13 November 2013

Plan to raid bank creditors could shatter Europe's calm

Market euphoria and soaring demand for European bank debt could be brought back down to earth if the European Union pushes ahead with the early introduction of rules allowing Cyprus-style raids on bank creditors and big depositors. Following demands from Germany, the European Union law to raid the bondholders and savers of failing banks could take effect as soon as January 2015, three years earlier than planned and in time to hit banks exposed by European Central Bank tests next year, Reuters reports.

The latest policy-maker to join the chorus of support is Jens Weidmann, president of Germany's Bundesbank. "It is important that bail-in be implemented as simultaneously to other measures as possible. In particular, the bail-in transition periods should be shortened", Reuters quotes him as saying. He said banks should be allowed to fail, but added: "Different to how things were done in the past, it should be done if possible without putting financial stability at risk and without using public money." (Weidmann speech, de)

The power to impose losses on bank creditors is the most market-sensitive part of Banking Union. Germany wants its early introduction in return for giving its full backing for the project to police and support banks in the eurozone. And the size of banks' potential liabilities have long overtaken government's ability to save them. ECB data shows that eurozone banks have issued more than €3.8 trillion of home loans - more than a third of the bloc's output and one-and-a-half times the German economy. This helps explain why Germany, the eurozone's biggest economy and the country most likely to be called on to bear the brunt of bank clean-up costs, wants the tough rules early.

Last week, the ECB came out in favour of an earlier introduction of bail-in, playing down concerns that this would exacerbate banks' funding difficulties. Moving forward the date, it said, would provide investors with certainty.

The Wall Street Journal reports that the Bank of Italy has claimed that a forced conversion or writedown of debt instruments would have to respect the rights of the creditors and shareholders in accordance with the Charter of Fundamental Rights so the European Union and the European Convention on Human Rights. The claim, made in the Bank of Italy’s Financial Stability Report, is one of the strongest objections yet to the new rules on state aid to banks agreed by the European Commission over the summer.

While the conditions of such bonds generally make clear that they can be converted into equity if a bank actually does fail, they generally don’t take account of regulatory actions such as stress tests, which calculate the strength of a bank in the event of a hypothetical scenario. At present, European authorities envisage forcibly applying the bail-in laws to banks which fail the stress test at the end of the European Central Bank’s ongoing "Comprehensive Assessment" of banks before it assumes responsibility for supervising them.

Conversion of bonds into equity, not to mention outright cancellation, would have to comply with the Charter, and that means "there must be a real and immediate threat to financial stability, and not a merely hypothetical scenario, such as that produced by a stress test", the central bank said.

The heavy presence of Italian retail investors in subordinated bank bonds makes the EU’s rules "perplexing" and in need of modification, according to ABI, the Italian Banking Association. "Prevention is better than such medicine", said ABI President Antonio Patuelli. Perhaps the fact that this issue is now being discussed in terms of human rights underscores how complex the completion of Europe’s Banking Union could be.