(Don’t) Blame It All on Brexit…

A key lesson for policymakers after the financial crisis was to reduce the likelihood of bank bailouts using taxpayers’ funds. Bailing out banks not only stresses public finances – it also undermines market discipline, produces moral hazard and thus incentivizes banks to take on more risk. All in all, a vicious circle. Policymakers thus looked for ways to ensure that failing banks can be recapitalized without tapping public coffers. As a result, the bail-in tool, codified in BRRD arts. 43 et seq. compels holders of bank equity and debt to bear the losses the ailing institution incurred. Yet, having proper resolution tools doesn’t guarantee their time-consistent application. Hence, lawmakers undertook to tie their hands. To strengthen the compelled private sector loss-participation, the BRRD stipulates in a somewhat entangled manner that in general a bail-in of debtholders needs to provide at least 8% of the resolved bank’s total liabilities before additional sources, such as resolution financing mechanisms or treasury funds can be used for bank recapitalizations (cf. BRRD arts. 44(5), 37(10)(a), 56 (1)). This is quite rigid and underlines the power policymakers originally vested in the bail-in tool.

Bailing in debtholders, however, may not always be wise. Consider the situation where the financial sector as a whole faces woes. A systemic crisis that involves the whole sector requires widespread recapitalization to ensure stability. Bailing in bank creditors during periods of systemic stress will be a shock and awe strategy that will wreak havoc on markets and will do anything but restore confidence in the continuous and proper functioning of the financial system. Legislators have foreseen this possibility and thus provided an exception to the rule in BRRD art. 32(4)(d): in order to avoid widespread panic and to ensure the safety and soundness of the financial system, resolution authorities can institute a precatory recapitalization outside of the BRRD framework in order to fill gaps in banks capital endowment, identified in stress-tests. As a consequence, the mandatory minimum bail-in of 8% is suspended and support for banks from other funds including government money is tolerated. From a theoretical point of view, this exemption seems reasonable.

However, many theoretically sound concepts of banking policy reveal their ugly traits when implemented in the midst of a political melee. In fact, there is one key issue here that was brought to the fore by the recent struggle over the fate of bondholders in Italy’s Monte dei Paschi: the notion of financial stability and systemic risk in the banking sector is very blurry and leaves plenty of room for interpretation. Even though a breadth of systemic risk measures are proposed by academics and policymakers, there is no one-size-fits all measure that captures “the” systemic risk in the financial sector. The level of bad credit in one country may be so high that further loan defaults trigger a systemic crisis, while the same level of bad credit may be sustainable in another country. Whether it is sustainable, however, depends on the underlying state of the economy and the structure of the financial sector. This conceptual uncertainty and context-dependence translates into ambiguities in the application of the relevant exception in the BRRD. This in turn provides a gateway for politicians who deem it easier to sell yet another bail-out to their electorate than a bail-in of certain parts of their constituency. In the current context, the rhetoric that stresses the BRRD’s “flexibility” comes to no surprise from politicians and central bankers with a known inclination for bail-outs.

While the law thus provides rooms for circumventing bail-in, one has to evaluate very carefully whether that is indeed the prudent path to take. Any perception that bail-in is only cheap talk and will not be applied in politically rough weather will immediately dull market-discipline and thus imperil the key policy goals of the new regulation. The looming erosion of the powerful bail-in tool needs to be avoided.

But isn’t Brexit a blessing in disguise for politicians, bureaucrats and bankers who stress the necessity of, yet another, bank bailout? The majority vote in favor of leaving the EU shook capital markets and particularly bank stocks came under pressure. Among other things, the curious implication of the BRRD’s exception is that all of a sudden there is an incentive to look bad in a stress test because such an outcome makes a bail-out not only politically but also legally viable. The methodology of the last health check of the banking system - results will be published on the night of July 29 - devotes heightened attention to foreign exchange exposures and operative risks, mainly but not exclusively conduct risk. Against this background, the exit-vote of June 23 could indeed be used to foster the Italian case for the exception. The Pound dramatically depreciated against the Euro and Brexit certainly causes additional costs for banks that should be included in oprisk-assessments. Yet again, some more headwind for troubled banks doesn’t necessarily imply that making their investors foot the bill will have systemic impacts. After all, while uncertainty about the economic development in Europe in a post-Brexit world still exists, market participants have adjusted their expectations and Italian banks, including the most-troubled ones, are still standing. Hence, arguments in favor of using or suspending bail-in need to be purely based on economic reasoning, focusing on the plausible showing of systemic risk going forward.

Martin R. Götz is SAFE Professor for Regulation and Stability of Financial Institutions at the Faculty of Economics and Business Administration, Goethe University Frankfurt, Germany.

Tobias H. Tröger is SAFE Professor of Private Law, Trade and Business Law, Jurisprudence at the Faculty of Law, Goethe University Frankfurt, Germany.