By Rob Gehring

Last month, the European Court of Justice (ECJ) determined that taxpayers should not be – or at least not immediately be – on the hook for rescuing banks in distress. During the financial crisis, several governments bailed out failing banks, thereby transforming bad private debt into bad public debt. Direct financial support i.e. state aid was necessary to ensure the stability of the financial system. Excessive public spending and minimizing distortions of the competition were mostly disregarded.

Article 107(1) TFEU defines state aid as

any aid granted by a Member State or through State resources in any form whatsoever which distorts or threatens to distort competition by favoring certain undertakings or the production of certain goods […], in so far as it affects trade between the Member States.

The Bail-In Concept

A bail-in allows the authorities to make sure that shareholders and creditors of a firm bear the costs of failure, without recourse to public funds.

Following the crisis, the framework for managing the failure of financial firms was reformed and new tools such as a ‘bail-in were developed. A bail-in allows the authorities to make sure that shareholders and creditors of a firm bear the costs of failure, without recourse to public funds. State support can create moral hazard problems and often undermines market discipline, especially with regards to banks (i.e. they expect to be bailed out). 

There is also empirical evidence indicating that the occurrence of a bail-in leads to a reduction in bail-out expectations.

A bail-in could, therefore, help dampen excessive risk taking by banks, since shareholders and subordinated creditors cannot rely on a blank cheque from the government if that particular bank gets into trouble. A bail-in is thus – in principle – the opposite of a bail-out, which involves the rescue of a financial institution by external parties, typically governments using taxpayers money.

How Banks Communicate

Besides the adoption of the Bank Recovery and Resolution Directive (BRRD) in the EU and the agreement on a Single Resolution Mechanism (SRM) in the euro area, which both subscribe to the bailing-in philosophy, one clear example of this new approach towards rescuing banks is the so-called Banking Communication from the European Commission. It provides a comprehensive framework for coordinated action in support of the financial sector so as to ensure financial stability while minimizing distortions of competition between banks and across the Member States in the single market.

Bail

Banking Communication: Comprehensive framework for coordinated action in support of the financial sector to ensure financial stability | Photo Courtesy: Daniel Foster via Flickr

It establishes conditions designed to ensure that State aid granted to banks is compatible with the internal market. The ECJ found the Banking Communication to be consistent with EU law.

How It Works

These states retain the right to notify the Commission of proposed state aid which does not meet the criteria laid down by the Banking Communication. The Commission may authorize such proposed aid in exceptional circumstances. Despite the fact that the Banking Communication is not binding on the EU member states, Banking Communication is equivalent to the effect of a limitation imposed by the Commission on itself in the exercise of its discretion. The assessment of the compatibility of aid measures with the internal market, under Article 107(3) TFEU, falls within the exclusive competence of the Commission, subject to review by the Courts of the European Union.

This means, that if an EU member State notifies the Commission of proposed State aid which complies with those guidelines, the Commission must, as a general rule, authorize that proposed aid.

The most important requirement of the Banking Communication is the condition of burden-sharing: both shareholders and subordinated creditors must be involved in meeting the costs of restructuring distressed banks in order to reduce their capital shortfalls. As a consequence, after losses are absorbed by equity capital, subordinated creditors are also called upon to contribute to the attainment of that objective either by the conversion of their claims into equity, or a write-down of the principal of those claims. Consequently, state aid must not be granted to a failing bank before equity, hybrid capital, and subordinated debt have fully contributed to offset any losses.

ECJ:

The scale of losses suffered by shareholders of distressed banks will, in any event, be the same, regardless of whether those losses are caused by a court insolvency order because no State aid is granted or by a procedure for the granting of State aid which is subject to the prerequisite of burden-sharing.

Is Bailing-in A Good Idea?

Let’s take an example. Assume that the balance sheet of ABC Bank before the bail-in is as follows:

as1

After the bail in – in this case, the par value of the shares, reserves, and relevant capital instruments is written down to nil and the principal amount of the subordinated debt is reduced by half –  the balance sheet becomes:

as3

After the bail-in and recapitalisation – in this case, (i) conversion of the remaining subordinated debt into shares, and (ii) partial conversion of the unsecured creditors into shares), the final balance sheet is as follows:

as4

Therefore, in principal, EU State aid law requires a bail-in (or burden-sharing) before governments may support banks in distress.

Prior to the grant of any state aid, a member state is not compelled to impose on failing banks an obligation to convert subordinated rights into equity or to effect a write-down of the principal thereof. However, as required by the banking communication, it will not be possible for the contemplated state aid to be regarded as having been limited to what is strictly necessary. The member state and the banks who are to be the recipients of the contemplated state aid take the risk that a Commission decision declaring the aid incompatible with the internal market will stand in its way.

Therefore, in principal, EU State aid law requires a bail-in (or burden-sharing) before governments may support banks in distress.

Time to think:

Bail in: a good idea or a dangerous precedent?


Rob Gehring is a Lawyer and economist specialized in European law, competition/antitrust law and free market economics.

Featured Image Credits: Jason Wells via Flickr

Fresh insights delivered to your phone each morning. Download our Android App today!

Posted by The Indian Economist