26/12/15: Depositors Insurance or Depositors Rip-off?

What's wrong with this picture?

In simple terms, nothing. The Central Bank has embarked on building up reserves to fund any future pay-outs on deposits guarantee.

In real terms, a lot.

Central Bank deposits guarantee will be funded from bank levies. However, in current market environment of low competition between the banks in the Irish market, these payments will be passed onto depositors and customers. Hence, depositors and customers will be funding the insurance fund.

Which sounds just fine, except when one considers a pesky little problem: under the laws, and contrary to all the claims as per reforms of the EU banking systems, depositors remain treated pari passu (on equal footing) with bondholders (see note here on EU's problems with doing away with pari passu clause even in a very limited setting: http://trueeconomics.blogspot.ie/2015/11/271115-more-tiers-lower-risks-but.html). Now, let's consider the following case: bank A goes into liquidation. Depositors are paid 100 cents on the euro using the new scheme and bondholders are paid 100 cents on the euro using the old pari passu clause.

Consider two balancesheets: one for depositor holding EUR100 in a deposit account in an average Irish bank over 5 years, and one for the bondholder lending the same average bank EUR100 for 5 years.

Note: updated version

Yes, the numbers are approximate, but you get the point: under insurance scheme the Central Bank is embarking on, the depositor and the bondholder assume same risks (via pari passu clause), but:

• Depositor is liable for tax, fees and insurance contributions, whilst facing low interest rates on their deposits; while
• Bondholder is liable for none of the above costs, whilst collecting higher returns on their bonds.

So, same risk, different (vastly different) returns. Still think that insurance fund we are about to pay for a fair deal?..

27/11/15: More Tiers, Lower Risks, But Higher Costs: FSB Latest Solutions to Systemic Crises

The Financial Stability Board (a mega quango set up under the G20 cover to make policy recommendations aimed at assuring that Too-Big-To-Fail banks are brought under some international oversight) has recently issued its position on the bank capital shortfalls under the assessment of their balance sheets designed to ‘prevent taxpayers bailouts of lenders’.

The FSB report based on stress tests stated that big international banks operating globally will have to raise anywhere between EUR42 billion and up to as much as EUR 1.1 trillion in funding by 2022 to cover the shortfall in bailable (special) tier debt that can be written down in the case of a bank running into trouble in the future. The tests explicitly covered what is known as banks’ Total Loss Absorbing Capacity (TLAC) - debt that can be converted into equity when a bank fails, in effect forcing debt holders to shoulder the cost of bank collapse and freeing taxpayers from the need to step in. The TLAC approach to bank funding also breaks the pari passu chain of rights distribution across the banks’ liabilities, separating (at last) depositors from bondholders. (1)

In releasing its estimates for TLAC shortfall, the FSB also provided final guidance as to the levels of TLAC it expects to be held by the globally important TBTF banks: 16% of total bank risk-weighted assets by 2019, rising to 18% by 2022. (2)

To be clear, the TLAC cushion is not an iron-clad guarantee that in a future crisis, depositors’ bail-ins and taxpayers’ supports won’t ever arise. Instead, it is just a cushion, albeit at 18 percent target - a significant one. And the cost of this insurance will also be material and likely to be shared across depositors and borrowers worldwide. Current estimates show the cost of 16% hurdle for TLAC to be around 2% of total income of the largest banks, spread over roughly 4 years, this would imply that up to 1/3 of average bank interest margin can be swallowed by the accumulation of cushion. Maintenance of this cushion will also require additional costs as TLAC instruments will likely carry higher cost of funding.

In a silver-lining for Western banking groups, the hardest hit banks amongst the 30 Globally Systemically Important Banks (GSIBs) (3) FSB are four Chinese banks: Agricultural Bank of China, Bank of China, China Construction Bank and Industrial and Commercial Bank of China, will no longer be exempt from TLAC. These banks currently hold no senior debt liabilities that can count as a part of TLAC cushion. In total, there are 60 GSIBs covered by TLAC, but in Europe, some 6,000 smaller banks are also covered by the Minimum Requirement for Eligible Liabilities (MREL) due in January 2016.

The core point for both, the MREL and TLAC is the issue of ‘loss-absorbing capital’. While the issue has been with regulators since the end of the Global Financial Crisis (2010), there is still no clarity on the mechanics of how this concept will work in the end. Currently there are three channels through which liabilities can be subordinated (bailed-in) in case of a crisis. All relate to bank-issued debt instruments:

1. Contractual channel for subordination: banks can issue senior subordinated debt (tier-3 debt) which ranks ahead of tier-2 debt already outstanding in case of normal crises, but is bailable in the case of a structural crisis. 
2. Statutory channel: bank-issued debt can be subordinated by statute.
3. Structural channel: bailable debt is issued through a holding company to be subordinated to debt issued by the bank itself.

Euromoney recently covered these channels, concluding that whilst all three channels are complex, contractual channel is the hardest to structure. It appears that FSB view is that the contractual channel is the one to be pursued. In contrast, Italian authorities have pursued statutory channel, with legislative proposal to make un-guaranteed depositors super-senior liabilities, bailable only in the last instance. German legislation currently in draft stage will make all bonds suboridinatable in the case of bank insolvency. Another case of statutory instrument that defines contractual subordination channel is Spanish regulator introduction of a legislation that will simply subordinate all tier-2 debt by creating a tier-3 debt wedged between senior and tier-2 debt. In contrast, two Swiss GSIBs - Credit Suisse and UBS - have issued at holding company bonds in 2015, opting for the structural channel to subordination. Finally, in the U.S. the Federal Reserve already applied (as of October 30, 2015) the TLAC standards, covering eight of the biggest U.S. banks, with total shortfall of long-term debt arising under TLAC rules estimated at $120 billion. On November 9, U.S. giant Wells Fargo & Co announced that it will need to issue between $40 billion and $60 billion in new debt to cover TLAC requirements, with $40 billion representing the minimum required volume.

Per Fed, U.S. GSIBs will be required to hold:

• A long-term debt balance of 6% of their respective GSIB surcharge of risk-weighted assets or 4.5% of total leverage exposure, whichever is greater; 
• Maintain a TLAC amount of 18% of RWAs or 9.5% of total leverage exposure, whichever is greater. 
• Maintain sufficient high-quality assets (proposed in 2014) as well as a cushion to raise capital levels by an additional $200 billion, over and above the industry requirements. (4)

The key problem with the most functional - contractual and statutory - channels is that TLAC approach requires creation of a new tier-3 debt that has to be ‘wedged’ between current senior and tier-2 levels. And this, as noted in Euromoney article (5) can violate the pari passu clauses already written into existent bank debt.

In simple terms, the regulatory innovations aiming to address the need to break the link between the state and the banks, including for the systemically important banks, seems to continue going down the route of creating added tiers of risk absorption that improve, but not entirely remove the problem of banks-sovereign contagion. At the same time, all these innovations continue to raise the cost of running basic banking operations - costs that are likely to translate into more expensive credit and lower credit-related activities, such as capex and household investment. On long enough time frame, if successful, the new tier of bank debt can, if taken to higher ratios, displace the problem of pari passu vis-a-vis the depositors. Question is - at what cost?


(1) Some basic details are available here: http://www.financialstabilityboard.org/2015/11/total-loss-absorbing-capacity-tlac-principles-and-term-sheet/,  http://www.euromoney.com/Article/3408580/TLAC-what-you-should-know.html and http://www.financialstabilityboard.org/2015/11/total-loss-absorbing-capacity-tlac-principles-and-term-sheet/

24/2/2013: EU's Banking Union Plan Can Amplify Moral Hazard It Is Designed to Cure

In a recent note, Germany's Ifo Institute (Viewpoint No. 143 The eurozone’s banking union is deeply flawed February 15, 2013) thoroughly debunked the idea that the European Banking Union is a necessary or sufficient condition for addressing the problem of moral hazard, relating to the future bailouts.

Per note (emphasis is mine), "Largely ignored by public opinion, the European Commission has drafted a new directive on bank resolution which creates the legal basis for future bank bailouts in the EU. While paying lip service to the principle of shareholder liability and creditor burden-sharing, the current draft falls woefully short of protecting European taxpayers and might cost them hundreds of billions of euros."

Instead of directly tackling the mechanism for bailing-in equity and bondholders in future banking crises, "the new banking union plans may... turn out to be another large step towards the transfer of distressed private debt on to public balance sheets..."

Here's the state of play in the euro area banking sector per Ifo: ECB "has already provided extra refinancing credit to the tune of EUR 900 billion to commercial banks in countries worst hit during the crisis... These banks have in turn provided the ECB with low-quality collateral with arguably insufficient risk deductions. The ECB is now ...guaranteeing the survival of banks loaded with toxic real estate loans and government credit. So the tranquillity is artificial."

I wholly agree. And worse, by doing so, the ECB has distorted competition and permanently damaged the process of orderly winding down of insolvent business institutions, as well as disrupted the process of recovery in terms of banking customers' expectations of the future system performance. Per Ifo, "Ultimately, the ECB undermines the allocative function of the capital market by shifting the liability from market agents to governments."

The hope - all along during the crisis - was always that although the present measures are deeply regressive, once the current crisis abates and is reduced from systemic to idiosyncratic, "the European Stability Mechanism (the eurozone’s rescue fund – ESM) and the banking union plan [will impose] more [burden sharing of the costs of future crises on] private creditors".

The problem, according to Ifo is that neither plan goes "anywhere near far enough" to achieve this. "..the “bail-in” proposals suggested by the European Commission as part of a common bank resolution framework [per original claims] “should maximise the value of the creditors’ claims, improve market certainty and reassure counterparties”".

Nothing of the sorts. Per Ifo: "Senior creditor bail-ins are explicitly ruled out until 1 January 2018, “in order to reassure investors”. But if bank creditors are to be protected against the risk of a bail-in, somebody else has to bear the excess loss. This will be the European taxpayer, standing behind the ESM."

"The losses to be covered could be huge. The total debt of banks located in the six countries most damaged by the crisis amounts to EUR 9,400 billion. The combined government debt of these countries stands at EUR 3,500 billion. Even a relatively small fraction of this bank debt would be huge compared to the ESM’s loss-bearing capacity."

Ifo see this four core flaws in "institutional architecture" of the bail-in mechanism:

• "First, the write-off losses imposed on taxpayers would destabilise the sound countries. The proposal for bank resolution is not a firewall but a “fire channel” that will enable the flames of the debt crisis to burn through to the rest of European government budgets." 
• "Second, imposing further burdens on taxpayers will stoke existing resentments. Strife between creditors and debtors is usually resolved by civil law. The EU is now proposing to elevate private problems between creditors and debtors to a state level, making them part of a public debate between countries. This will undermine the European consensus and replicate the negative experiences the US had with its early debt mutualisation schemes." 
• "Third, asset ownership in bank equity and bank debt tends to be extremely concentrated among the richest households in every country. Not bailing-in these households’ amounts to a gigantic negative wealth tax to the benefit of wealthy individuals worldwide, at the expense of Europe’s taxpayers, social transfer recipients and pensioners."
• "Fourth, the public guarantees will artificially reduce the financing costs for banks. This not only maintains a bloated banking sector but also perpetuates the overly risky activities of these banks. Such a misallocation of capital will slow the recovery and long-run growth."

Note that per fourth point, the EU plans, while intended to address the problem of moral hazard caused by current bailouts, are actually likely to amplify the moral hazard. In brief, "...the proposal for European bank resolution exceeds our worst fears."

Note that the Ifo analysis also exposes the inadequacy of the centralisation-focused approach to regulation that is being put forward as another core pillar of crisis prevention. "A centralised supervision and resolution authority is necessary to address the European banking crisis. But that authority does not need money to carry out its functions. Instead bank resolution should be subject to binding rules for shareholder wipeout and creditor bail-ins if a decline in the market value of a bank’s assets consumes the equity capital or more. If the banking and creditor lobbies are allowed to prevail and the commission proposal passes the European parliament without substantial revision, Europe’s taxpayers and citizens will face an even bigger mountain of public debt – and a decade of economic decline."

I couldn't have said it better myself.