Why Taxpayer-funded Bail-out rather than a Bail-in may be in the Public Interest: Proportionality and the Limits of Bank Resolution in the Light of Recent Developments in Italy

It may sound odd that a taxpayer-funded bank bail-out should be in the public interest, whereas formal bank resolution – which transfers the losses exclusively to bank owners and bank creditors (in particular investors in debt instruments issued by the banks), rather than to the public purse – is not. Yet this is exactly the rationale given for the recent decision by the Single Resolution Board (‘SRB’), ie, the central decision-making body for the management of insolvencies of ‘significant’ banks within the Eurozone, not to initiate resolution measures with regard to two struggling Italian lenders, Veneto Banca and Banca Popolare di Vicenza, leaving the institutions to be liquidated under national Italian law instead (which, for that purpose, was complemented with a generous ad-hoc package of financial support to retail investors). Or so it seems. On closer inspection, however, the recent developments in Italy highlight an ill-understood feature of the legal underpinnings of the Banking Union and of the harmonised framework for bank insolvency management across the EU: the principle that formal bank resolution, including bail-ins of creditors’ claims, must be confined to cases where the relevant bank’s collapse gives rise to concerns for systemic stability. As I have argued in a recent paper, the Italian cases, which combined elements of liquidation with a bail-out of certain groups of creditors, should be evaluated in light of this principle. Tainted with questionable political motives though it may well be, the management of these cases should not let us forget that the harmonised resolution toolbox, contrary to public opinion, has not been designed as a ‘catch all’ solution to every incident of bank insolvency, regardless of size, complexity, or the level of interconnectedness with other intermediaries. And there are good reasons, rooted in the principle of proportionality, to treat some cases differently.

1. The Italian banks and the broader picture

The SRB justified its decision not to initiate formal resolution with regard to Veneto Banca and Banca Popolare di Vicenza on the grounds that resolution was ‘not warranted in the public interest’, as neither of the two institutions provided critical functions and their failure was not expected to have a significant adverse impact on financial stability’. This has met with fierce criticism.  Quite a few observers have argued that with these cases, both the substantive and the procedural arrangements for the treatment of insolvent banks that had been established in response to lessons learnt after the global financial crisis have been robbed of their credibility. Specifically, the victims are perceived to be those substantive rules of the EU Bank Recovery and Resolution Directive (Directive 2014/59/EU, ‘the BRRD’) and the Regulation establishing the Single Resolution Mechanism (Regulation (EU) no. 806/2014, ‘the SRMR’) which expressly stipulate that in bank insolvencies – just as in other cases of corporate bankruptcy – losses should be borne by owners and creditors rather than by the state (cf, in particular, Article 34(1) BRRD, Article 15(1) SRMR, respectively). At first sight, it is thus perfectly understandable that any use of public money to compensate any or both groups of actors is perceived to be flying in the face of the constituting elements of the new, post-crisis framework for bank insolvency management in the EU.

2. But consider the principle of proportionality

This does not, however, invalidate the function of proportionality concerns as a determinant of the choice between traditional forms of insolvency management on the one hand, and resolution under the BRRD and the SRMR on the other. Pursuant to Article 32(1)(c), (5) BRRD and Article 18(1)(c) SRMR, any resolution action – including a bail-in – is permissible only if it is ‘necessary in the public interest’, which in turn requires that it is ‘necessary for the achievement of, and is proportionate to one or more of the resolution objectives…and winding up of the entity under normal insolvency proceedings would not meet those resolution objectives to the same extent’. The need to distinguish systemically relevant insolvencies, which may lead to resolution, from others is thus part and parcel of the relevant authority’s decision making process, and it is rooted in the overarching principle of proportionality. By their very nature, resolution actions under the BRRD and the SRMR come with infringements of rights of shareholders and creditors. Just as with any expropriation of private property by public authorities, resolution actions therefore have to comply with the principle of proportionality, as required by the applicable provisions of the EU Charter on Human Rights and the European Convention of Human Rights. The function of proportionality in the area of bank resolution is more complex than in other areas of bank regulation, given the need to reconcile creditor rights with the public interest in preserving financial stability and preventing contagion. Against this backdrop, the ‘public interest test’ set out in Article 32(5) BRRD and Article 18(5) SRMR has to be interpreted as a key instrument to restrict the application of the resolution toolbox to cases where public interest concerns justify the inevitable infringement of individual creditors’ rights.

3. What follows

Even if the Italian rescue package deviates significantly from both legal instruments, this does not affect the fundamental concerns with regard to creditor rights in resolution discussed above, which justify the restriction of the scope of resolution to cases where the public interest in preventing systemic contagion outweighs the private interest of creditors. In this respect, the wide-spread criticism of the Italian measures misses the point: Arguably, the problem illustrated by these cases is not the differentiation between traditional insolvency management and alternative ‘resolution’, based on the notion of proportionality and the need to differentiate between ‘resolution’ and standard liquidation under national law, but rather the disapplication of traditional insolvency procedures in favour of a bail-out package, which reveals a lack of commonly accepted principles for the management of bank insolvencies below the ‘public interest’ threshold among EU Member States. If this is perceived as politically unacceptable, the appropriate response would be a combination of harmonised principles for the resolution of non-systemically relevant bank institutions and more restrictive state-aid regulation, rather than the extension of the resolution toolbox to all cases of bank insolvency, irrespective of the systemic relevance of the institution in question.

Jens-Hinrich Binder is Professor of Law at Eberhard-Karls-Universitaet Tuebingen.