Blog Post

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. 

By: Date: June 24, 2014 Topic: European Macroeconomics & Governance

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.

 


Republishing and referencing

Bruegel considers itself a public good and takes no institutional standpoint. Anyone is free to republish and/or quote this post without prior consent. Please provide a full reference, clearly stating Bruegel and the relevant author as the source, and include a prominent hyperlink to the original post.

View comments
Read article More on this topic More by this author

External Publication

La Banca centrale europea

This external publication delves into the new responsibility given to the European Central Bank: supervision on banks in the euro-area. It tells its history and illustrates its functions, structure and responsibilities and the exceptional answers to respond to the "perfect storm" of the crisis.

By: Francesco Papadia Topic: European Macroeconomics & Governance Date: July 31, 2019
Read article More on this topic

Blog Post

European champion-ships: industrial champions and competition policy

This blog post investigates the debate on whether European competition rules should foster European industrial champions, or allow national champions to grow to a European scale. It explores the criteria that one would intuitively ascribe to industrial champions, illustrating the difficulties in defining either ‘European’ or ‘Champion’. It then conducts a brief look into whether EU Merger decisions have impeded the formation of ‘European Champions’.

By: Mathew Heim and Catarina Midoes Topic: Innovation & Competition Policy Date: July 26, 2019
Read article More on this topic More by this author

Blog Post

Modernising European Competition Policy: A Brief Review of Member States’ Proposals

French, German and Polish governments have jointly proposed options for modernising EU competition policy. The debate to recalibrate European competition rules was already well underway. So, it is not surprising that proposals are consistent with other statements made by France and Germany. Yet, proposals do not address current issues weighing on the international competition community, such as conglomerate effects theory or algorithmic collusion.

By: Mathew Heim Topic: Innovation & Competition Policy Date: July 24, 2019
Read article More on this topic

Blog Post

Talking about Europe: Die Zeit and Der Spiegel 1940s-2010s

An on-going research project is seeking to quantify and analyse printed media discourses about Europe over the decades since the end of the Second World War. A first snapshot screened more than 2.8 million articles in Le Monde between 1944 and 2018. In this second instalment we carry out an analogous exercise on a dataset of more the 500 thousand articles from two German weekly magazines: Die Zeit and Der Spiegel. We also report on the on-going work to refine the quantitative methodology.

By: Enrico Bergamini, Emmanuel Mourlon-Druol, Francesco Papadia and Giuseppe Porcaro Topic: European Macroeconomics & Governance Date: July 18, 2019
Read article More on this topic More by this author

Blog Post

Opening speech by Bruno Le Maire

Bruno Le Maire, minister of the economy and finance, delivered the opening speech at Bruegel's event “The Eurozone agreement – a mini revolution?”, 8 July 2019.

By: Bruno Le Maire Topic: European Macroeconomics & Governance Date: July 9, 2019
Read article Download PDF More on this topic

Policy Brief

The European Union energy transition: key priorities for the next five years

The new members of the European Parliament and European Commission who start their mandates in 2019 should put in place major policy elements to unleash the energy transition. It is becoming economically and technically feasible, with most of the necessary technologies now available and technology costs declining. The cost of the transition would be similar to that of maintaining the existing system, if appropriate policies and regulations are put in place.

By: Simone Tagliapietra, Georg Zachmann, Ottmar Edenhofer, Jean-Michel Glachant, Pedro Linares and Andreas Loeschel Topic: Energy & Climate Date: July 9, 2019
Read about event More on this topic

Past Event

Past Event

Eurozone agreement: a mini revolution?

What does the new Eurozone budget do, and what does it not do? What are its strengths and weaknesses?

Speakers: Bruno Le Maire and Guntram B. Wolff Topic: European Macroeconomics & Governance Location: Bruegel, Rue de la Charité 33, 1210 Brussels Date: July 8, 2019
Read article More on this topic More by this author

Podcast

Podcast

Director's Cut: Priorities for the new ECB president

In this Director's Cut of 'The Sound of Economics', Guntram Wolff talks to two of the authors of Bruegel's memo to the new ECB president, Maria Demertzis and Grégory Claeys, to specify the most important issues at the beginning of this eight-year cycle and to clarify the parameters within which the new incumbent will have to work.

By: The Sound of Economics Topic: European Macroeconomics & Governance Date: July 4, 2019
Read article Download PDF

Policy Brief

The threats to the European Union’s economic sovereignty

Memo to the High Representative of the Union for Foreign Affairs and Security Policy. The authors describe the current context and the increasing interlinkages between economics and power politics and the role to play in reinforcing and defending Europe’s economic sovereignty.

By: Jean Pisani-Ferry and Guntram B. Wolff Topic: European Macroeconomics & Governance, Global Economics & Governance Date: July 4, 2019
Read article Download PDF More on this topic

Policy Brief

Preparing for uncertainty

Memo to the president of the European Central Bank. Grégory Claeys, Maria Demertzis and Francesco Papadia present the challenges that the next ECB president will face during the upcoming mandate, reinventing monetary policy in a system riddled with uncertainties.

By: Grégory Claeys, Maria Demertzis and Francesco Papadia Topic: European Macroeconomics & Governance Date: July 3, 2019
Read about event More on this topic

Past Event

Past Event

How comprehensive is the EU political realignment?

Has the left-right divide become obsolete in EU politics?

Speakers: David Amiel, Otilia Dhand, Nicolas Véron and Silke Wettach Topic: European Macroeconomics & Governance Location: Bruegel, Rue de la Charité 33, 1210 Brussels Date: June 25, 2019
Read article Download PDF More on this topic

Policy Contribution

Redefining Europe’s economic sovereignty

This Policy Contribution delves into the position of the EU in the current global order. China and the United States increasingly trying to gain geopolitical advantage using their economic might. The authors examine the specific problems that China and the US pose for European economic sovereignty, and consider how the EU and its member states can better protect European economic sovereignty.

By: Mark Leonard, Jean Pisani-Ferry, Elina Ribakova, Jeremy Shapiro and Guntram B. Wolff Topic: Global Economics & Governance Date: June 25, 2019
Load more posts