30 September 2013

ECB/Cœuré: Implications of bail-in rules for bank activity and stability

The scope of bail-in clauses is generally broad, encompassing all liabilities apart from those explicitly excluded. Non-excluded liabilities will be bailed-in following the order of their ranking in national insolvency laws. It is important to stress that the Directive does not exclude other funding sources to manage banking crises. Also, the Directive does not completely exclude the possibility of a bail-out via extraordinary public financial support. Additional to the bail-in rules, the European Commission adapted temporary state aid rules, applicable as of the 1 August, 2013. These rules demand mandatory capital write-down and bail-in of subordinated debt before any public supports is granted. Therefore, these rules further clarify the interaction between bail-in and bail-out in the European Union, even before the BRRD becomes effective, and provide for a level playing field between similar banks located in different Member States.

The implementation of bail-in rules can be expected to affect banks activity both in bank funding and bank lending.

Bank funding

There are many factors to be taken into account:

• The systemic importance of the bank. The greatest effect of the new bail-in rules should in principle be on those banks that would in the past have benefited most from an implicit guarantee. In other words, it should affect more significantly systemically important financial institutions (SIFIs).
• The bank’s liability structure. For those banks that fall short of the bail-in-able debt requirements, the Directive will force them to increase their unsecured liabilities, since secured ones cannot be bailed-in. This could increase overall funding costs, as it would require banks to adapt their liability structure such that more costly debt plays a greater role. But equally, the higher share of senior unsecured liabilities could also result in a lower level of encumbered assets, possibly lowering the overall cost of funding.
• To assess the overall impact of bail-in rules on bank funding, we have to consider their interaction with other initiatives in the field of regulation.
• We have to take into account the effect of bail-in on banks investment and lending behaviour.

By redistributing the risk between tax-payers, depositors and debt holders, bail-in rules can reduce the overall risk in the system. All in all, however, while a good resolution framework is needed, it can only be a complement, and not a substitute for market discipline and supervisory vigilance.

So far, the evidence points to a possible increase in the cost of funding for senior unsecured debt. Indeed, econometric results undertaken at the ECB for a sample of European banks suggest that the announcement of the Directive had so far limited impact on the cost of senior unsecured debt. 

Bank lending

Turning now to the effect of bail-in on bank lending, my baseline assumption is that the higher cost of bail-inable liabilities will have a limited impact on bank lending:

Clearly, if overall funding costs were to rise, this could in theory have an effect on banks’ lending activity: banks may respond by providing less credit and charging higher loan interest rates. That said, I am not certain how realistic this scenario would be in practice. Building on the vast literature on the bank lending channel, one can argue that even if overall funding costs increase, there are several factors that can mitigate the transmission of funding shocks to lending. For instance, capital and liquidity buffers allow banks to shield borrowers from funding shocks and these are in the process of being strengthened by the Basel III requirements.

Concluding remarks

Creating an efficient mechanism to swiftly resolve insolvent banks is a crucial step towards making the costs of tackling bank crises less onerous for taxpayer. While there is a lot of work ahead, a well-designed, comprehensive and consistent regulatory framework for banking resolution, including creditor-funded recapitalisation schemes, will mitigate excessive risk-taking phenomena. By improving financial stability, it would also have a favourable long-term impact on the real economy.

While a good resolution framework is needed, it can only be a complement, and not a substitute for market discipline and supervisory vigilance. The Single Supervisory Mechanism (SSM) and its founding act, the balance sheet assessment and asset quality review of all directly supervised euro area banks that will take place in 2014, can therefore be seen as complementing and supporting the new resolution framework.

Effective resolution is not only about strong rules creating sound incentives, but also about quick judgement and decision-making. Given the inherent instability of financial markets, there is no time for a negotiation between bank creditors and shareholders leading to an equity write off and a conversion of debt into equity, as would be usual outside the financial sector – and in the case of a large systemic bank, such a process would have the potential to impose significant negative externalities on the economy. In this respect, the creation of a strong and independent Single Resolution Authority (SRA) is needed in Europe as a necessary complement to the SSM. The SRA should have the capacity to take swift decisions in the European interest and to tap a Single Resolution Fund financed by the industry.

If these steps are taken, bail-in rules will be conducive to a better monitoring of banks’ risk behaviour and will thereby lead to a better banking system – a system that fulfils its economic role without creating an excessive risk for society.

Full speech

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