Comfortably numb: ESM direct recapitalization
On one hand, the crises has eased over these two years, and the sense of urgency for this instrument in the eyes of both policy makers, markets and external observers has faded accordingly. On the other hand, the partial information disclosed until now suggests quite clearly that this is not going to be the game changer it was supposed to be.
Two weeks ago something happened in Europe, which attracted remarkably low attention. After two years of negotiations, euro area member States seem to have finally reached a “political understanding” on the operational framework for the ESM direct bank recapitalisation instrument, which should therefore be adopted after the relevant national procedure will be completed.
Why such low interest for what should in principle be regarded as a significant step forward in the laudable mission to break the link between euro area sovereigns and banks? The reason is probably twofold. On one hand, the crises has eased over these two years, and the sense of urgency for this instrument in the eyes of both policy makers, markets and external observers has faded accordingly. On the other hand, the partial information disclosed until now suggests quite clearly that this is not going to be the game changer it was supposed to be.
The initial objective of direct recapitalisation by the ESM was very clear. After the turmoil in financial markets had reached new highs, between summer of 2011 and early 2012, European leaders had reached the conclusion that it was “imperative to break the link between banks and sovereigns”. The possibility to recapitalise banks directly with the ESM – bypassing the state’s balance sheet – was put forward as an important part of this plan. Since then, the lexicon has changed significantly, reflecting the coming into place of additional (often conflicting) objectives and the consequent shifting of the policy ambitions.
In the “main features” paper published in June 2013, the mission of ESM direct recap is described less ambitiously as to “help remove the risk of contagion from the financial sector to the sovereign. Oddly enough, no mention of this objective is found in the statement issued by the President of the Eurogroup last week, after the agreement was reached. The ESM on the contrary published on its website a series of Frequently Asked Questions, tellingly clarifying that: “when the instrument was first proposed, it was supposed to cut the link between troubled banks and sovereigns. However, it soon became apparent that the remaining building blocks of the banking union would most likely achieve this aim without the need for DRI to provide substantial amounts of fund”.
Although rephrased in a politically acceptable way, this sentence points to the crucial issue. In fact, the known features of the instrument are such that it is hard to see how it could possibly sever the sovereign-banking link. While it requires important private sector participation as a precondition, the ESM direct recap instrument still puts considerable burden on the State.
Private sector contribution will be relevant. For a transitional period until 31st December 2015, a bail-in of 8% of total liabilities, including own funds of the beneficiary institution, will be applied. In addition, the ESM Member’s national resolution fund will have to make a contribution, up to the 2015 target level. From 1st January 2016, the criteria in the Bank Recovery and Resolution Directive (BRRD) will apply. The objective of these requirements is to avoid the costly public recapitalisation that we saw in the past, thus breaking one of the vicious circle’s leg. But the bail-in requirements are very tough and, considering that direct recap will be available only for “systemically relevant credit institutions”, the systemic consequence could be important.
Nevertheless, the conditions on the State are significant. Direct recap is available only to member states whose fiscal position is perceived to be at risk. To be able to use this instrument, in fact, a sovereign must be “unable to provide financial assistance to the beneficiary bank without very serious effects on its own fiscal sustainability”, or it must be that alternative solutions “could endanger the continuous access to markets of the requesting ESM Member”. If these conditions are not satisfied, and there is no perception of significant risk to financial stability, the Member State would not be eligible for direct recap. Obviously, it could still access the indirect loans for bank recap – the one used in the Spanish case. This creates an inconsistency: if the finances of the requesting State are not perceived (by those who take the decision) to be at risk, the State would most likely be pushed towards indirect recap, which would however end up on its balance sheet, thus possibly creating the perception that public finances will be at risk in a near future.
Second, while being reserved to member states whose finances are perceived to be at risk, ESM direct recap still requires the state to always contribute to the recapitalisation. In particular, if the beneficiary institution has insufficient equity to reach the legal minimum Common Equity Tier 1 of 4.5%, the state will be required to make a capital injection to reach this level before the ESM participates in the recapitalisation. If the bank instead already meets the minimum capital ratio, the state will anyway be obliged to make a capital contribution alongside the ESM. The ESM Board of Governors will have the right to partially or fully suspend an ESM Member’s contribution in the exceptional cases when the ESM Member is not able to contribute up-front due to fiscal reasons. In light of the previous point, however, it is going to be very hard for the Board to discriminate and avoid the two corner solutions in which this exception is applied either to everybody or to nobody.
The continuing involvement of the state meets different objectives of European leaders, which gained relevance in the policy debate during 2013. First, the need to act under a self-imposed constraint of 60bn, i.e. the maximum of ESM resources usable for direct recap. Second, the need to deal with the fact that a large part of the problems now affecting European banks can be seen as the “legacy” of past supervisory and governmental mistakes or misdeeds, at the national level. This is a legitimate need in the short term, but it is hard to justify it for a long-term in which supervision will have been cleaned up and supervision will be entirely moved at the central level. The “main features” paper published in June 2013 included provision for the revision of the instrument’s guidelines every two years since entry into force, to cater for the advancement of Banking Union and the progressive disappearance of legacy assets. No mention of this is found in the statement release by the Eurogroup president, but the actual implementation of this promise will be crucial.
The limitations of the instrument as it currently stands are evident and have been recognised by the IMF in its Article IV on the Euro area, published yesterday. The Fund explicitly says “work needs to continue to establish a common backstop to sever effectively sovereign-bank links. […] While the proposal for ESM direct recapitalization is a step in the right direction, as currently envisaged, the thresholds for such support are too high”.
Ultimately, the problem of ESM direct recap is that its initially clear purpose got lost in translation among the political attempts to meet numerous and conflicting objectives. A very well known law in economics, named after the Dutch economist Jan Tinbergen, says that at least as many independent instruments are needed as there are objectives, for the instruments to be useful. A wise advise, which however did not survive the test of politics, in the case of the soon-to-be-born ESM instrument for direct bank recapitalisation.
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