At the end of March, the European Commission nearly produced its long-awaited proposal for a resolution regime. Instead, a non-paper emerged to discuss the “debt write-down tool”. In other words, how can bank bondholders be bailed-in without causing a further funding crisis or raising the cost of bank funds to the point that it would seriously damage the economy? There was only “about” a month allowed for comments, yet this paper raised profound issues about the banking system and its stability. In turn, that has enormous consequences for the EU’s econom,y as bank assets are close to twice GDP – reflecting the much greater bank intermediation of the financial system than in the US.
The basic concepts set out in the non-paper are simple enough but – as usual – the devil is in the details. The supervisors become aware that the bank has run up large losses that would take its capital ratio below the minimum required for it to remain authorised as a credit institution. Should it be shut or could something be saved? What are the implications of a closure for the financial system? Once the loss is big enough to absorb much of the formal capital, can some other liabilities (but not all) be reduced in value by the losses so that the bank still has enough capital to trade? This is the act of bailing-in – via a debt write-down and conversion to equity. These liabilities would need to have this risk specified in their terms so that they can be priced appropriately at issue.
Speed will be of the essence in such an operation. Holders of other classes of liability, e.g. deposits, will be very nervous that the scale of losses will turn out to be greater than expected, take out all the bail-in capital – effectively a Tier 3 of capital – and lead to losses for uninsured depositors that will also entail lengthy delays in getting the money back during a complex liquidation. Lehman Brothers stands as an excellent example of this risk.
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