The gaping contradictions in EU bank bail-out law and policy

The EU’s hugely complex banking resolution framework is generally supposed to have one key goal – to ensure that failing banks are ‘resolved’ without recourse to public bail-outs, thereby breaking the link between private banks and sovereigns…  The reality, we have seen today, is quite different – and, it seems, legal!  The EU can just about argue that technically, the rules have not been broken - but overall, the appearance is of a policy in logical disarray once again.

After all, the whole purpose of EU banking resolution policy has been to prevent large tax-payer injections into stressed and failing private banking institutions - and instead, to ensure that the private sector investors take the financial pain. 

But the European Commission has, in conjunction with the European Central Bank and the Single Resolution Board, accepted  the Italian government's case, that that once again, the taxpayer should keep the private banking system going.

We read this on the website of the Single Resolution Board (SRB), which was set up in 2015 to take a lead role in bank resolution:

“Resolution is the restructuring of a bank by a resolution authority through the use of resolution tools in order to safeguard public interests, including the continuity of the bank’s critical functions, financial stability and minimal costs to taxpayers.”

And again, 

“Rather than relying on taxpayers to bail these banks out, a mechanism is needed to put an end to potential domino effects. It should allow public authorities to distribute losses to banks' shareholders and creditors – rather than on the taxpayers.

This is what the SRB says of its own role:

“Established by Regulation (EU) No 806/2014 on the Single Resolution Mechanism (SRM Regulation), the Single Resolution Board (SRB) has been operational as an independent European Union (EU) Agency since January 2015. The SRB strives to become a trusted and respected resolution authority with a strong resolution capacity and the ability to act swiftly and in an appropriate, consistent and proportionate manner in establishing and enforcing an effective resolution regime for banks in the Single Resolution Mechanism (SRM) jurisdictions, thus avoiding future bail-outs.”  (My emphasis)

The key task of the SRB is to decide whether “resolution” is possible – or whether it is of insufficient importance and should be allowed to be wound up without further ado:

“Resolution occurs at the point where the authorities determine that a bank is failing or likely to fail, that there is no other supervisory or private sector intervention that can restore the institution to viability (for example by applying measures set out in a so-called recovery plan, which all banks are required to draft) within a short timeframe and that normal insolvency proceedings would cause financial instability while having an impact on the public interest.

If it is decided to resolve a bank facing serious difficulties, its resolution will be managed efficiently, with minimum costs to taxpayers and the real economy. In extraordinary circumstances, the Single Resolution Fund (SRF), financed by the banking sector itself, can be accessed.” (My emphasis)

But when it comes to the two failed Italian banks, the European Central Bank and the SRB decided they are not of systemic importance, and should thus be left to the Italian authorities.  The SRB website says this:

Following today’s decision taken by the European Central Bank to declare Banca Popolare di Vicenza S.p.A. and Veneto Banca S.p.A. as ‘failing or likely to fail’, the Single Resolution Board has decided that resolution action by the SRB is not warranted for these banks. As a consequence, the winding up of the banks will take place under national proceedings launched by the Italian authorities.  

The SRB concurred with the ECB’s assessment and concluded that there are no alternative supervisory or private sector measures which could prevent the failure of the banks. Upon careful consideration whether resolution action is necessary and proportionate to safeguard the objectives set out in the Banking Union resolution framework, the SRB has today concluded that for these two banks, resolution action is not warranted in the public interest. In particular, neither of these banks provides critical functions, and their failure is not expected to have significant adverse impact on financial stability. As a result, the banks will be wound up under normal Italian insolvency proceedings.

This is an 'interesting' conclusion, since both of the failed banks appear on the European Central Bank's list of 125 "significant supervised entities", updated in January 2017.  As of course does Intesa Sanpaolo, the larger bank taking over the failed banks' better assets, and being effectively tax-payer subsidized to do so.  All 125 "currently fall under the direct responsibility of the SRB", again as per its website.  Yet when their direct supervisees fail, the ECB and SRB seem to say, "not our problem."

But of course the only reason for leaving it to the Italian authorities, and for considering that the failure of the banks is not of sufficient public interest for the SRB to be involved, is precisely that the Italian government's solution is based on a taxpayer bail-out estimated at €17 billion - around €5 billion in cash and €12 billion guarantees to Intesa, the larger bank that is being paid to take over the risks.  And this is not the political time to pick a fight with the Renzi government.  But if the taxpayer was not on the hook, a significant crisis would very likely have arisen. 

Now €17 billion is not a small sum, even though the two failed banks are said to form only about 2% of the Italian banking sector.  It is about 1% of Italian GDP. Since it is state aid, it is unlawful unless the European Commission gives its permission, under Article 107 of the Treaty on the Functioning of the EU.  And the beneficiary is of course not the failed banks, but the going concern, Intesa.

EU State aid and taxpayer bail-outs

So as part of the rushed deal, it was essential to get the European Commission on board.  That was achieved over the weekend, and a press release issued:

Commissioner in charge of competition policy, Margrethe Vestager, said: "Italy considers that State aid is necessary to avoid an economic disturbance in the Veneto region as a result of the liquidation of BPVI and Veneto Banca, who are exiting the market after a long period of serious financial difficulties. The Commission decision allows Italy to take measures to facilitate the liquidation of the two banks: Italy will support the sale and integration of some activities and the transfer of employees to Intesa Sanpaolo.

Shareholders and junior creditors have fully contributed, reducing the costs to the Italian State, whilst depositors remain fully protected. These measures will also remove €18 billion in non-performing loans from the Italian banking sector and contribute to its consolidation...

The Commission found these measures to be in line with EU State aid rules, in particular the 2013 Banking Communication. Existing shareholders and subordinated debt holders have fully contributed to the costs, reducing the cost of the intervention for the Italian State. Both aid recipients, BPVI and Banca Veneto, will be wound up in an orderly fashion and exit the market, while the transferred activities will be restructured and significantly downsized by Intesa, which in combination will limit distortions of competition arising from the aid.

The subsequent deep integration by Intesa will return the sold parts to viability. The Commission also confirmed that the measures do not constitute aid to Intesa, because it was selected after an open, fair and transparent sales process, fully managed by Italian authorities, ensuring that the activities were sold at the best offer available.

These are curious, if not weasel, words.  The claimed contribution of "existing shareholders and subordinated debt holders" is not made explicit or documented by the Commission, ECB nor SRB.  And Intesa was the only bank that had come forward willing to take on some of the failed banks' assets - so it is hard to read this as anything but a state aid to Intesa.  That is not to say that some use of public funds was wrong - after all, redundancy costs on bankruptcy would have had to be picked up by the state.  But what is at stake here is clarity, consistency and basic integrity of the official process - after all, what we see here is a complete reversal in practice of the "bail-in don't bail-out" official policy line.

I must underline that the state aid agreed by the Commission falls under the discretionary power in Article 107(2) of the Treaty on the Functioning of the EU.  This provides:

3. The following may be considered to be compatible with the internal market:

(b) aid to promote the execution of an important project of common European interest or to remedy a serious disturbance in the economy of a Member State...

The Commission considers, it appears, that the aid is necessary "to remedy a serious disturbance in the economy of a Member State", due in part to the potential loss of employment (if the banks simply closed down), and to the credit impact in the Veneto region.

The Commission's own State Aid Banking Communication of 2013 (setting out its general state aid policy in respect of bank resolutions, and referred to in the present case by Ms Vestager) is based on the general assumption that credit institutions are inherently inter-connected:

25. The Commission will apply the principles set out in this Communication and all Crisis Communications (9) to ‘credit institutions’ (also referred to as ‘banks’). Credit institutions exhibit a high degree of interconnectedness in that the disorderly failure of one credit institution can have a strong negative effect on the financial system as a whole. Credit institutions are susceptible to sudden collapses of confidence that can have serious consequences for their liquidity and solvency. The distress of a single complex institution may lead to systemic stress in the financial sector, which in turn can also have a strong negative impact on the economy as a whole, for example through the role of credit institutions in lending to the real economy, and might thus endanger financial stability.

If there was not a fear of contagion in the present case - after all, Italy possesses a string of inter-connected smaller banks - then why all the present kerfuffle?  Italy's banking system as an entity is at risk - yet the ECB and SRB have in essence refused to accept their part of the responsibility, and again "nationalised" the issue.

Furthermore, the Commission has not yet clarified how its approach meets the terms of Part 6.3 of the Communication, on  "Sale of a credit institution during the orderly liquidation procedure":

79. The sale of a credit institution during an orderly liquidation procedure may entail State aid to the buyer, unless the sale is organised via an open and unconditional competitive tender and the assets are sold to the highest bidder. Such competitive tender should, where appropriate, allow for sale of parts of the institution to different bidders.

80. In particular, when determining if there is aid to the buyer of the credit institution or parts of it, the Commission will examine whether: (a) the sales process is open, unconditional and non-discriminatory; (b) the sale takes place on market terms; (c) the credit institution or the government, depending on the  structure chosen, maximises the sales price for the assets and liabilities involved.

81. Where the Commission finds that there is aid to the buyer, the Commission will assess the compatibility of that aid separately.

82. If aid is granted to the economic activity to be sold (as opposed to the purchaser of that activity), the compatibility of such aid will be subject to an individual examination in the light of this Communication

Now the Commission has already stated that it does not consider that there is a state aid to Intesa, since it was taking over pursuant to an open competitive process... but then, to whom is the aid granted?  It seems odd to say that it is granted to the failing bodies which are being liquidated, when the real beneficiary is to be Intesa!  No doubt some of these problems will clarify themselves... but if para 82 applies, we have not seen it directly addressed.in today's release.

Tentative Conclusions

The tentative conclusions I draw from this saga are as follows:

The bail-in requirement will be made to apply, if ever at all, to the case of credit institutions deemed to be of systemic importance - but the definition of systemic will remain at the whim of the EU and national authorities.

If deemed systemic, the failing institution will generally be subject to the "resolution" mechanism, triggered by the ECB and SRB.  The fact that both the failing and take-over banks in the present case are on the ECB list of 125  "directly supervised entities", and on the SRB's list of institutions for which they have direct responsibility, appears to be irrelevant.

In any other case, national insolvency provisions will be invoked, and provided some gesture is made towards a contribution by junior creditors, these may place the principal financial burden on to the general tax-payer, as in the past. (As I understand it, the main junior creditor contribution will be to not receive anything on sale of assets, at least until the state aid is fully covered..)

Provided also that there has been some gesture to show junior creditors taking a bit of the pain, the European Commission's state aid policy will be to agree to the tax-payer contributions, which will include significant subsidies (including state guarantees) to the bank taking over, to reflect the new risks being borne by it.  

Yet the new entity will not be deemed to actually be receiving state aid, if there has been a form of open competition for taking on the assets, or more likely some of the assets, of  the failed institution.  (Since the aim, which is not an improper one, of the taking-over entity is to strengthen their future base and market position, it is truly hard to see how they have not received a benefit, but let's let that pass for now).  It's not clear to me who is then actually the recipient of the aid...

Perhaps there is a reason why EU policy should be that taxpayers should not be made responsible for bailing out institutions deemed systemically important, but should be in the front line in relation to failed institutions deemed not to be systemically important, but I confess that it has so far eluded me.  

I am in general terms in favour of loosening EU state aid rules, to provide more discretion at member state level to help protect regional economies in temporary difficulty.  (See also my proposals for EU Treaty changes, here at page 35).   But the motto now seems to me - if you are not too big as a bank, you can count on the tax-payer taking the burden if things go badly wrong.  If you get a bit bigger and fall into the "systemic" camp, the burden will fall - well, should fall - on private investors.