because they were considered "too big to fail". The level of state support has been unprecedented.
In late 2013, the EU took a major step towards a “banking union”. Such a system, its backers hope, would sever toxic links between weak banks and their governments. The introduction of bail-in debt clearly shows politicians’ willingness to shield taxpayers from bailout costs. The new regime is set to become law from 2016, and it is a crucial component of the banking union that is supposed to make the single-currency club work better. The tool is to be used to ensure that bank shareholders and bondholders bear some of the burden by having part of the debt they are owed written off. A public “precautionary recapitalisation” would be possibly only as a last resort.
Let’s take what happened in Italy over the last few week. The Italian Government used a newly created bank resolution fund, financed by three big banks: Unicredit, Intesa SanPaolo and Ubi Banca, to rescue of four small banks Banca Marche, CariFerrari, CariChieti and Banca Etruria, before EU “bail-in” rules under Europe’s Recovery and Resolution Directive comes into force next year. An attempt to clean up the banking system’s non-performing loans, but at the same time pushing losses on shareholders and junior creditors. About 130,000 shareholders and junior bond-holders lost money following the rescue of those banks.
Thus the big question is if the bail in rules can ever be effective. It’s hard to say. It is no mystery that non-performing loans are a touchy issue in Italy. According to Italian Banking Association they amounted to €181 billion, tarnishing banks' balance sheets and creating a huge hurdle to an economic recovery through more easily available credit. If, in following with the bail in rules, a minimum level of losses equal to 8% of total liabilities will have to be imposed on an institution's shareholders and creditors, it seems inevitable that there would be a need for more money.
This is even before the Single Resolution Fund , that will be built up over eight years through levies on banks, is fully phased-in. At the end, the most burden would fall on those investors who had clearly not been made aware of the risks. Recent empirical evidence confirms that market expectations of public bank bail-outs are still high. The bail in mechanism is not a panacea. It was one such bail-in, the restructuring of Greek government debt, that led to the problems faced by the Cypriot banks, which were big holders of Greek bonds.
The bail in procedure would also serve to reduce moral hazard of investors, pushing them to act less diligently or cautiously. This is why, shareholders and bondholders expect the government to shield them from losses. The message is clear: savers need to check their banks' health before taking the risk of investing in bank subordinate (bail-in-able) debt, or depositing money. But how to manage with the issue that investors do not usually possess sufficient knowledge to assess the risk either?
What has happened in the Italian and European banking field, shows that the common system architecture for banking supervision, resolution and financial backstop may be too complex to deal effectively with major banking crises. Can the banking union restore trust in a banking system that is viewed as starving the economy of credit, mis-selling products to the public, and taking excessive risks to feed oversized bonuses? Most of these questions will probably remain unanswered for some time.
But for it to work, a credible system for resolution of banks would first have to include preventive measures, such as dealing with the “too-big-to fail” problem. Meanwhile, the European banking sector is still dominated by megabanks. There have been no major attempts to organize a genuine separation of deposit-taking banks and investment banks. From this perspective, deposit or retail banks would not have the right to engage in speculative activities or trading activities or to lend to speculators (hedge funds, arranging LBO transactions). These banks would be backed fully by a government guarantee. So, if banks are not reformed, the bail in plans bear most of the burden under the banking union. This is also due to the fact that the most active regulations continue to be capital requirements. Financial regulators have always focused on capital adequacy, in order to correct incentives to make excessively risky loans and investments, but these rules leave a lot of space to banks for speculative adventures. In the case of Italian banks, they sold the subordinate bonds, rated as high risk financial products, to ordinary savers , who maybe didn’t know what they were buying.
Now, Italy is working to set up a solidarity fund to bail out investors hit by the rescue. This will be partly financed by public resources and partly by the same banks. The State walked out the door to return through the window, but the risks for savers remains still high and unpredictable.
Photo:Getty/ DANIEL ROLAND