Jacob Funk Kirkegaard, senior fellow of the Peterson Institute, has published an excellent summary on the euro area’s political deal for bank recapitalisation and resolution, targeted at breaking “doom loops”, i.e. escalating negative feedback of banking and sovereign solvency troubles. The key parts, from a market perspective, are (i) the possibility of direct recapitalisation of banks through the European Stability Mechanism (even retroactively) and (ii) stricter bail-in rules for private bond and equity owners.

Jacob Funk Kirkegaard, “The Road to a European Banking Union”
http://www.piie.com/blogs/realtime/?p=3720

“The euro area and EU finance ministers have struck two major political deals as part of the European banking union. The first was on the European Stabilization Mechanism (ESM) direct bank recapitalization instrument. The second was on the new EU directive on bank recovery and resolution. Both decisions are far-reaching steps forward for the integration of Europe’s financial services industry and regulatory framework.”

Recapitalization through the ESM

“The most important element of the banking union launched in June 2012 for financial markets was the possibility of direct equity injections by the ESM [seen as a way to keep the Spanish sovereign solvent by shifting the burden of bank recapitalization from the national to the euro area level]…Access to ESM direct banking recapitalization is not a supranational insurance policy against the full costs of a banking crisis. Rather it is a less comprehensive insurance against loss of market access by a euro area sovereign. The cost of a banking crisis will continue to be largely borne by the national authorities and bank creditors… Direct ESM recapitalization [pdf] is an option only if ‘other alternatives would have the effect of endangering the continuous market access of the requesting ESM Member and consequently require financing of the sovereign needs via the ESM.’ “

“Several additional restrictions were placed on the direct recapitalization instrument.

  • The maximum amount available for this purpose would be EUR60 billion… a largely meaningless figure because it ‘can be reviewed by the [ESM] Board of Governors’.
  • Two types of national government cofinancing are envisioned. First, national governments will have to inject sufficient capital to get the beneficiary institution up to the legally required minimum Common Equity Tier 1 (CET1) ratio of 4.5 percent in a stress test established by the Basel III framework…For capital injections above the 4.5 percent threshold, direct ESM recapitalization is possible, but only with a 20 percent member state copayment…[However] direct recapitalization ‘leaves flexibility to the Board of Governors to partially or fully suspend such [national] contribution by mutual agreement in those exceptional cases in which the ESM Member is not able to contribute up-front due to its fiscal position and significant implications for its market access.’ this euro-speak means that if a member state cannot afford its share, it can get off the hook through mutual agreement, implying again that additional unspecified political conditions will be part of a deal.
  • Access to ESM direct recapitalization is separate from the issue of when the ECB takes over as the euro area banking regulator [scheduled for the second half og 2014]. As the statement of the European finance ministers put it, ‘the potential retroactive application of the instrument should be decided on a case-by-case basis and by mutual consent.’”

“The deal on the ESM direct bank recapitalization reinforces the impression that the ESM has no rules, and its Board of Directors has complete discretion to implement whatever deal they see as politically acceptable… the board is made up of the euro area finance ministers.”

EU directive on bank recovery and resolution

“The EU (27) deal on banking resolution introduces a new and unprecedented degree of costs imposed on creditors (bail-ins) in European banking crises, while allowing for national government flexibility—a classic compromise between single centralized rules and national discretion.”

Europe now has creditor ranking that in principle looks like that of the Federal Deposit Insurance Corporation (FDIC) in the United States. And national flexibility concerning the use of government money to rescue banks will be restricted, so that bail-ins will increasingly be the new norm in Europe…The European Commission’s Directorate General for Competition—which oversees the European Union’s state aid rules—announced that government bailouts of banks must include write-downs to zero for shareholders and junior bondholders starting later this summer.”

“Bank restructurings and recapitalizations are envisioned to be regulated in three stages. [i] Losses of 8 percent of a crisis-stricken bank’s total liabilities are imposed on…shareholders and creditors…This requirement may compel national governments to bail in senior uncovered bondholders. [ii] The second stage allows national governments more freedom…to restructure a banking institution. [The] government could impose more losses on (senior) bank creditors, or use their own taxpayer funds or national resolution fund for an additional bailout of up to 5 percent of the bank’s total assets. [iii] Only after at least 13 percent of an institution’s total assets in losses have been covered by…is it foreseen that a direct ESM recapitalization can take place. Such a step would require that unsecured, non-preferred liabilities other than eligible deposits (i.e., all unsecured senior bonds), are bailed in.”

“The EU countries further committed themselves to setting up national bank resolution funds worth 0.8 percent of covered deposits in the country within 10 years… These national funds could lend to each other in a crisis. But the decisions are a long way from a genuinely integrated European or euro area bank resolution and deposit insurance framework.”

The single resolution mechanism

“The creation of a single resolution mechanism (SRM) in the euro area with the power to overrule national regulatory authorities…would speed the arrival of genuine euro area decision making, rather than harmonization of national rules… A revision of the European treaties will be required to establish a legally sound basis for an SRM and thereby the banking union as a whole. The discussion will likely be long and contentious.”