Struggling Banks and Struggling Politicians: Precautionary Recapitalisation as a Threat for Goals of European Financial Regulation?

Lately, the instrument of precautionary recapitalisation has aroused more and more attention in discussions on European financial regulation, mostly in the context of the recent Italian version of the ongoing financial crisis. While the Italian government and others are trying to sell precautionary recapitalisation as a benevolent application of an instrument officially provided for in the new European bank resolution framework, critics see it as a potential circumvention of this very framework’s overarching no-bail-out principle.

But what exactly does precautionary recapitalisation mean and why might or should we have a problem with it?

Quick read

Precautionary recapitalisation as set forth in Art. 32 paragraph 4 lit. d (iii) BRRD was designed as a tool for alleviating negative impacts from stress tests
If precautionary recapitalisation were to be employed for this original purpose, it can be a useful and legitimate instrument within the new European regime of financial regulation
In fact, however, precautionary recapitalisation is becoming prone to turn into a threat for the overarching European no-bail-out policy

1. The backdrop: European policies and laws against bail-outs and their recent challenges

It is widely agreed that the lack of a specific and credible insolvency regime for banks was one of the major problems during the 21^st century’s first global financial crisis. Since there existed no adequate rules providing for the case of a defaulting bank, governments saw themselves confronted with the choice of bailing out the banks with public funds or otherwise facing uncontrollable “domino effects” and systemic meltdown.[1] Drawing from this lesson, European regulators were determined to prevent states from bailing out banks with taxpayers’ money ever again.

Thus regulators put in place a uniform recovery and resolution scheme throughout the EU, whose main body of rules is to be found in the SRM (Single Resolution Mechanism) Regulation and the BRRD (Bank Recovery and Resolution Directive). Under the new regime, extraordinary state aid for banks is only allowed under very limited circumstances and will usually trigger the resolution of the bank. In the resolution scenario, the new regime builds on the principle of burden sharing: Creditors of a bank that is undergoing resolution will have to participate in losses suffered. The core tool designed for realising this aim is provisioned for in Art. 27 SRM Regulation and Art. 43 BRRD: The so-called bail-in. Generally speaking, the bail-in mechanism works as follows: When the resolution of a bank is triggered, a certain share of senior and subordinated debt claims will be subject to write-down or a conversion to equity.[2] With the resolution of Banco Popular, this mechanism seems to have gotten its first practice example.[3]

The problem with making a bank’s creditors participate in the losses suffered is that this path can lead to politically delicate situations. As concerns the recent Italian banking crisis, a significant percentage of senior and subordinated debt of struggling Monte dei Paschi di Siena (MPS) is held by domestic retail investors; estimates are that this is true for billions of EUR worth of such debt.[4] Perhaps most of those domestic retail investors should never have purchased such bonds, but it is far too late for such complaints now. The dilemma is already complete, since bailing in those parts of the bank’s debt would mean that once again, common people, an individualised group of taxpayers so to speak, would have to share the burden of a failing bank. On top of that, the situation also entails an identified person problem[5]: True, an old-school public bail-out using funds of the general national budget would burden all the taxpayers at once, but it would do so in a rather indirect, opaque manner. Bailing in a certain group of creditors of one specific bank, like struggling MPS,[6] on the other hand, would most likely lead to extremely unpopular pictures. Television reports on humble elderly countryside ladies who have lost all their “savings” because cold-hearted politicians have failed to save their bank are looming on the horizon. As a consequence, self-interested politicians aiming for re-election are given substantial incentives to protect the special interest of retail investors.

2. What is precautionary recapitalisation?

Luckily for the Italian government – and for all governments that might see themselves in similar situations – not all doors are closed for providing extraordinary state aid to struggling banks.

True, the general idea of the new rules, as per Art. 32 paragraph 4 BRRD, is that providing “extraordinary public financial support” to a struggling bank will subject the bank to a verdict of “failing or likely to fail” (FOLTF) and thus trigger its resolution. This is, however, not true for so-called precautionary recapitalisation, as set forth in Art. 32 paragraph 4 lit. d (iii) BRRD.

States may provide extraordinary public financial support to banks without triggering resolution if (and only if) this support is required “in order to remedy a serious disturbance in the economy of a Member State and [to] preserve financial stability” (1).

Additionally, the measure shall be “confined to solvent institutions” (2), as well as “precautionary”, “temporary”, and “proportionate” (3).

Besides, such measures shall be “conditional on final approval under the Union State aid framework” (see Art. 107 TFEU), with the EU Commission having authority to make their approval conditional on the application of the principle of burden sharing. Thus the Commission could, in theory, require a bail-in to take place in order to grant approval of the extraordinary support at issue.[7]

Moreover, if the support does not take the form of certain types of guarantees set forth in Art. 32 paragraph 4 lit. d (i) and (ii) BRRD, but amounts to an “injection of own funds or purchase of capital instruments” as per Art. 32 paragraph 4 lit. d (i) and (ii) BRRD, it must not exceed the “injections necessary to address capital shortfall established in the […] stress tests” conducted by the relevant authorities.

This makes it clear that the main idea behind granting such a merely precautionary recapitalisation of an otherwise solvent bank was basically that regulators wanted to alleviate possible consequences of a negative stress test result.[8] Providing public support to a bank that is generally solvent, and only for a precautionary purpose and a limited period of time was not what should be categorically banned under the new resolution regime. Plus, since precautionary recapitalisation is always subject to State aid review by the Commission, with the Commission having the authority to make such support conditional on measures of burden sharing, what could possibly go wrong?

3. What is the problem with precautionary recapitalisation?

The issue with precautionary recapitalisation is that the safeguards to keep it the extraordinary instrument it was designed to be – one that can only be used for solvent banks[9] and only in accordance with the principle of burden sharing – seem not to work all that well after all. In its practical application, precautionary recapitalisation runs danger of being misused as a means to circumvent the general prohibition of outright and unconditional state aid. It runs danger of turning into a means for de facto bail-outs.[10] So how does this work if precautionary recapitalisation is only an instrument for solvent banks anyways, and also subject to review by the Commission?

The first problem is that many banks certified as “solvent” by the ECB, and thus generally eligible for precautionary recapitalisation, might not be so solvent after all.[11] In the current situation in Italy, none of the struggling banks at issue has been declared not solvent. And yet they are apparently struggling more than just a bit.[12] Even if this might seem flummoxing at first blush, we must not forget that (in)solvency is a harsh binary criterion. Since a bank’s struggle can come in many degrees and varieties, it might indeed be advisable to be very cautious with a verdict of insolvency. That being said, incentives for any supervision authority to declare a bank insolvent are rather moderate anyways, since by making such a declaration, supervisors would imply that they have not really done their job.

Even if this unfortunate setup of incentives may indeed be overcome, as the recent case of Banco Popular has demonstrated, and whatever the intricacies of pre-emptive banking supervision and solvency standards might be, a second problem for precautionary recapitalisation lies in the lack of clear definitions for what “precautionary” and “temporary” means. Neither the relevant norms themselves nor the recitals provide reliable guidance on this. Hence the regulation leaves open an overly huge space for flexibility and institutional leeway – which is always a bad idea if your aim is to prevent future governments from letting themselves being pushed too far by the political heat of the moment.

The third problem is that the Commission’s State aid assessment does not work as a proper safeguard. At the moment, it seems unlikely that the Commission will effectively force the Italian government to mandate a comprehensive simultaneous bail-in when providing public funds for MPS and the likes.[13] And there is more than just a certain logic to that: Burden sharing means that creditors have to partake in actual or feared losses. But if a state provides financial aid only as a precautionary and temporary measure, and – most importantly – only to a generally solvent bank, why should anyone be afraid of losses? Especially, out of interinstitutional loyalty and dynamics, the Commission will of course make sure to not even implicitly overrule the ECB’s assessment of solvency.

Considering the interplay of these three unfortunate circumstances, precautionary recapitalisation might indeed be turning into a tool that could allow for not-so-cautious factual bail-outs.[14]

4. Summary and Conclusion

Summing up, my point was to show that precautionary recapitalisation as set forth in Art. 32 paragraph 4 lit. d (iii) BRRD was initially implemented into the BRRD in order to leave open the possibility of providing struggling yet solvent banks with extraordinary public funding, especially as a means to alleviate potential negative impacts from stress tests. If employed for these ends, it could be a legitimate instrument within the new European regime of financial regulation. In the wake of recent developments, however, precautionary recapitalisation might turn into a threat for the aim to prevent bail-outs from happening ever again. Regulators, governments, and citizens should be on the watch.

Philipp Lassahn graduated from Harvard Law School (LL.M.) and from Albert-Ludwigs University in Freiburg (Ph.D.). He is currently working as a research and teaching assistant at Humboldt University in Berlin.

[1] See http://www.mcgrawhillprofessionalbusinessblog.com/2012/07/25/the-financial-domino-effect/ and http://www.bbc.com/news/business-14985256.

[2] For more background information on the bail-in tool, see Chapter 16.5 of John Armour et al., Principles of Financial Regulation, Oxford 2016.

[3] See https://seekingalpha.com/article/4079869-banco-popular-espanol-europes-first-bail-in-test.

[4] See https://www.whitecase.com/publications/alert/italian-banks-thoughts-recapitalisation-and-sharing-burden and https://www.bloomberg.com/news/articles/2016-07-27/italians-nest-eggs-risk-cracking-as-bank-rescue-plans-mulled.

[5] For background information on this phenomenon, see Deborah A. Small, On the Psychology of the Identifiable Victim Effect, in: Identified versus Statistical Lives (I. Glenn Cohen, Norman Daniels and Nir Eyal eds.), New York, NY 2015, at 13-23.

[6] On MPS specifically and also generally on the developments in Italy, see http://bruegel.org/2016/12/the-strange-case-of-the-mps-capital-shortfall/ and https://www.europeaninstitute.org/index.php/296-european-affairs/ea-january-2017/2203-italy-shores-up-failing-bank-a-template-for-rescuing-europe-s-other-weak-banks. On more thoughts and developments concerning MPS bail-in, see http://www.italy24.ilsole24ore.com/art/markets/2016-12-15/mps-analisi-175831.php?uuid=ADewTvEC.

[7] From a perspective of regulatory puritanism, one might criticize this link (which is clearly envisioned in recital 30 of the SRM Regulation), because State aid review under Art. 107 TFEU is a mechanism of competition law, and not a question of financial regulation.

[8] See Binder, Systemkrisenbewältigung durch Bankenabwicklung? Aktuelle Bemerkungen zu unrealistischen Erwartungen, ZBB 2017, 57-71, at 70.

[10] Recently, officials of the European Commission said State aid could be used to finance the purchase of nonperforming loans (NPLs) by asset-management companies above market price and to provide the bank with capital “to cover losses coming from sale of NPLs” (https://www.bloomberg.com/news/articles/2017-04-26/eu-eyes-taxpayer-cash-to-help-struggling-banks-offload-bad-loans, emphasis added).

[11] See https://www.forbes.com/sites/francescoppola/2016/12/31/the-european-union-is-bailing-out-banks-again/#4dbd34016670.

[12] Cf. https://www.bloomberg.com/gadfly/articles/2017-05-05/a-curious-calm-in-italy-s-drama.

[13] Cf. https://www.bloomberg.com/news/articles/2017-04-26/eu-eyes-taxpayer-cash-to-help-struggling-banks-offload-bad-loans, but also https://www.ft.com/content/3c6e3cb8-46ae-11e7-8519-9f94ee97d996 (some form of bail-in seems to have been agreed on).