Public interest loophole casts doubt on EU banking union

Bondholders face fresh uncertainty about European use of bail-in, critics warn

A decision that it was not in the public interest for the European Single Resolution Mechanism to be involved in tackling two failed Italian banks has created fresh uncertainty for bond investors, critics warn.

“How this public interest test now works is open to question. If it is highly discretionary, as it might appear now to be, then it doesn’t give bondholders much predictability as to what their position is going to be. It is like rolling the dice or flipping a coin: either you are going to be in the Single Resolution Mechanism system or you are going to be subject to some localised arrangement which could be brought in as an emergency measure without much, if any, consultation,” says Barnabas Reynolds, head of the financial regulatory practice at law firm Shearman & Sterling in London.

On June 23, the European Central Bank (ECB) declared that two Italian banks – Banca Popolare di Vicenza (BPVI) and Veneto Banca – were “failing or likely to fail”. This meets one of the criteria for the banking union’s Single Resolution Board (SRB) to resolve a failing bank: the institution is declared failing or likely to fail; there are no other private sector measures or supervisory actions available to shore the bank up; and it is in the public interest to launch a resolution action.

Since the Single Resolution Mechanism came into force in January 2016, any bank resolution in the eurozone should be conducted by the SRB. But in this instance, the SRB decided it was not in the public interest for it to resolve the two Italian banks, so they could be liquidated under Italian insolvency laws.

Bailout becomes liquidation aid

The decision to avoid declaring a resolution took the banks out of scope of rules that restrict the use of state aid to a failing bank, known as the Bank Recovery and Resolution Directive (BRRD). This raises fears the public interest argument could be used to circumvent rules designed to ensure the risk of bank failure sits with shareholders and non-deposit creditors, not the taxpayer.

The BRRD, which came into effect in January 2015, decrees that before state support can be used, 8% of a bank’s total liabilities must be bailed in.

In the case of the two Italian banks, the authorities did not bail in that amount of liabilities before using public funds. Instead, only the holders of equity and junior bonds received haircuts. But since the SRB’s decision took the banks outside the scope of BRRD, it still allowed the Italian state to use so-called liquidation aid, including a €4.785 billion ($5.447 billion) capital injection and a legal indemnity of up to €1.5 billion, which was extended to Banca Intesa to acquire the performing assets and liabilities of the banks, without the non-performing assets or junior debt.

“The SRB has deliberately sidelined itself as it doesn’t want to be involved in an Italian state bailout, saying: ‘We don’t want to use our powers; you guys can do whatever you like’,” complains a partner at a different London-based law firm.

Systemic or not?

This has prompted calls for the SRB to disclose how it arrived at the conclusion that it was not in the public interest to intervene in the two banks. Critics say the decision appears entirely discretionary and lacks a clear methodology.

According to the SRB press release on June 23, resolution was “not warranted” because “neither of these banks provides critical functions, and their failure is not expected to have significant adverse impact on financial stability.”

In an email to Risk.net, a spokesperson for the SRB details the conditions under which normal insolvency proceedings are deemed appropriate.

“Whether the application of normal insolvency proceedings to the bank is credible depends on whether the failure of the bank has a material adverse impact on: the functioning of the financial market and market confidence; financial market infrastructures; other financial institutions; or the real economy and in particular the availability of critical financial services,” says the spokesperson.

But this seems to be partly contradicted by a press release published by the EC on June 25, approving the use of liquidation aid to Intesa to acquire the performing assets and liabilities of the two banks precisely because there would otherwise be an economic impact.

“Italy has determined that the winding up of these banks has a serious impact on the real economy in the regions where they are most active. Outside the European banking resolution framework, EU rules foresee a possibility for Italy to seek Commission approval for the use of national funds to facilitate the liquidation by mitigating such regional economic effects,” the press release stated.

Two days after the press release, Italian news site Il Foglio published an article written by Pier Carlo Padoan, the Italian finance minister, explaining his views on the need for state aid. His analysis went even further than that of the EC.

“A simple liquidation would have triggered a huge crisis for a territory that is pushing Italy into economic recovery: the two banks had 200,000 businesses among their customers. A liquidation would create damages to account holders, depositors and savers who have invested in bonds with those banks. It would probably have forced the whole Italian banking system to assume the cost of a mandatory protection of depositors, with consequences on the degree of capital for many banks, creating a deep uncertainty among all the savers,” Padoan wrote on June 27.

Effectively, this means the SRB declined to use its powers because the banks had no impact on financial stability, but the Italian government chose to use state aid because the banks did represent a risk to financial stability.

“It is a bit hard to understand that the SRB made their decision that the banks were not systemically important but then the Italian authorities came out the second afterwards saying these banks are systemically important in the Veneto region, and therefore they pressed on with this state intervention using an exemption in the state aid framework. I would have liked to see a bit more explanation on why the determinations differ,” says a resolution expert at a European resolution authority outside the banking union.

The SRB spokesperson states that the public interest case for it to intervene is defined as when “the resolution objectives cannot be met to the same extent through winding up the bank under normal insolvency proceedings.”

The BRRD’s resolution objectives are: to ensure the continuity of critical functions; to avoid a significant adverse effect on the financial system; to protect public funds by minimising reliance on extraordinary public financial support; to protect depositors; and to protect client funds and client assets.

“With the public interest test stating [resolution] is needed to ensure the protection of public funds, [the SRB’s explanation] is hard to believe, because surely they have put in more public funds through this [insolvency] route,” says the London-based partner at a law firm.

A full resolution bail-in of at least 8% of liabilities would most likely have reduced the liquidation aid needed by Intesa to acquire the assets and liabilities of the two distressed banks.

Drawing the line

Critics argue this now introduces uncertainty to senior bondholders of small European banks because they do not know whether a bank will be subject to BRRD or not. If it is, senior bondholders may take losses before state support is used. If not, then only junior bondholders seem to be in the firing line.

“How does this protect financial stability? I don’t understand that, because they allegedly say they are doing this in order to protect financial stability. I don’t think you protect financial stability by introducing discretion, because investors want to know exactly where they stand,” says Panicos Demetriades, professor of financial economics at the University of Leicester and former governor of the Central Bank of Cyprus from 2012 to 2014. During his time at the central bank, he was responsible for resolving the banking crisis in Cyprus.

To get an indication of the instances when a bank’s resolution might constitute a matter of public interest, Risk.net compared the two Italian banks with the resolution of Banco Popular in Spain. In the case of Banco Popular, the SRB decided to undertake resolution, which must mean the SRB thought it was in the public interest to do so.

“Now the question is whether the SRB can be justified, because the SRB is actually looking at both the stability in the European as well as the Italian market. Maybe these banks were so small that even for the Italian market they were not systemic,” says a resolution expert at a second European resolution authority outside the banking union.

Data in the table above shows Popular had assets almost three times larger than those of the two Italian banks combined. Italy is also a larger banking market in total.

"We take a group of the largest banks when we look at the average performance per country and we used to include Popular in that average for Spain for the top five or six Spanish banks. We would never have had Veneto or Vicenza in the equivalent for Italy,” says Bridget Gandy, co-head of European financial institutions at Fitch in London.

Banco Popular also provided a significant amount of lending to small and medium-sized enterprises (SMEs), which are commonly regarded by EU lawmakers as a vital part of the real economy. On the other hand, the two failing Italian banks may not have been significant for the entire Italian economy.

“I don’t think their failure would be that much of a problem because we are talking about Italy, which is a trillion-plus [euro] economy. Even if the losses were not taken by the government, it is like a rounding error for the economy. Second, everyone knew these banks were in trouble. Would it create a deposit run because the shareholders were wiped out? I don’t think so,” says Hugo Cruz, an Italian banks analyst at Keefe, Bruyette & Woods.

Time to clarify

But this sanguine assessment contradicts Padoan’s justification for using state aid to avoid a deposit run, and leaves open the question of why senior bonds were absorbed by Intesa rather than being bailed in.

The liquidation of the two Italian banks has also raised the question of why they were included in the Single Supervisory Mechanism’s (SSM) direct supervision regime if they were not systemically important.

The SSM, based at the ECB, is intended to directly supervise only those banks that are deemed systemic for the banking union. Smaller banks are supervised indirectly via national competent authorities.

“[The SRB] said they are not systemic and not providing critical functions. If that is the case then why are they being supervised by the SSM in the first place? So there is some inconsistency in the application of EU rules,” says Demetriades, who was a member of the governing council of the ECB during the discussions that led to the setup of the SSM.

Gunnar Hökmark, a Swedish member of the European Parliament, is the rapporteur for draft proposals designed to incorporate the international standard for total loss-absorbing capacity into the BRRD. The revision process could be an opportunity to clarify the public interest criteria for resolution, he says.

“This is one of the issues that could be clarified and needs to be followed up: the difference between when something is and is not in the public interest and how they decide upon those. It needs to be shown as legal, and the EC [departments] can explain how they looked upon that and show this wasn’t a way that they were circumventing the legislation. There are question marks that need to be sorted out,” says Hökmark.