State aid, bail-in, and systemic financial stability in the EU

Stefano Micossi, Ginevra Bruzzone, Miriam Cassella

Following the financial crisis, the EU banking system is still plagued by widespread fragilities. This column considers the tools and legal provisions available to EU policymakers to address moral hazard and incentives encouraging excessive risk-taking by bankers. It argues that the new discipline of state aid and the restructuring of banks provide a solid framework towards these ends. However, the application of new rules should not lose sight of the aggregate policy needs of the banking system.

The financial crisis of 2008-09 and the ensuing sovereign debt and banking crises within the Eurozone led national governments to underpin the balance sheets of several banks through extensive bailouts, at the expense of taxpayers. Public outrage over the enormous losses placed on taxpayers convinced policymakers and legislators across the Atlantic – under the auspices of the G20 and the Financial Stability Board – that bank shareholders and creditors should be called in to take losses and suffer the full consequences of reckless management through bail-in, before any public back-stop could come into play.

Accordingly, the new EU regulatory system, enacted at record speed in 2013-15, includes provisions on bank resolution establishing the credible promise that shareholders and creditors would carry the full burden of bank losses, mainly through the new burden sharing and bail-in instruments.

In a Special Report recently published with CEPS, we argue that the Treaty principles, the new discipline of state aid, and the restructuring of banks provide a solid framework for combating moral hazard and removing incentives that encourage excessive risk-taking by bankers (Micossi et al. 2016). However, the application of the new rules should resist the temptation of becoming excessively attentive to the case-by-case evaluation of individual institutions, while perhaps losing sight of the aggregate policy needs of the banking system and the economy’s credit needs.

Burden-sharing and bail-in in the current EU legal framework

In its 2013 Communication on the application of Article 107(3)(b) of the TFEU in the banking sector (the Banking Communication), the European Commission stated that, whenever there is a capital shortfall, it will require that any state aid be preceded by all possible measures to minimise the cost of remedying that shortfall, including capital raising by the bank, burden-sharing by shareholders and subordinated creditors, and measures aimed at avoiding the outflow of funds from the bank. However, the Banking Communication provides for an ‘exception rule’ whereby burden-sharing can be derogated when implementing such measures would endanger financial stability or lead to disproportionate results (point 45).

The Bank Recovery and Resolution Device (BRRD), like the 2013 Communication, aims to prevent moral hazard by making the bailout of banks virtually impossible and providing that any extraordinary public financial support will normally entail at least some bail-in of shareholders and creditors, in accordance with the order of their priority claims under normal insolvency proceedings. Under the BRRD, senior unsecured debt instruments as well as uninsured bank deposits may also be bailed-in, while the deposit insurance fund will stand in place for insured deposits.

The only exception to the rule whereby extraordinary financial support requires the write-down or conversion of the relevant capital instruments, are precautionary recapitalisations fulfilling the conditions set forth in Article 32(4)1 – that is, when the institution concerned is solvent, and the injection of funds or purchase of capital instruments takes place “at prices and on terms that do not confer an advantage upon the institution”.

Are the rules on the control of state aid and the BRRD sufficiently flexible?

Expectations on the use of burden-sharing and of the bail-in tool by competition and resolution authorities directly affect the risk of capital instruments in the banking sector and, if not properly governed, may actually become a source of instability, rather than firming up the system. The critical distinction here – not always easy to establish in practice – is that between a crisis affecting one bank and a confidence or liquidity crisis where many banks get in trouble at the same time. In such circumstances, weak balance sheets may create expectations of widespread banking crises possibly triggering bail-in.

The assumption that a private-market solution to higher capital requirements for solvent banks will always be available cannot be taken for granted – even if it would clearly be the preferred solution. Should the need arise for some form of public support in the systemic interest of financial stability, the way in which the new bail-in instrument will be used in different market settings and the ability to take full account of its systemic repercussions are of critical importance.

In view of the current challenges for economic policy, a crucial issue is whether the rules on state aid and those contained in the BRRD, including the rules on burden-sharing and bail-in, are sufficiently flexible to allow member states to adopt the policy measures that may be necessary in the public interest, as has been described in the previous section.

The adequacy of the approach depends importantly on the willingness of the Commission to apply the proportionality principle formally endorsed in its Banking Communication. Some concerns, in this respect, arise from the very specific and narrowly construed circumstances which the Communication refers to when explaining how the exception to burden-sharing will be applied.2

As to the substantive criteria for state aid control, as recently stressed by Advocate General Wahl,3 the only binding legal rule is Article 107. Therefore, member states remain free to notify to the Commission measures that they consider compatible with Article 107(3)(b) even without meeting the conditions set out in communications, and the Commission is under duty to diligently examine their compatibility with the Treaty provisions. Commission decisions may be challenged before the Court of Justice.

Under EU law, for aid measures or schemes to be considered compatible under Article 107(3)(b) it should be sufficient to demonstrate:

The existence of a disturbance in the economy of a member state;

The serious nature of that disturbance;

The capability of the disturbance to affect the whole of the economy of the member state concerned; 4 and

and The necessity of the aid measure and its proportionality to remedy the disturbance, in the general interest, as well as the absence of less-distortive measures to attain an equivalent result.5

As to the BRRD provisions, their interpretation must respect fundamental rights, notably regarding the impact of bail-in on property rights. The Directive recalls the ‘no creditor worse off’ guiding principle. It is clear, however, that the application of the ‘no creditor worse off’ principle is conjectural and complex and it is therefore not sufficient to exclude a priori that the discipline may affect property rights.

The right to property, protected both by the European Convention of Human Rights and by Article 17 of the Charter of Fundamental Rights, is not absolute and must be viewed in relation to its function in society. Consequently, the exercise of the right of property may certainly be restricted by national or EU rules, but only provided that those restrictions correspond to objectives of public interest pursued by the Union and do not constitute, in relation to the aim pursued, an improper or disproportionate interference.

Conclusions

The EU banking system is still plagued by widespread fragilities that are a major source of uncertainty, raising the spectre of a broad-based liquidity crisis in large segments of the banking sector. Rapid action is needed to reinvigorate the financial system ensuring that, overcoming the legacy of the crisis, banks are fully able to play their role as lenders to the real economy.

There is ample room to interpret and apply Article 107(3)(b) TFEU and Article 32 of the BRRD in a way that is consistent with the public interest, the Charter of Fundamental Rights and the proportionality principle. In particular, once it is acknowledged that important parts of the EU banking industry may still need substantial fresh capital to clean their balance sheets and go back to normal lending activities, and that moreover private sources of capital may be insufficient for that purpose, then the competent authorities should be ready to open the way to well-designed precautionary recapitalisations supported by public back-stops.

References

De Grauwe, P (2013) “The new bail-in doctrine: A recipe for banking crises and depression in the Eurozone”, CEPS Commentary, Brussels, 5 April.

Goodhart, C and E Avgouleas (2014) “A critical evaluation of bail-in as a bank recapitalization mechanism”, in F Allen, E Carletti and J Gray (eds), Bearing the losses from bank and sovereign default in the Eurozone, FIC Press, Wharton Financial Institutions Center.

Micossi S, G Bruzzone and M Cassella (2016) Fine-tuning the use of bail-in to promote a stronger EU financial system, CEPS Special Report, No 136, April.

Persaud, A D (2014), “Why bail-in securities are fool’s gold”, Policy Brief 14-23, Peterson Institute for International Economics, Washington, DC.

Endnotes

[1] Article 32 specifies that such recapitalisations, which remain conditional on final approval under the Union State aid framework, shall: (i) be adopted to remedy a serious disturbance in the economy of a member state and preserve financial stability; (ii) be of a precautionary and temporary nature; (iii) be proportionate to remedy the consequences of the serious disturbance of the economy; and (iv) not be used to offset the losses that the institution has incurred or is likely to incur in the near future. Moreover, Article 32(4) also indicates that those support measures shall be limited to injections necessary to address the capital shortfall established in the national, Union or SSM-wide stress tests, asset quality review or equivalent exercises conducted by the ECB, EBA or national authorities, where applicable, confirmed by the competent authority.

[2] Point 45 of the Banking Communication mentions the circumstance “where the aid amount to be received is small in comparison to the bank’s risk-weighted assets and the capital shortfall has been reduced significantly” in particular through capital raising measures endorsed by the supervisory authorities.

[3] Opinion of Advocate General Wahl, case C-526/14, Kotnik and others, 18 February 2016.

[4] Ibid. The opinion of AG Wahl adds that recourse to the legal basis of Article 107(3)(b) TFEU seems even more justified when several member states are affected by a serious disturbance of their economy deriving from a global financial crisis.

[5] See point 53 of the opinion of AG Wahl.