IF ONE goal has animated the reform of finance since the crisis of 2007-08, it has been a desire to spare taxpayers from having to pick up the bill for bank failures. Regulators have introduced stress tests to see how banks stand up to shocks; America’s latest round of tests concluded this week (see article). They have forced banks to fund themselves with more equity and to issue layers of debt that are earmarked for losses in the event of severe trouble. They have even asked banks to draw up plans for their own dismemberment in the event of failure.
The first real tests of this post-crisis machinery were always going to happen in Europe, which has been damagingly slow to face up to the sorry state of its banks. One such trial occurred early in June, when the European Central Bank (ECB) declared that Banco Popular, a big Spanish lender, was failing or likely to fail. In that instance, the machinery purred. A new European agency, the Single Resolution Board (SRB), took charge. Popular’s shareholders and junior bondholders lost their money; another Spanish bank, Santander, raised its own cash to fund the purchase of Popular; taxpayers watched from the sidelines; and regulators hailed a textbook bank resolution.
The latest test was more reminiscent of Heath Robinson. On June 23rd the ECB handed out the same “failing or likely to fail” verdict to two midsized lenders in Italy, Veneto Banca and Banca Popolare di Vicenza. But this time the outcome was very different. The SRB determined that the pair did not pose a threat to financial stability, and handed them to the Italian authorities to deal with under national insolvency procedures. Instead of senior bondholders taking losses, as would otherwise have happened, taxpayers have again found themselves on the hook. Public money will subsidise the purchase of the two banks’ good assets by Intesa Sanpaolo, a big Italian rival. As much as €17bn ($ 19bn) of state funds could be at risk, although the actual bill is likely to be lower (see article).
It’s the political economy, stupid
What conclusions should be drawn from these divergent outcomes? Optimists see the fruits of reform in both episodes; pessimists fulminate that promises to protect taxpayers are broken after the Italian deal, and that hopes of moving towards a true banking union are dead. The reality lies somewhere in the middle.
Europe’s post-crisis reforms have yielded genuine progress. First, the ECB’s supervisory powers over euro-zone banks are welcome. National regulators were prone to look the other way when banks wobbled; the ECB, which took on the powers in 2014, has waited too long to flex its muscles but is a more credible judge of financial trouble. Second, junior bondholders can now be certain that they will be wiped out when banks get into deep trouble (something that was not always guaranteed during the crisis). New instruments such as “contingent convertible” bonds, which are explicitly designed to force losses on their owners in bad times, are doing their job.
There is a third reason to be hopeful. Italy has long assumed an ostrich-like posture on the non-performing assets clogging up its banks, estimated at €349bn (gross) by the Bank of Italy. One reason for the delay has been a politically charged quirk of Italian finance: the fact that retail investors are big owners of Italian bank debt. Imposing losses on creditors is less attractive when the effect is to wipe out the savings of ordinary citizens. The liquidations, and an earlier rescue of Monte dei Paschi di Siena, a bigger bank, have avoided this outcome. That infuriates many, who equate wriggle-room in the rules on resolution with licence to ignore them. But a cleaner banking system results. This week a measure of default risk in Europe’s banks fell to its lowest level since at least 2010. And the problem of retail-owned bonds is fading as they mature.
But the cases of Popular, Monte dei Paschi and the two mid-sized Italian banks have also revealed that the big shortcoming in Europe’s resolution framework is an unwillingness to impose losses on senior creditors, who rank above shareholders and junior bondholders in banks’ capital structures. Sparing them pain is wrong in principle. There is no reason why such investors should be free from risk. And it will exacerbate worries in Germany and elsewhere that a full banking union, complete with a European deposit-guarantee fund, is a way to spend taxpayers’ money, not protect it.
Yet handing out losses from a bank failure is an inherently political judgment. That is why ordinary depositors are protected. The reluctance to hit senior investors reflects a genuine fear of sparking wider contagion, perhaps even panic. Financial regulators ought to acknowledge this dilemma and be pragmatic in response. They should make sure that banks issue equity and layers of explicitly at-risk debt to institutional investors in large enough quantities to minimise the chances of having to bail in anyone else. Do that, and taxpayers will benefit even more from the post-crisis overhaul.