The bail-in strat­egy and Europe’s cri­sis

Financial Mirror (Cyprus) - - FRONT PAGE -

The cur­rent Ital­ian bank­ing cri­sis car­ries with it the pos­si­bil­ity of bank fail­ures. The con­se­quences of these fail­ures pyra­mid the cri­sis be­cause of Euro­pean Union reg­u­la­tions. Es­sen­tially, the po­si­tion of the Euro­pean Union is that the Euro­pean Cen­tral Bank (ECB) and the cen­tral banks of mem­ber coun­tries can­not bail out fail­ing banks by re­cap­i­tal­iz­ing them — in other words, in­ject­ing money to keep them sol­vent. EU reg­u­la­tions go so far as to pro­hibit Italy from us­ing its state funds to shield in­vestors and share­hold­ers of banks from losses, un­less there is risk of “very ex­tra­or­di­nary” sys­temic stress. Rather, the Euro­pean Union has adopted a bail-in strat­egy.

The bail-in strat­egy is in the­ory a mech­a­nism for en­sur­ing fair com­pe­ti­tion and sta­bil­ity in the fi­nan­cial sec­tor across the eu­ro­zone. It pro­tects coun­tries, like Ger­many, from spend­ing their money on bank fail­ures in other coun­tries, and keeps the ECB from print­ing ex­tra money and ex­pos­ing Europe to in­fla­tion that would re­duce the po­si­tion of cred­i­tors. The fear of in­fla­tion is re­mote at this mo­ment but it still is an in­sti­tu­tional prin­ci­ple of the ECB. And con­trol­ling na­tional ex­pen­di­tures on banks im­poses fis­cal dis­ci­pline on coun­tries that seek to bail out not just banks, but the eq­uity hold­ings of in­vestors, who will lose their in­vest­ment when the bank fails.

The is­sue is this: who is con­sid­ered an in­vestor? In the view of the EU, de­pos­i­tors are, in cases of a bank res­o­lu­tion, in­vestors in the bank. The bail-in process can po­ten­tially ap­ply to any li­a­bil­i­ties of the in­sti­tu­tion not backed by as­sets or col­lat­eral. There is some in­surance avail­able, and there are EU reg­u­la­tions on de­posit in­surance, but there is no EU-wide sys­tem of de­posit in­surance. This is be­cause cred­i­tor nations do not want to share the li­a­bil­ity for bank fail­ures in other nations. This means that while the first 100,000 euros ($111,000) in de­posits are pro­tected, in the sense that they can­not be seized, any money above that amount can be.

On the sur­face, 100,000 euros is a sub­stan­tial amount of sav­ings. But if you con­sider the po­si­tion of a pro­fes­sional who has saved all his life for re­tire­ment, he may have sub­stan­tially more. And at in­ter­est rates avail­able today, even a bank ac­count with a mil­lion euros would not gen­er­ate enough in­come through in­ter­est to sus­tain a planned re­tire­ment. The prin­ci­pal would have to be used, and in a bail-in, both the planned in­come and prin­ci­pal (above 100,000 euros) would be dis­solved. As for busi­nesses, par­tic­u­larly small and medium-sized en­ter­prises (SMEs), the bail-in could evap­o­rate pay­roll ac­counts and other work­ing cap­i­tal.

The idea of the bail-in oblit­er­ates a dis­tinc­tion that has be­come fun­da­men­tal to Euro­pean and Amer­i­can bank­ing since the mas­sive bank­ing fail­ures of the 1920s and 1930s. It was un­der­stood that the pur­pose of a sav­ings ac­count was to find a safe haven for your sav­ings or your op­er­at­ing cap­i­tal. The de­pos­i­tor paid for the safe haven by ac­cept­ing ex­tremely mod­est in­ter­est rates. In con­trast, an in­vestor takes on greater risk and is re­spon­si­ble for eval­u­at­ing the fi­nan­cials of an in­vest­ment. The bank is an in­sti­tu­tion that is an al­ter­na­tive to riskier in­vest­ments.

We saw the con­se­quence of a bail-in pro­ce­dure dur­ing the Cypriot bank­ing cri­sis.

Claim­ing in­for­mally that Cypriot banks con­tained pri­mar­ily Rus­sian money meant for laun­der­ing, Ger­many in­sisted that the bail-in process should pre­vail. There was un­doubt­edly il­le­gal Rus­sian money in Cypriot banks, but there were also re­tire­ment funds for Bri­tish ex­pa­tri­ates who re­tired to Cyprus and ac­counts held by Cypriot busi­nesses. The re­sult was dev­as­tat­ing.

Money that had been pru­dently de­posited in a bank — so the de­pos­i­tor be­lieved — was lost as de­pos­i­tors dis­cov­ered they were con­sid­ered in­vestors. Em­ploy­ees of ho­tels, for ex­am­ple, were not paid for a month and then re­ceived about half a pay­cheque for a while. The ho­tels lost their in­vest­ments in the banks, with­out ever hav­ing re­al­ized that they were in­vestors and with­out any op­por­tu­nity to par­tic­i­pate in the banks’ suc­cess, while un­wit­tingly be­ing ex­posed to fail­ure.

There is one tremen­dous con­se­quence in this bail-in strat­egy. It in­creases the pos­si­bil­ity of runs on banks, par­tic­u­larly by large de­pos­i­tors. As it be­comes known that de­pos­i­tors are in­vestors — rather than cred­i­tors — and that their as­sets will be for­feited to pay debtors, the bank ceases to be a safe haven.

The more aware the de­pos­i­tor be­comes that he will be treated as an in­vestor, the more he will be­have like an in­vestor. Re­al­iz­ing that his bank de­posit is all risk with no up­side, any in­di­ca­tion that risks are mount­ing will cause a ra­tio­nal ac­tor to with­draw his money, and this will in­crease the risk of a run and col­lapse.

It is not clear what the EU is think­ing. The Amer­i­can ap­proach to the 2008 bank­ing cri­sis was that some com­pa­nies and banks were “too big to fail.” The con­cept op­er­ated on many lev­els. One was that the fed­eral gov­ern­ment en­sured that the Fed­eral De­posit In­surance Cor­po­ra­tion (FDIC) had enough money to cover all guar­an­tees. The rel­a­tively gen­er­ous guar­an­tees of the FDIC might not have been suf­fi­cient to deal with the cri­sis. The FDIC in­sures $250,000 in in­di­vid­ual de­posits and $500,000 for a mar­ried cou­ple. In ad­di­tion, it in­sures the same amount at the same bank in dif­fer­ent types of ac­counts. So, if an in­di­vid­ual had a per­sonal ac­count, a small cor­po­rate ac­count and a foun­da­tion ac­count, he could have $750,000 in guar­an­tees at the same bank. And if he had more money, he could open ac­counts at an­other bank. The FDIC would cover all of it and the fed­eral gov­ern­ment was pre­pared to en­sure the FDIC was able to do so.

An­other as­pect of the Amer­i­can ap­proach was the in­fu­sion of cap­i­tal into banks to guar­an­tee that the banks could honor their debts. This pro­tected li­a­bil­i­ties be­tween fi­nan­cial in­sti­tu­tions. It also pro­tected SMEs and in­di­vid­ual de­pos­i­tors. What­ever the vices of the bank man­age­ment, it guar­an­teed not only that in­ter­bank debt was se­cure, but that the de­pos­i­tors were treated as de­pos­i­tors and not in­vestors — nor even cred­i­tors. This, plus ag­gres­sive in­ter­ven­tion as banks failed, re­duced the pos­si­bil­ity that de­pos­i­tors would panic, and pre­vented the eco­nomic and po­lit­i­cal melt­down that a bail-in so­lu­tion might cre­ate.

This was pos­si­ble be­cause the United States is a sin­gle coun­try. Tex­ans might not be happy sta­bi­liz­ing banks in Cal­i­for­nia, but there is no sys­temic way for Texas to with­draw from the process. In some wild the­o­ret­i­cal sense, Texas might have the op­tion to se­cede, but in prac­ti­cal terms, there is no dif­fer­ence be­tween Texas’ li­a­bil­i­ties and Cal­i­for­nia’s. It is a sin­gle in­te­grated sys­tem.

Europe, for all the dis­cus­sion of in­te­gra­tion, is not in­te­grated. Italy is not Ger­many, and Italy’s prob­lems are not Ger­many’s prob­lems. There is no EU-wide de­posit in­surance sys­tem be­cause li­a­bil­ity is not dis­trib­uted at an EU level. Nor, as there is only one cur­rency, are the de­vices avail­able to the ECB avail­able to Italy. And fi­nally, the Euro­pean ethos of aus­ter­ity cre­ates li­a­bil­i­ties among the most vul­ner­a­ble classes.

The con­se­quence of large banks fail­ing is sig­nif­i­cant. The de­struc­tion of large num­bers of de­posits in what was re­garded as a safe haven can also have sig­nif­i­cant con­se­quences, and not just fi­nan­cial ones.

The sense of vul­ner­a­bil­ity that the bail-in con­cept cre­ates among in­di­vid­u­als has two con­se­quences. One is a shift in the pat­tern of sav­ing. Some will de­cide that if sav­ings are in­vest­ments with­out an up­side, they might as well get into the eq­uity mar­kets. The risk in these mar­kets is high. Or they may de­cide that they are bet­ter off with their money in gold or hid­den un­der their mat­tresses. The con­se­quences of that on a large scale are also sub­stan­tial.

But the big­gest con­se­quence is po­lit­i­cal. If re­tirees and oth­ers lose their sav­ings, and SMEs are un­able to pay their staff, the po­lit­i­cal im­pact on the es­tab­lished par­ties, which are al­ready un­der at­tack, could trans­form Europe. If this strat­egy works to con­tain the cri­sis in Italy, fine. But if it spreads into a panic, which is not un­likely, it will res­onate for a long time.

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