Thursday, June 27, 2013

Designing the next banking crisis

The European Union Council of finance ministers was popping the Champagne last night as they reached agreement to implement a 2008 decision to beef up their authorities to wind up busted banks. In theory the deal creates large room for bail-in i.e. support from existing creditors before taxpayers have to pick up the tab. But the various thresholds which the deal imposes for these bail-ins to apply are small, and riddled with exceptions e.g.

Certain types of liabilities would be permanently excluded from bail-in: – covered deposits; – secured liabilities including covered bonds; – liabilities to employees of failing institutions, such as fixed salary and pension benefits; – commercial claims relating to goods and services critical for the daily functioning of the institution; – liabilities arising from a participation in payment systems which have a remaining maturity of less than seven days; – inter-bank liabilities with an original maturity of less than seven days.

This invites the EU's next Anglo Irish to (1) go deep, load up on such dodgy loans that you'll quickly bust through any bail-in thresholds, (2) pay your reckless managers large salaries and pensions, which are protected from bail-in, and (3) finance yourself as much possible through the payments system, especially when things are about to go pear-shaped., because payment system transactions and short-term liabilities are also protected from bail-in.

At some point, we're at the "it's not a bug, it's a feature" conclusion.

UPDATE 9 JULY: Credit where it's due, Jörg Asmussen, ECB Board member lists the ECB complaints about the above in a speech in London --

Second, the arrangements for bail-in could be more rules-based. The ECB has always argued for discretionary exclusions from bail-in to be limited so as to make the rules of the game clear for global investors. The Council approach gives the resolution authority powers to discretionarily exclude any type of liability for reasons of impossibility within a certain time frame, or to avoid wide-spread contagion. In our view, there would have been a benefit in defining ex ante the categories of liabilities that could have been excluded. This means that investors will lack certainty about how the new framework will be used, and in my view it may slow down the process of reducing financial fragmentation. For instance, there will inevitably be a political economy dimension to how national resolution authorities decide to exercise their discretion, with creditor classes that have particular importance in different national contexts likely to be favoured. This will affect the level-playing field between Member States. Moreover, the BRRD foresees that after 8% of a bank’s liabilities have been bailed-in, the national resolution authority has the option to use its resolution fund to bail-out a further 5% of the bank’s liabilities. However, some countries will have larger resolution funds than others, for instance if they have more banks paying into the fund. This means that these countries would be able to bail-out more domestic banks before they exhaust the fund than those with less resolution resources available, who would need to use more bail-in. This will also not help reduce fragmentation.