Blog Post

Market turbulence highlights bumpy transition to Europe’s new bank policy regime

Concerns about Europe’s banks contributed to turmoil in global financial markets in February, but Europe’s new banking sector policy regime should gradually help reduce uncertainty.

By: Date: March 8, 2016 Topic: Finance & Financial Regulation

This post is based on a piece written for the Peterson Institute of International Economics.

Bank shares have been hammered on both sides of the Atlantic, as investors fear that a new period of negative (or in the United States, continued low) interest rates, or another major economic downturn, will eat into banks’ profitability.

Shares rebounded in recent days, but to these general worries, investors have added specific concerns about European banks. This is justified: European banks suffer from problems that their US counterparts don’t.

However, none of the issues that have caught the market’s attention of late are new system-wide threats. The radical policy change initiated in mid-2012 with the inception of Europe’s banking union is delivering positive results, and the uncertainties associated with this change are gradually, if too slowly, eroding.

European banks suffer from problems that their US counterparts don’t.

Both sides of the Atlantic suffered from the financial shock of 2007–08, but European and US policymakers have addressed their banking problems very differently.

The United States applied a comparatively logical sequence: first, the combination of forceful recapitalization and well-timed stress testing restored confidence in the core of the system by mid-2009; second, legislative reform (the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010) framed the policy response; and third, this legislation was implemented through rulemaking by federal agencies in the years that followed.

No indication of systemic fragility in the United States has emerged since then, despite recent energy sector weakness. By contrast, the European Union has remained embroiled in banking system fragility, despite rolling out a stream of new legislative and regulatory initiatives.

Europe has lagged behind the United States on financial reform for several reasons. Europe’s financial system is dominated by banks, whereas the US system is cushioned by the variety of its financial markets and other nonbank financial channels.

Pervasive banking nationalism prevented adequate action by national bank supervisors.

Consequently, Europe has a harder time addressing large banking crises. Starting in 2009, the bank-sovereign vicious circle, in which problems in a country’s public finances and banks feed each other, aggravated the situation greatly.

Pervasive banking nationalism—the tendency of governments to protect their own national banking champions—and the occasional instance of regulators being captured by banks they were supposed to regulate, prevented adequate action by national bank supervisors

Eventually euro area leaders, with their backs against the wall, initiated the supranational pooling of banking sector policy known as banking union in mid-2012. The diverging paths of nonperforming loans (NPLs) in Europe and the United States summarize this contrast.

With this context in mind, the recent market volatility represents a belated acknowledgment by investors of risks that had been insufficiently recognized until now, rather than adjustment to the emergence of new risks. This is true of the three main issues that have driven uncertainty.

Untested contingent convertible securities

CoCos, a new form of debt that may be converted into equity, faced their first test under adverse market conditions. They were first issued in 2013 by Credit Suisse and have become widespread in Europe, though not in the United States, where their tax treatment is unfavourable.

They typically yield a higher rate than senior debt, but coupon payments can be stopped and the debt may be converted into equity if a pre-agreed trigger is crossed. The Basel Committee on Banking Supervision has excluded them from its preferred Core Equity Tier One (CET1) yardstick of regulatory capital. Depending on the contractual trigger, they form part of Additional Tier One (AT1) or Tier Two capital.

CoCos issued by Deutsche Bank lost significant value when they came close to missing coupon payments. But in spite of all the alarm, the experience with CoCos remains inconclusive. When a bank approaches the trigger point, there is (destabilizing) additional volatility and uncertainty but also a (stabilizing) incentive for that bank to quickly reinforce its balance sheet.

Deutsche Bank did exactly that by buying its own debt at a discount. More investors now realize that despite their loose labelling as “capital,” CoCos do not absorb losses in an orderly manner like common equity, and may thus weaken financial stability.

But whether CoCos serve their intended purpose can be known only when a CoCo conversion is triggered, which has not happened yet. CoCos are thus untested as a potential protection against sudden balance sheet deterioration, and it is too soon to conclude that they create their own major problems.

Unfinished banking system clean-up

Markets continue to reflect concerns about the soundness of euro area banks, and by implication about the ability of banking union to address the problem.

Supervisory efforts centre on the Single Supervisory Mechanism (SSM), which was granted authority over all banking licenses in the euro area in November 2014. The SSM simultaneously assumed direct supervisory authority over the 130 largest institutions (known as “significant institutions”), while national authorities remain supervisors of around 3,500 so-called less significant institutions.

Just before it took over supervisory responsibility for large institutions, the SSM conducted a comprehensive assessment of the 130 larger banks, adding nine more in late 2015, and since then has ramped up its capital requirements. Many investors quickly considered the entire system sound.

Recent developments in Italy appeared to contradict this picture. It had actually been singled out in the 2014 assessment. One ninth of all banks assessed (15 out of 130) were Italian, but Italy accounted for a third of banks found to be undercapitalized by the end of 2013 (9 out of 25) and even after additional capital raising in 2014 (4 out of 13).

Later media reports suggested that the SSM and Bank of Italy disagreed on capital requirements. The Italian government hesitated over what to do, and its welcome reform of bank cooperatives was riddled with loopholes. In November 2015, Italy hastily introduced an ad hoc scheme to bail out four tiny failed banks, with funding provided by larger (and presumably sounder) Italian banks, but at an ostensibly high cost.

Italian authorities added uncertainty when they advocated a delay in implementing the EU Bank Recovery and Resolution Directive (BRRD, see below), even though this legislation was enacted in May 2014 with Italy’s assent. It is now fully in force, and cannot be modified without majorities in the European Parliament and Council, which are unlikely to materialize.

Long negotiations between Italy and the European Commission to create a “bad bank” have led to a scheme that will have only limited impact

Meanwhile, Italian banks have more than €300 billion in NPLs. Long negotiations between Italy and the European Commission to create a “bad bank” scheme intended to relieve banks of these troubled loans have led to a scheme that will have only limited impact, because EU competition authorities have (appropriately) insisted that transfers not be made at above-market price.

A thorny problem derives from the fact that Italian banks have sold much of their own debt to retail clients who saw this debt—estimated at €200 billion—as safe while prudential and market authorities looked the other way.

In the event of a bank’s failure, the 2014 BRRD implies that these savings will be bailed in (i.e. losses will be imposed on creditors), but the political fallout might be disruptive. Thus Italy, the third-largest country in the euro area, is saddled with large NPL stocks, discord among public authorities, and hard-to-price political and financial risks, in addition to its longstanding high stock of public debt.

The Italian situation does not reflect a failure of the SSM, however, because most of the uncertainty (and all four recent bank failures) concern less significant banks still supervised by the Bank of Italy.

Germany and Austria also have lots of small banks, but most of them are covered by so-called institutional protection schemes, which provide for their bailout and absorption by local peers in case of sudden weakness.

While such schemes create supervisory challenges of their own (on which the SSM has just started a consultation), their viability in Austria and Germany is not a short-term concern. Italy’s banking sector situation is thus uniquely precarious. While it undeniably requires a more decisive approach (and the sooner the better), it does not portend a broader weakness on a pan-European scale.

Uncertainty about future crisis management and resolution

The euro area’s future bank crisis management regime remains blurred. In theory, things are clear. The BRRD dictates future resolution processes. In the euro area, these processes are managed by the second leg of banking union, the Single Resolution Mechanism (SRM), centred on a Single Resolution Board (SRB) in Brussels, itself endowed with a Single Resolution Fund (SRF).

As the saying goes, in theory there is no difference between theory and practice, but in practice there is. The combination of the BRRD and SRM represents a complete change of regime. The automatic bail-in or losses imposed on failing banks’ senior unsecured creditors (up to 8 percent of total assets), and the transfer to the supranational SRB of decision-making authority over resolution schemes, are radical and untested innovations that came into force on January 1, 2016.

Even fundamentally healthy transitions produce uncertainty. The old European regime of taxpayer-financed bailouts was politically unsustainable and aggravated the bank-sovereign vicious circle.

In the absence of a European budget, authorities had to impose costs on debt-holders to underpin banking union and preserve the integrity of the euro area. But the long transition towards full mutualisation of resolution funding at the euro area level (not envisaged before 2024) and the fact that deposit insurance remains purely national have deepened that uncertainty.

In November 2015 the European Commission published a project to create a European Deposit Insurance Scheme (EDIS) as a third leg of banking union, complementing the SSM and SRM. But negotiations among member states have barely started, and Germany is so far less than supportive.

The discussion on EDIS now also includes proposals to reduce the current high home bias in many euro area banks’ sovereign debt portfolios. If adopted, these proposals would harden market discipline for sovereign issuers. Some of the more indebted euro area countries, including Italy, resist them.

Europe’s SRM framework remains a work in progress.

Europe’s SRM framework remains a work in progress. National authorities, not the SRB, are to oversee the implementation of resolution schemes. The legal requirement in BRRD, that no creditor should be worse off in a resolution than if the bank had gone through a court-ordered insolvency, prevents the resolution processes from being consistent across countries as long as bank insolvency frameworks remain different, or even increasingly divergent from one another following several recent national law changes.

The contentious decision by the Bank of Portugal at the end of 2015 to bail in some but not all senior creditors of Novo Banco has put all these challenges into focus. It was made before the SRM entered into force and thus has no precedent value in a narrow sense. But by highlighting the new reality of losses incurred on senior debt, it acted as a wake-up call.

It is a good thing that many investors were thus shaken out of their complacency and became more aware of the current European bank resolution framework, warts and all. These uncertainties will not be removed any time soon. But as the new resolution regime sets in, markets will gradually become more able to price in Europe’s new willingness to let weak banks fail.

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