17/6/2013: ESM Rules Book Draft

Reuters recently reported [Updated: link is here http://pdf.reuters.com/pdfnews/pdfnews.asp?i=43059c3bf0e37541&u=2013_06_17_11_43_b16e8d8f95d140d2a6693737fcd98885_PRIMARY.pdf  H/T to @Taleof2Treaties] on a document prepared for the Eurogroup meeting in Luxembourg that puts forward more detailed set of rules for ESM deployment in recapitalising the banks.  The rules, as seen by Reuters, involve:

• A private sector bail-in to be required before any ESM contribution can be made. More on this below; and
• The ESM will apply a two-tier test in deciding whether recapitalisation can be carried out: the capital must fall below critical adequacy levels, and the bank must be considered systemic for the eurozone as a whole, not a national system. Which means in the case of Ireland - no recapitalisations of ANY irish bank, neither BofI, nor AIB, nor Anglo. Per ESM rule book, the whole country can go insolvent, as long as Deutsche Bank or Credit Agricole are still floating.

When a bank gets into trouble, the Euro-Troika: ECB, the European Commission and the ESM,

• Will stress-test / value bank’s assets. Euro-Troika will set the required level of capital the bank will require, thus opening the process to the transfer of foreign-held liabilities onto the shoulders of the country taxpayers. For example, suppose an Irish bank X holds 10% of its liabilities against external foreign subordinated lenders. In normal case, these would be forced to take a haircut first. But Euro-Troika can determine that is must make good on full 10%, thus transferring liability fully to the sovereign of bank X domicile via the first requirement that the sovereign must step in ahead of any ESM recapitalization. 
• After determining the amount of capital required, the ESM will also determine if the bank has the minimum legal common equity Tier 1 ratio, currently at 4.5%. If the bank does not meet the minimum, the government would inject between 10% and 20% of the funds shortfall. The ESM will provide the residual.
• If the government cannot meet the demands for 10-20% injection, the ESM will not step in to recap the bank
• Once the bank is recapitalised using ESM funds, ESM will take equity in the bank and will engage in setting bank strategy and business model. The ESM will also track bank performance to targets and will also have power to change bank management and board. This will be a major departure from the modus operandi of the Irish authorities, but to what extent it will be effective / significant remains to be see. After all, pro forma changes can be put in place with minor alteration to the pre-crisis status quo.

The document says ESM will deal with legacy assets, which is an ambiguous statement, but potentially holds some hope for Ireland.