With the Italian bank Monte dei Paschi di Siena (MPS) about to be bailed out again by the Italian taxpayer, push comes to shove: Are post-crisis reforms working? First and foremost, this concerns the innovative resolution instrument of “bail-in”. While until a few days ago, there was no reason to assume that the vicious combination of political interference and regulatory discretion has ended, the successful resolution of Banco Popular stirs hope.

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Quick Read

• Bail-in allows governments to credibly commit themselves to not bailing out banks
• Regulatory discretion substantively impairs this mechanism
• Setting a precedent for bail-out in the case of MPS will implicitly raise discretion and should be avoided at all costs

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The European strand of the financial crisis is being brought back to the center stage of financial regulation. Unlike in the financial crisis of 2008/2009, however, there are strong forces arguing against state intervention today: European law requires creditors of a systemically relevant bank in the vicinity of insolvency to be “bailed-in” – that is, having their claims written off or converted into an equity stake). In MPS’ case, around 40% of this bail-inable debt is held by small retail investors,[1] which puts strong political pressure on the Italian government to inject state funds.

Hence, it is becoming more and more likely that the far-fetched exemption to the bail-in concept, a “precautionary recapitalisation” will be used to inject taxpayer funds by way of Art. 18 IV d SRM-Regulation/ 32 IV d BRRD (for details, see Philipp’s earlier post).

1. Bail-in as a self-commitment device 

Anything that comes close to circumventing bail-in is, however, a very dangerous undertaking.[2] Even a single precedent could render void the genius that is idea behind it. As posited here, bail-in should first and foremost be understood as a device to commit future governments/authorities to not to bail-out creditors, eliminating the funding subsidy (that is, the lower interest rates required by creditors protected by the taxpayer) enjoyed by financial institutions that are deemed “too big too fail”.

The power of bail-in consequently hinges on the careful, timely and – most importantly – realistic calibration of the terms triggering the debt write-down: the yardstick for the effectivity of bail-in powers being how well authorities manage creditors’ expectations: Will markets reasonably assume bail-in will be applied? As will be shown, this crucially depends on limiting regulators’ discretion in situations of extreme financial stress. S&P seems to be very doubtful in this regard. Functionally, bail-in powers should be understood as an instrument to overcome time-series problems by enabling a current governments/regulators to self-commit to a future no-bailout policy.

2. A credible bail-out alternative

Before the crisis, creditors were willing to price loans to banks not in a way that reflected their true risk, because of their expectation that financial institutions deemed “too big too fail” were to be bailed out by the taxpayer if need be. The government, they (accurately, it turns out) predicted, would be in a hold-up situation: rather than letting banks fail and allowing them to take down the entire financial system, they would resort to injecting state funds. To prevent this from happening ever again, government must present the resolution of financial institutions as a credible alternative to bailout. Bail-in, functionally a “miniature and internal resolution” is crucial to this endeavour: By making resolution more likely, actual bank resolutions and taxpayer rescues will become less likely. In a way, it is the bazooka that you don’t need to fire.

3. Creditor beware! Or else…?

Unlike other reforms addressing the underlying reasons put forward for bailing out banks,[3] bail-in rules seeks to do away with the menace of socially costly bank insolvencies in the first place: They seek an “internal resolution” by way of writing down liabilities or converting them into equity, thus avoiding balance sheet insolvency. In consequence, “resolution” is shifted to an earlier point in time. This already improves governments’ capacity to commit themselves to not bailing out institutions in the future.

But are bail-in powers likely to be exerted when push comes to shove, that is, even in times of extreme financial stress? Otherwise, bank creditors could reasonably expect and price in taxpayers’ rescue. Governments’ deliberations will crucially hinge on whether applying bail-in will exacerbate the severity of distress. Therefore, generally speaking, the higher the reliance on authorities’ discretion, the less credible resolution will powers be. This is because the enforcement of bail-in rules relies heavily on how the extreme political and economic pressure on all participants in a very short window of time is expected to be handled (“until Asia opens”). The more discretion given to authorities in these kinds of situations, the more susceptible the actual decision-making process will be to external pressures, e.g., politicians who would rather play it safe and not risk a crisis or regulators prone to industry lobbying. In essence, this touches the very core of the bail-in’s credibility, given that situations of severe financial stress by all means constitute realistic cases of application.

The mere public discussion about the feasability of bail-in surrounding MPS shows, however, that even in rather mundane scenarios, bail-in is up in the air. In order to conceptualize how governments’ discretion can be reduced without doing away with the necessary flexibility altogether, two dimensions warrant closer inspection: How do regulators come to a decision over conversion and how are the terms of conversion calibrated?

4. Getting to No

In general, we can distinguish two models of bail-in decision making. First, one in which a resolution authority has the right to write off the bank’s liabilities (regulatory bail-in alternative) by waving creditors’ (and shareholders’) property rights. The conversion terms and conditions are specified in legislation or in administrative rules, leaving the determination of the exact amount to be determined for the actual application, that is ex post “internal insolvency”. Second, and in a broader understanding of bail-in powers, regulators can mandate financial institutions to issue a specific level of debt in advance of any deterioration in the bank’s balance sheet[4] which, upon reaching a contractually predetermined trigger point (e.g., balance sheet criteria, market valuations, CDS spreads)  will automatically convert into equity (contingent convertible debt). The decision over a future conversion is thus made ex ante “internal insolvency” by the contracting parties in conjunction with the relevant authorities.[5]

In the latter case (ex ante), authorities can more effectively exert a level of pre-emptive control over who holds the bail-inable debt. This is the idea underlying the Financial Stability Board’s standard of TLAC (Total Loss Absorbency Capital) respectively MREL (Minimum Requirement for Own Funds and Eligible Liabilities) in the EU. Having fragile and interconnected financial institutions – that is, other banks or systemically relevant institutions – holding these claims, however, would easily spread contagion if bail-in happens. This, in turn, would render the application of bail-in by regulators less likely. In terms of credibility, a pre-emptive control offered by ex ante bail-in models is certainly to be preferred.

To be sure, a resolution authority could legally bind itself to a specific and foreseeable bail-in process by issuing detailed terms and processes for its application through (binding) administrative rules. Nevertheless, it is far from certain that the agency would then actually go ahead with such self-proclaimed rules when facing the prospect of a severe financial meltdown. This is due to the political economy incentives civil servants in these institutions face and the fact that there is no external and sufficiently incentivized claimant to provide for the enforcement of the plan. This illustrates the public-good character of “financial stability”: No single individual has sufficient incentives to lobby effectively for regulators’ bail-in of financial institutions, especially in times of severe and systemwide financial distress.

5. Calibrating conversion

It should be clear from the previous discussion that bail-in is not a credible threat to creditors if its actual enforcement exacerbates financial stress. This is reflected in the bail-in legislation, which restricts bail-inable debt to long-term claims. There is a plethora of possible designs to be conceived of. The most important issues will be the point of time a bail-in will be triggered and the kind of claim the debt will be converted into.[6]

As posited here, bail-in powers should be understood as an instrument to overcome time-series problems by enabling the regulator to effectively commit to a future behaviour (namely: bailing-in the creditors in the resolution scenario). Concerning the point of time, it seems preferable to have relatively easily triggered and regular conversions with only little impact on the financial system as a whole – external pressures on the authorities to resist bail-in will be lower.  Therefore, an incremental approach makes bail-in more likely to happen, in turn reinforcing the instrument’s credibility. This should be particularly useful when it comes to large banks, given that the systemic consequences of a bail-in at one dash are especially unpredictable.

Regarding the terms of conversion, turning debt claims into equity poses an incentive for shareholders not to burden the company with too much debt, for their stake in the company would be diluted. John C. Coffee expands on this concept and argues for the conversion of debt into voting preferred stock.[7] This would build a shareholder constituency that – due to its more senior claims than ordinary shareholders – could counterbalance the risk-seeking behaviour of the latter class.

6. The law in action: Now is the time – the MPS case

Coming back to MPS, the Italian regulator could make use of the “financial stability” exception in the BRRD to circumvent a bail-in – say, in order to protect retail investors or to prevent domino effects on other banks – and inject public capital (see Philipp’s earlier post). This would, however, substantially impair bail-in’s self-commitment function by implicitly opening up discretion: Setting a precedent against bail-in will lower the burden for future authorities, even in potentially benign situations and in turn raise expectations that public money will be used again. The recent winding down of Banco Popular and its acquisition by Banco Santander, however, raises hopes that this will not be the case: On the day of announcement, holders of bail-inable debt claims had to suffer losses in market value of around 90%.

Restricting the relevant authorities’ discretion vis-à-vis bail-in is the way to go. This would make it an useful device of self-commitment. As long as the law “on the books” still allows for undue discretion, bail-in powers have to be made credible by enforcing them “in action”. The MPS case offers an excellent opportunity to showcase bail-in’s feasibility in the presence of political and market pressure.

 

Lukas Koehler graduated from Oxford University (MJur) and is a PhD candidate at Bucerius Law School, Hamburg.

[1] This might have been prevented by an objective-based supervision.

[2] And herein lies the danger resulting from the MPS crisis: Resorting to the bail-out option is still possible if necessary for the preservation of financial stabilty (Article 32(4.d) BRRD). would set a bad precedent for it will widen future regulators’ discretion and will consequently make the threat of bail-in less credible.

[3] Reasons might lie in the protection of depositors, the provision of a payment system and credit, liquidity and maturity transformation.

[4] For example, on the basis of using the discretion provided by Pillar II powers or in accepting this debt as AT1 or Tier2 capital.

[5] Which might rather be the supervisory than resolution authority.

[6] The discussion about the appropriate amount of bail-inable debt should best be left to economists.

[7] Coffee, Systemic Risk after Dodd-Frank, Columbia Law Review 2011, 795, 830.