26 June 2013

Martin Sandbu: Flexibility decided by states is a wrong move for Europe's banks

The main [bail-in] stumbling block is some nations’ demand for greater “flexibility” in the bail-in rules. That term should set off alarms. Flexibility can mean two things, both bad.

First, it could mean lots of ad-hoc making: leave governments to decide on a case-by-case basis who to save (bail-out) and who to let drown (bail-in) when a bank is bust. This would guarantee unpredictability when a liquidity or solvency crisis hits.

Part of what made the Cyprus bail-in more damaging than it should have been was the initial uncertainty about whether supposedly guaranteed deposits would be written down. And Cyprus is just the most extreme case. Every banking crisis in the EU has been made worse by uncertainty about who would take losses on their claims against banks.

If ministers are serious about reducing future financial instability, they must commit to explicit predetermined hierarchies of claims on banks. They must make clear who bears losses, and in which order and to what extent, when their bank runs out of money.

Second, flexibility could mean that a hierarchy of loss absorption is clear in advance but differs between countries. This makes no sense in a single financial market. If rules are different, each type of bank funding will flow to the states that are the most willing to bail them out. Anyone who does not see why this is harmful should remember Dublin’s blanket guarantee of bank liabilities in 2008, thrown back into the spotlight by the release of taped conversations between shameless Irish bankers in those hectic days.

A safe banking system requires people to understand that higher rewards come with higher risks. That means they must be told clearly and uniformly what risks they take by entrusting their money to banks in various ways. This is what the ministers profess to want and yet seem to find it so agonisingly difficult to do.

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