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Experience should have taught policy-makers to be more careful in designing a bail-in and bail-out mechanism, with a view to avoiding putting the European financial and banking systems at a disadvantage compared to the rest of the world and thus penalising European taxpayers. Unfortunately, it does not seem that the lesson has been learnt. The recently agreed European Stability Mechanism direct bank recapitalisation instrument contains the same fault lines of the Deauville agreement.
It is surprising that this problem has not emerged yet in public. It is even more surprising that the heads of governments of the more vulnerable countries have signed up to it while it makes their countries’ banking systems more fragile and further increases the correlation between sovereign and banking risk. It is thus detrimental to their taxpayers.
The ESM instruments foresee that the mechanism can be used to directly recapitalise banks only subject to the bailing-in of shareholders and private creditors, according to the pecking order established in the forthcoming Bank Recovery and Resolution Directive. Such a provision is appropriate to address an individual bank’s solvency problems. However, the solution becomes very problematic if the aim is to stop the contagion that can emerge from a specific shock, such as the bankruptcy of a bank, to the rest of the financial system.
Under such circumstances, as it happened in the post-Lehman US situation, the supervisor may consider it necessary that the whole banking system must rapidly raise capital, as a precautionary measure. If, under current ESM rules, such a capital injection can be implemented only if private creditors are also bailed-in, any suspicion about the solvency of a specific bank will immediately induce the creditors of other banks to withdraw their funds. Contagion would thus rise, instead of abating. Under such circumstances, the amount of capital needed, and thus the funds to be drawn from the ESM, would have to be much higher. The ECB and national central banks would face pressure to inundate the system with emergency liquidity.
The provisions included in the ESM instrument have been conceived to address individual bank problems, not systemic crises such as those we have experienced in the recent past, including after Lehman’s bankruptcy. The likelihood that an individual crisis spreads to a systemic has increased.
We cannot wait for another crisis to find out that the new instrument has been ill-conceived. As for the Deauville agreement, the ESM needs to be changed to eliminate its perverse effects. In particular, the requirement for bailing-in private creditors should be excluded when the supervisor – i.e. the ECB – considers it appropriate for the stability of the financial system. Unless this is done, the burden for taxpayers will increase. Those that do not want to make the change should be accountable for it.
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