New European legislation covering the way EU financial bailouts will be resolved goes into effect tomorrow as an intermediary step to improve the legal framework for handling the ongoing crisis before the Single Resolution Mechanism (SRM) is finalized next year.

EU’s Attempt To Bail-In Cypriot Depositors

“Bank bailouts will be organized around two major principles,” says Natixis economist Alan Lemangnen. “A restructuring of the institution facing problems will now be a precondition for any disbursement of public aid, and the restructuring plans must provide for a bail-in of shareholder and subordinated debts.” Deposits will be excluded from the process, no surprise after the controversy created by the EU’s attempt to bail-in Cypriot depositors earlier this year.

Europe is getting ready for the AQR

The timing of the new law may seem strange, considering the SRM will come into effect in just five months, but the Asset Quality Review (AQR) is due later this year, and not everyone is optimistic about what the findings will be. If banks fail the EU stress test there could easily be need for another round of aid before the SRM is online.

The ECB and EBA are also not willing to continue with the ad hoc policies that they have been using so far. Before the current banking crisis it was illegal for countries to directly help their banks in the spirit of free competition, but when that policy became unrealistic in 2008 the EU State Aid Law was passed with the primary goal of stabilizing the banks.

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New Policy Leaves Many Practicalities Unaddressed

The EU State Aid Law has come under criticism because it puts off restructuring until banks have been stabilized, and some say this removes the incentive for cooperation. The new law reverses the order, so that if a bank is less compliant it risks going bankrupt before bailout funds are available. For those that imagine rogue banks are the source of the problem this is a benefit, but it creates a number practical problems.

“How will the restructurings be financed?” asks Lemangnen. “Launching a resolution process always generates costs… governments will undoubtedly have to shoulder this spending.” Aside from the additional costs of complying with the new law, banks that are approaching collapse will have to find operating expenses until the EBA is fully satisfied with their plans, which again will likely end up coming from governments.

The change in order also puts more power in the hands of creditor nations, who will have the advancing threat of bankruptcy on their side as restructuring takes place. The Financial Minister of Malta Edward Scicluna memorably wrote about the negotiation process in Cyprus, and how the Cypriot government entered into agreements “with a pistol to the head.”