The Incomplete Banking Union

by: Ben Emons

On 6 June 2013, the European Commission [EC] published its proposal for the Recovery and Resolution Directive [RRD], taking a step closer towards a European banking union. It outlined, among other key points, how creditors will be ranked in case of possible future 'bail-ins.' However, the proposal does not speak to a single rule book. That means each recapitalization case will be approached in a separate, "unique" manner. To that effect, individual countries are given "flexibility" to shield specific groups of creditors in case they fear a bail-in may trigger an unintended contagion. Furthermore, countries have the option to dip into state resources to recapitalize banks. More importantly, the proposed directive's language leaves the door open for potential interpretation on how bail-in procedures will apply in future bank recapitalization cases.

While the RRD, for example, specifically states a "no creditor worse off principle," the capital structure - the rank order of equity and bond holders - sees some changes. At the top of the capital structure are guaranteed deposits and the national deposit guarantee schemes, while deposits from households and small and medium enterprises [SME] are located further down the ladder. These deposits have a preferred, but not superior, senior status. In other words, they can be bailed-in, but rank senior to senior unsecured debt and corporate deposits. Notably, the proposed directive stops short of introducing a full depositor preference, with senior unsecured debt and depositors from large corporations ranked equal to another. One drawback is a greater subordination for senior bond holders and corporate deposits in comparison to guaranteed deposits than previously was the case.

The RRD also includes a list of assets such as guaranteed deposits, secured liabilities including covered bonds, employee salaries and pension benefits, interbank liabilities with a maturity of less than seven days and commercial claims that would be excluded from future bail-ins. By explicitly exempting secured deposits and liabilities from future bail-ins, a bank's funding mix may shift towards deposits and covered bonds, away from senior unsecured debt. The EC statement was also clear about the contribution from national resolution funds, which will be capped at 5% of liabilities. The national resolution funds will only become available after a bail-in buffer of 8% of total liabilities has been used up. Since many of the European banks do not currently have sufficient capital, equity and subordinated debt to make up for the 8% of their liabilities, sources such as senior unsecured or uninsured deposits may be called upon if a recapitalization should be required.

What remains unclear is the exact timing for when bail-ins should be implemented. While the RRD references 2018, the European Central Bank [ECB] and German officials have argued for an earlier start date of 2015 or 2016. In the absence of unified banking rules, it is likely that different bank failures will be treated on an ad hoc basis. This could result in creditors of non-systemic banks in non-systemic countries depended on an external balance sheet to more likely suffer heavy losses versus creditors of systemic banks located in countries with stronger sovereign balance sheets.

What may be the most noteworthy conclusion about the RRD is that the use of the European Stability Mechanism [ESM] for direct bank recapitalizations has been watered down. Instead of prioritizing bail-ins before countries can turn to the ESM, there could be an unintended negative impact on growth via higher funding costs for banks. The ESM has been mentioned in European Union [EU] statements as a credible back stop or "firewall." The intention was to sever the adverse link that exists between sovereigns and banks. However, this has not been completely accomplished given the persistence of significant political differences. Although the RRD is a step in the right direction, a Single Resolution Mechanism [SRM] seems not likely in the short-term.

Achieving a banking union is an important step towards greater eurozone integration; however, its progress remains politically challenged. This is demonstrated by the RRD's emphasis on national control over bail-ins when it comes to decisions regarding tax payer funds.

The EU so far has only achieved an "incomplete banking union."

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