A handsome European haircut

A handsome European haircut
For most of the post-Lehman Brothers period, the priority for banking regulators has been to focus on reforms that should strengthen bank balance sheets and liquidity to try to prevent another bank failure. Less visible has been continuing discussion about how to deal with the failure of those reforms to prevent a "too-big-to-fail" bank from getting into strife.

The lesson from the crisis is that systemically important banks can’t be allowed to fail. It’s been an expensive lesson for the taxpayers of the US and Europe, who have had to pick up the tab for the recklessness of their institutions. Another lesson is that there are no established frameworks in place for dealing with too-big-to-fail institutions in distress – the approaches tended to be ad hoc and of the "whatever it takes" variety.

Late last week the European Commission moved a step closer to constructing a legislated framework for dealing with the future failure of any of its banks, opening a consultation process that it intends to lead to legislation by the middle of this year.

What it wants to put in place are common tools and powers across the EU that allow intervention in the affairs of ailing banks by regulators at an early stage and which minimise the eventual cost to taxpayers.

Those powers would include the authority to prohibit dividends, sack the management and sell or transfer assets and liabilities to other institutions. The EC is also advocating the creation of "resolution" funds, levying the banks to create "bail-out" funds that would enable a rescue funded by the industry rather than taxpayers – the ECD refers to it as the "polluter pays principle".

The measure that has already caused most disquiet, however, is the EC’s determination to force bondholders to share in the pain when a bank gets itself into trouble. It proposes giving regulators the ability to write down the debts of a failing bank, or convert debt to equity in what it describes as a "bail-in" concept that would enable a quick re-capitalisation of the institution.

That would be a step beyond the voluntary issuance of contingent convertible bonds that convert to equity when certain minimum capital or liquidity ratios are triggered – the EC proposal would allow regulators to force senior lenders to take a "hair cut".

The proposal would only apply to debt issued by European banks after the measures were legislated, but has already sparked concern that it will lead to a permanent spike in bank borrowing costs and ignite a stampede by the banks to borrow long before the legislation is in place.

It is one of the peculiarities and inequities of the crisis experience that bank creditors have generally escaped loss while taxpayers have been forced to write blank cheques. In Europe the cost to taxpayers of bailing out banks is estimated at about 13 per cent of the EU’s GDP.

There are two layers (at least) of moral hazard generated by banks regarded as too big to fail. One is the risk that it will lead to excessive risk-taking by the institution itself and the other is that its creditors won’t be as vigilant as they would be if they were lending to an organisation without implicit taxpayer support. Risk-conscious creditors can be a disciplining force.

While the big increases in the proportions and quality of capital and liquidity banks are going to have to hold in future ought to reduce the risk of bank failures, it would require far more draconian – and costly – measures than those proposed to completely obviate that risk.

It makes sense, therefore, to plan for those potential failures long before they occur and put the banks, their shareholders and their creditors on notice about how the fate of a future failing bank will be resolved and funded.

In the US the regulators are proposing to put failing banks into receiverships managed by the Federal Deposit Insurance Corp. The EC regime would allow a similar process but would also give regulators a lot more flexibility to reorganise their institutions and reshape their balance sheets while maintaining them as going concerns.

While the EC proposals would inevitably push up the cost of banking services in its member countries to reflect the higher borrowing costs and the resolution fund levies (beyond the increases that will flow from the higher capital and liquidity requirements), employing creditors’ self-interest to discipline bank risk-taking and distancing taxpayers as much as possible from bank balance sheets would appear to be obvious and rational responses to the traumatic lesson and legacies of the crisis.