Keeping Pandora’s Box Closed: Precautionary Recapitalisation and the Dangers of Regulatory Discretion

Precautionary recapitalisation as set forth in Art. 32 paragraph 4 lit. d (iii) BRRD could become a key to the Pandora’s box of factual bail-outs and thus throw back European financial regulation by years. This threat, which I described in an earlier post on this blog, seems to have become somewhat more imminent after the case of Monte dei Paschi di Siena (MPS), whose recapitalisation has been approved on 4 July 2017.[1] Today, I want to venture a look at if and how we could best counter the threat.

Basically, we can identify three main problems in the way precautionary recapitalisation is currently handled: First, the failure of solvency as a sufficient criterion for allowing precautionary recapitalisations. Second, the BRRD’s overly vague description of what precautionary recapitalisation should look like. Third, the failure of European State Aid review as a proper safeguard.

 


Quick read

  • The problem with precautionary recapitalisation is that it gives overly broad discretion to states and regulators
  • Since financial regulation is mostly about reducing regulatory discretion, precautionary recapitalisation would best be replaced by a detailed scheme of more or less automatic regulatory reactions
  • The problems of domestic retail investors should be addressed by explicit compensation laws on the national level

 

1. Can we fix precautionary recapitalisation?

Thinking about solutions for the mayhem at hand, it might be self-suggesting to try to remedy one or all of the identified problems in order to “fix” precautionary recapitalisation and make it an acceptable and workable tool in the long run.[2] It is, however, more likely than not that such an attempt is doomed to fail.

First, pushing the ECB towards adopting a stricter take on solvency tests is unrealistic. It would also be inadequate, since the binary assessment of “solvency” with its potentially harsh consequences is too strict to be our steering wheel here. Struggling banks, like solvency itself, come in just too many varieties.

Second, providing stricter definitions for the conditions and forms of precautionary recapitalisation (“precautionary”, “temporary”), i.e. narrowing down the interpretational leeway that is opened by Art. 32 paragraph 4 lit. d (iii) BRRD, is not only difficult to achieve.[3] Moreover, it is hard to conceive of more detailed definitions of “precautionary” and “temporary” in our context, and especially so of definitions that would not leave open too much room for discretion. Plus, if the problem with precautionary recapitalisation is that public money is given to de facto insolvent banks in order to cover their losses, the problem will not be solved by stipulating that such money can only be provided for, say, three months.

Third, changing the Commission’s current State Aid practice would not be helpful either. True, as a condition for approving a measure of precautionary recapitalisation under the State Aid regime, the Commission could require some form of bail-in take place.[4] One might think that this could prevent precautionary recapitalisation from turning into a tool for outright bail-outs. But we must make no mistake: Linking precautionary recapitalisation with a bail-in requirement in this way would have the unwanted effect of lending undue credibility to precautionary recapitalisation, flexibilise it even further, and thus turn it into a standard instrument to be used for handling a scenario of struggling or failing banks. (De facto) Bail-outs would not be prevented, but rather provided with a disguise that could make them look all acceptable.

What is more, such a link between precautionary recapitalisation and substantial bail-in is very unlikely to be established under the current conceptualisation of the bail-in instrument itself. Bail-in as currently set forth in Art. 27 SRM Regulation and Art. 43 BRRD is a tool that is reserved for the resolution scenario. If a bank is considered solvent by the ECB, no losses should be feared. In turn, if no losses are to be feared, why should one make a merely precautionary recapitalisation conditional upon the write-down or conversion of debt?

 

2. No discretion where discretion is undue

Instead of trying to remedy precautionary recapitalisation, it would help to remember how the threat emerged in the first place. Simply put, the flaw of precautionary recapitalisation is that it introduces an element of undue discretion into a regime of financial regulation that is otherwise determined to cut off discretion whenever needed to avoid bail-outs from happening ever again. While leaving some discretion in place might make sense for the imminent future, where the integration towards an ever closer Banking Union might not be achievable without a certain degree of flexibility,[5] it will be impossible to secure and maintain a stable Banking Union without bail-outs if broad discretion were to remain in place. Because, unlike not so few politicians and citizens in Northern Europe seem to think,[6] transgressing rules of financial regulation is neither inherent nor exclusive to Southern European governments. Quite the contrary, any European government that might be facing a situation of severe distress in the financial and political sector would definitely make quite a stretch if it saw a chance to circumvent the unpopular bail-in requirement.[7]

Thus, ideally speaking, it would be best to replace precautionary recapitalisation altogether. Either a bank is solvent and can thus get necessary means (liquidity and, if need be, fresh capital) from the ECB or on the market. If a bank is insolvent, compulsory recovery and resolution schemes should kick in. In order to reach this aim, it might be our best option to reduce discretion as much as appropriately possible, and instead to put in place a more detailed, more minute scheme, e.g. of mandatory bail-in cascades. Lukas has provided a first idea of what such an incremental approach could look like.

Such a shift is indeed necessary, because financial regulation is all about credibility and credibility is all about the absence of discretion. True, flexibility is a trait of the law and of regulation just as well as commitment. But in an area of the law where the key problem is about barring future governments from yielding to political pressure, from falling to the temptations of popularity, we might be better off with a scheme of discretion-free, but finely tailored rules.

It cannot be described in full detail here what such a scheme would look like. But the point is rather to discuss about the general direction and structure of future European banking regulation. In this respect, we might be best advised to go for regulation that is as strict, but also as detailed and as microscopic as it is reasonably feasible. In this case, truly extraordinary measures might even remain in place, but they must be restricted to truly extraordinary situations, like substantial crises of a global dimension.

 

3. How should banking regulation react to negative stress test results?

Remains the problem of how to alleviate the impact of negative stress test results – one of the scenarios that precautionary recapitalisation was originally designed for.[8] Again, the answer should be to implement a stricter scheme that is more detailed, and less discretionary. In case of a negative stress test result, why should it not be helpful to have a whole detailed variety of precisely designed tools at hand,[9] with some of them kicking in more or less automatically depending on the specific features of the respective stress test result. True, much of this is subject to feasibility. But again, the point here is to make a general, a more fundamental case – a case for detail over discretion.

 

4. What happens with domestic retail investors in Italy?

Alongside with this, if a problem like in Italy occurs where certain (vulnerable) groups of the population are affected, there should of course be means to help these groups, but not through the back door of bailing out the bank that caused the trouble in the first place.[10] The actual problem in Italy and the aspect that makes us think that a harsh bail-in might not be the means of choice is that the groups that would be affected by a bail-in are, politically speaking, too similar to the group that would be most severely affected by a bail-out: In both cases, it is consumers of low or medium income.

If such a situation is at hand, the problem should be addressed openly and explicitly. The respective government should fight for national laws that regulate compensation for those individuals that would be affected by a bail-in and set up a fund that may cover their compensation claims. Those claims should especially be justified in cases where there has been fraud, exploitation of misunderstandings or lack of comprehension etc.[11] Such legislation would of course have to be careful not to contradict the European ban of (indirect) State Aid to private companies (banks). That being said, we should not forget that generally, the simple nexus between high chances and high risk in financial investments should be understandable for everyone.[12]

 

5. Summary and Conclusion

Summing up, the point here is that states and regulators should be cautious when it comes to potential misuses of precautionary recapitalisation under Art. 32 paragraph 4 lit. d (iii) BRRD, as well as with regard to possible remedies. Instead of “fixing” precautionary recapitalisation and trying to make it appear less dangerous or harder to implement, the focus should be put on further reducing regulatory leeway, and to choose detailed over discretionary rules wherever we can. Ideally, precautionary recapitalisation would be replaced in the long run, with its only legitimate purpose being to facilitate the transition towards a better integrated Banking Union in Europe.

 

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] Before MPS, precautionary recapitalisation was used with two banks in Greece, Piraeus Bank and National Bank of Greece, in 2015. For a good overview of the brief history of precautionary recapitalisation under Art. 32 paragraph 4 lit. d (iii) BRRD, see http://www.europarl.europa.eu/RegData/etudes/BRIE/2017/602084/IPOL_BRI(2017)602084_EN.pdf, 3-5. To be fair, a certain form of burden sharing seems to have been implemented in the recent MPS case, but what has been done is still far from a strict and comprehensive application of the bail-in tool. On the State Aid component in the MPS case cf. also http://europa.eu/rapid/press-release_IP-17-1905_en.htm.

[2] Partly, it is even being suggested that precautionary recapitalisation ought not tob e altered at all, or at least not materially, see http://bruegel.org/wp-content/uploads/2017/07/PC-21-2017-BRRD-1.pdf, at 9.

[3] To be fair, it might be less hard to achieve if the respective changes were to be worked into a renewal of the Commission’s Banking Communication, see http://eur-lex.europa.eu/legal-content/EN/ALL/?uri=CELEX:52013XC0730(01).

[4] Such a link is previsioned in marginal no. 43 of the Commission’s Banking Communication. On the history and controversy of the bail-in tool, see also https://www.ft.com/content/8ad2ed98-d0a0-11e5-986a-62c79fcbcead. In the case of MPS, at least salary caps for the management have been imposed, see http://www.europarl.europa.eu/RegData/etudes/BRIE/2017/602084/IPOL_BRI(2017)602084_EN.pdf, at 5.

[5] See http://bruegel.org/wp-content/uploads/2017/07/PC-21-2017-BRRD-1.pdf („transitional“ function), at 3-4 and 8-9.

[6] Cf. http://www.tagesspiegel.de/wirtschaft/der-steuerzahler-muss-zahlen-kritik-an-staatshilfe-fuer-italienische-banken/19983192.html.

[7] For German State Aid for struggling banks in the past, cf. https://www2.deloitte.com/de/de/pages/financial-services/articles/from-bail-out-to-bail-in.html. Cf. also https://www.bloomberg.com/view/articles/2012-05-23/merkel-should-know-her-country-has-been-bailed-out-too on how Germany benefitted from the Greek bail-out.

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

[9] Such tools or measures could consist of, i.a., stock capital increases backed by a fund that is in turn financed by private financial institutions, similar to the SRF.

[10] In the case of MPS, it seems to be still unclear how this problem will be handled in the end, see http://www.europarl.europa.eu/RegData/etudes/BRIE/2017/602084/IPOL_BRI(2017)602084_EN.pdf, at 5.

[11] To be fair, one obstacle of this solution would be to make sure that it does not set undue incentives for bankers to generate funds for their bank by entering into re questionable contracts with retail investors (who might be subject to unduly low risks if such legislation were to be put in place).

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

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