European Bank Recovery and Resolution Directive: the key issues

At the 5^th Local Authority Treasurers’ Investment Forum last week, topics that came up in discussion were the proposed European Bank Recovery and Resolution Directive (BRRD) and European banking union.

Looking back at the global financial crisis in Euroland, fear of contagion and the lack of loss-absorbing capital in the banking system forced political co-operation of a sort, and there was no bail-in of senior bank debt and no sovereign defaults. Looking forward, the proposed European BRRD is supposed to change this, and senior debt of a failing or likely to fail institution is going to be ‘bail-in-able’ and subordinate to depositors and other liabilities.

The good news is that many large European banks have been able to increase their capital cushion through retained earnings or private capital raisings, but the weaker part of the European banking sector, the medium-sized institutions that were not able to increase their capital and whose un-provisioned doubtful loans could be exposed in the planned Asset Quality Review by the ECB and the EBA stress tests, are likely to be subject of a political debate at the European level. We may expect that any country (including Germany) will want to be in charge of deciding the closure of any of its second tier banks, and an issue therefore is whether a national state should be allowed by the EC to provide the missing capital. In the case of (peripheral) countries which don’t have the funding to do this, the problem of legacy assets will likely arise again, and the extent to which losses will be paid for through capital from a common resolution fund or the ESM, will be subject to intense political debate.

Banking union as an over-arching issue will have significant impacts on financial markets in the years ahead, and given the conflict between national and European interests, several outcomes are possible with tough negotiations likely. As a particular point, Germany’s position after their election will be important.

In terms of the key issues, the proposed building blocks of a banking union contain both the so-called Single Supervisory Mechanism (SSM) and the Single Resolution Mechanism (SRM). Whilst the SSM has just passed the European Parliament, there are still fierce political debates taking place about the SRM and problematically the two pillars are interlinked. The ECB’s Asset Quality Review and the EBA’s stress test are supposed to increase financial market confidence and this implies that problems will be surfaced but whilst the ECB wants an SRM in place before reviews are conducted, the current proposal by the EC is to have it ready if and when needed. In addition, the scope to cover potential capital shortfalls from joint European funds currently seems limited, due to core European backtracking. The SRM seems more likely to take the form of coordinated but separate national resolution funds and the ESM’s direct recap potential also has been truncated.

Without an explicit common backstop in place, the exposure of large recapitalisation needs could be very risky, but doing nothing is no alternative, as un-provisioned non-performing loans are clogging up bank balance sheets, preventing investment in the real economy and slowing growth. The ECB will be uncomfortable with the lack of progress from European governments and for Germany, there are two reasons why the currently proposed SRM is not desirable. First, transfer of sovereignty that a common resolution represents may be unconstitutional for Germany. Secondly, it is hard to justify the use of taxpayer funds to bailout foreign banks which haven’t written down legacy assets. In consequence we may expect Germany to push for solving legacy asset problems with bail-in creditors, then recourse to national recovery and resolution funds, and only draw on ESM funds if all else fails.

Compromise is likely with limited and conditional commitments, that would allow strong banks to recapitalise in the private market and weak (small) ones through idiosyncratic (i.e., not worrying for the markets) bail-ins or wind- downs. For the success of the exercise it will, however, be necessary for systemically (or politically) important banks to be saved with the respective sovereign needing to step in and provide capital if required. Only if the sovereign was not able to provide sufficient capital itself, would Europe assist.

One implication for markets is that the higher the mutualisation of bank resolution costs, both in the future as well as with regards to so called legacy assets, the better for peripheral sovereign spreads, and all other things being equal, the worse, for core European spreads. This is because the higher the degree of bail-in, the weaker the connection between banks and their domestic sovereign should be, and the more this is forced, (i.e., national bailouts made impossible), the more this also applies to weaker banks in financially stronger countries. Against this backcloth, we may see tightening of sovereign spreads (particularly in the periphery) and a widening of respective bank spreads (particularly in the core).

James Bevan is chief investment officer of CCLA, specialist fund manager for charities and the public sector. CCLA launched The Public Sector Deposit Fund in 2011 to meet the needs of local authorities and other public sector organisations. You can follow James on twitter @jamesbevan_ccla