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Monthly Report - Focus
Insolvent banks: the Council opts for bail-in 2.0

At its meeting on 26 June, the European Council reached a joint position regarding how to intervene in insolvent banks in the future. Supported by the European Parliament, this agreement will offer strong protection for retail depositors although it will not completely break the loop between bank risk and sovereign risk.

The Council has ratified the use of the bail-in as from 2018 as the main instrument to recapitalize such banks, sharing losses among bank creditors as a previous step before injecting public money (up to 2018, a system similar to the one in Spain will be used, which the European Commission will specify before August). The order of seniority established is as follows: 1) capital, 2) other capital instruments, 3) junior debt, 4) senior debt and uncovered deposits by large firms, 5) deposits over 100,000 euros by SMEs and individuals, and 6) the Deposit Guarantee Fund (DGF). Excluded from the write-down are covered deposits (those below 100,000 euros), secured liabilities (including covered bonds) and interbank liabilities with maturities of up to 7 days. Moreover, national resolution authorities must establish the minimum percentage of liabilities subject to bail-in which each institution must hold, depending on its risk, size or business model. This percentage might be harmonized as from 2016 if recommended by the EBA.

In spite of the importance of the bail-in, this agreement allows some discretion for national resolution authorities to inject funds without needing to use up all liabilities. The aim of this is to avoid contagion to other banks, ensure the continuity of critical functions or prevent value from being lost. After applying a minimum bail-in equivalent to 8% of the liabilities of the intervened bank, national resolution funds can be used to inject up to an additional 5% before writing down the next liabilities according to the order of seniority. These resolution funds will be pre-funded with annual contributions made by financial institutions until they reach at least 0.8% of the system's covered deposits in 10 years. Should these funds not be enough to reach the additional 5%, the resolution authority could resort
to the Treasury.

The incentives provided by this system are strongly oriented towards protecting retail depositors. On the one hand, in order to improve credit ratings and reduce the cost of senior debt, the banks are very likely to maintain at least 8% of their liabilities in the form of capital or subordinated debt. On the other hand, the resolution authorities will minimize contagion if they decide to inject the 5% before writing down senior debt.

In this way, only losses greater than 13% of assets would involve write-downs of senior debt and deposits of large firms. However, even in this case, the Council's agreement allows resolution authorities to resort to national Treasuries to avoid writing down the uncovered deposits of large firms and retail depositors.

Regarding this role of the national Treasuries as ultimate guarantors for the scheme, the Eurogroup's agreement on 20 June also contains another crucial point: the possibility of the ESM injecting funds directly into intervened banks and thereby weakening the link between bank risk and sovereign risk. This will be possible only if the funds that must be injected by the Treasury jeopardize the state's fiscal sustainability. In any case, the ESM will only contribute once the state has backed the necessary amount to reach 4.5% of the risk-weighted assets. This resource will only be available once the single supervisor comes into force, so that, in principle, it will not be used for the upcoming stress tests.

In brief conclusion, it should be noted that the formula found aims partly to reduce the implicit guarantees enjoyed by banks. The ESM's direct involvement will also help to considerably reduce the possibility of contagion to sovereign debt in the case of individual bank crises. Nevertheless, the mechanism is far from the kind of system that should be in operation in a robust banking union as the state's contribution could still be excessive in situations of systemic crisis, such as the one we are still going through.