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Does Europe Plan To End "Too Big To Fail"?

Officials from rich northern countries, led by Germany, have said that taking joint responsibility for bank rescues is possible only if recapitalizations don't create major losses-a strong case for putting a heavier burden on private investors.

The EU... in June proposed a new legal framework for dealing with failing banks...Crucially, the new rules would force national authorities to force losses on-or "bail in"-all creditors, for instance by converting debt into shares, when a bank has to be recapitalized by its governments.

WSJ, 15 July 2012

It would appear that the EU and/or the eurozone are drifting in the direction of removing the safety net from senior creditors and thus ending Too Big To Fail (TBTF). If the proposal becomes law, bank resolutions would impose losses on senior creditors. This means that, if regulators can write off senior debts without a court-supervised liquidation, then senior debt is neither senior nor debt, it is capital. Real debtholders have the right to demand a liquidation, with losses assessed against more junior claimants. If regulators can simply step in and treat senior bonds the same as other capital instruments, then senior bonds are capital instruments. When a bank can default on its senior debt, it is not TBTF.

This is another example of the eurozone expressing its unconscious death wish. Earlier, the zone experimented with the idea of allowing Greek government bondholders to take losses, which caused huge yield spikes for Spain and Italy from which they have not recovered. Now it proposes the same experiment with bank bondholders. Let's see if it works better this time.

I do not see how, if this policy is adopted and rating agencies react, that this will not permanently close the debt markets to weak eurozone banks. Indeed, the bond market has already punished such dodgy names as Bankia and Caixabank in Spain, Unicredit and Monte dei Pasche in Italy, Dexia Credit Local in France, and HSH Nordbanken in Germany.

Ending TBTF would mean that the only remaining source of refinance for weak European banks would be the ECB.

One might have thought that the object of policy would be to (1) recapitalize all weak banks; and (2) draw a safety net around these banks, such that they would be viewed as creditworthy by creditors. It would appear that the current object of policy is to do too little too late about solvency, while signaling to creditors that they are at risk. Stop me if I've said this before, but these people have a deathwish.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.