A big week for banking reform

Four things happened in a single week in December to set the scene for the future credit risk of lending to banks and building societies in the UK and Europe.

Firstly, after months of waiting, the failed Co-operative Bank was finally rescued on Monday 16^th December and placed on a slightly firmer footing, enabling it to continue trading beyond the regulator’s New Year’s Eve deadline.  Unusually for recent UK rescues, this didn’t come as a taxpayer funded bailout from the government, nor as a reluctant takeover from a competitor. The Co-op was only rescued through the generosity of its junior bondholders agreeing to lose around half the value of their investments.  George Osborne’s comments earlier in the month were particularly telling: “our first priority is to save this incredibly important bank … but in a way that does not depend on a taxpayer bailout, which we want to move away from in this country.”

So what does the Co-op story tell us about the chance of a government bailout at any other UK bank?  Well if George wouldn’t put taxpayers’ money into a customer-owned ethical bank, it seems unlikely he’ll feel differently about one owned by rich individuals and overseas investors.  But what about Royal Bank of Scotland – since the government already owns 80%, would it have fewer qualms about bailing its own bank out?  Well until Tuesday 17^th December, RBS was paying the Treasury a regular insurance premium for a contingent capital facility, effectively the promise of another £8 billion bailout if it was ever needed.  Now that facility has stopped, there won’t be another chunk of taxpayer money going RBS’s way – after all, you can’t stop paying the premiums then ask the insurer to cough up anyway.

The EU has been grappling with the problem of “too big to fail” banks since the 2008 crisis, and at its 20^th December summit, it agreed the details of the Bank Resolution and Recovery Directive that had been proposed by the commission in September. This will ensure that there is a bail-in of investors in a failing bank before there can be a government bailout. Many classes of investor – including individuals, small businesses, other banks and suppliers – will be exempt from taking losses. So if there are insufficient junior bondholders, then wholesale depositors including local authorities and large companies will be bailed in for the shortfall.

The scheduled start date for the bail-in regime in the EU is January 2016. But we are ahead of the game in the UK. When it was pretty clear what the European mechanism would be, HM Treasury amended the Banking Reform Act late in its Parliamentary progress to include an identical bail-in provision for this country. This became law on 18^th December, signifying the official end of the bailout era in the UK.  We have now joined Denmark, Netherlands and Cyprus as countries where the government or regulators can force bail-ins to happen, rather than asking investors to vote to take losses themselves.

So, if a UK bank or building society gets into trouble now, there will be a much quicker resolution than the Co-op managed last year.  Around the same time that the bank’s losses become public knowledge, the regulator will announce the size of the losses that will be incurred by various classes of investors in the bank, quite possibly including local authority depositors and account holders.  So on the downside, I expect defaults will be slightly more common – the 17 year gap between BCCI and Iceland might be rather shorter next time.  But on the plus side, you won’t have to wait years and years to get your money back – you should still have access to 60-80% of your cash on the maturity date.  Welcome to the brave new world!

David Green is Client Director at Arlingclose Limited. This is the writer’s personal opinion and does not constitute investment advice.