EU bail-in proposal brings big banks back into fashion

May 25 could turn out to be the start of a quiet revolution for European Union banks. If the blockbuster package of reforms approved by EU finance ministers that day is implemented, the future will belong to the big lenders. At the same time, no bank, whatever its size, will be too big to fail.

That’s the theory, anyway. Although this outcome does not sound bad, the road there will be painful, for some banks in particular.

The proposed reforms to the Bank Recovery and Resolution Directive (BRRD) specify how banks must build controversial buffers of bail-in debt, which could be converted into equity if the firm is placed into resolution, avoiding the need for a public bailout.  

The problem is issuing such debt is expensive because investors demand high returns to account for the risk they might never get their initial investment back.

The bank’s size and country of origin play a role in those costs. At the high end, the European Banking Authority has predicted that subordinated debt would cost the same as equity for mid-sized banks that are not large enough to be deemed systemically important by the EBA, as well as for all banks, including the largest lenders, in countries that required international bailouts during the eurozone crisis – namely, Cyprus, Greece, Ireland and Portugal.

What’s more, many banks will struggle to sell enough bail-in bonds to beef up or, in some cases, create the required buffer from scratch. That’s partly because the market for such bonds may be about to shrink dramatically.  

The affected institutions will want assurances that supervisors will actually use this discretion. If not, the BRRD II will make banks safe to fail, but prevent many from succeeding

European retail investors have traditionally been significant buyers of banks’ subordinated debt as a way to get more out of their savings, especially in France, Italy, Portugal and Spain. However, banks will probably now target retail customers a lot less, if at all, as product governance rules introduced in January require them to demonstrate that subordinated debt is an appropriate product for amateur investors.

Thirdly, even if banks manage to build up a sufficient bail-in buffer, many will see their net interest margins destroyed as a result. This is a big risk for banks that rely heavily on cheap retail deposits for funding, such as those mid-tier lenders that are not systemically important, many of them based in Italy and Spain. These banks will be forced to expand the liability side of their balance sheets by selling subordinated debt, but might not be able to put that pricey funding to work by, for example, growing their mortgage book.

The BRRD II proposal agreed by finance ministers gives supervisors the freedom to accept a lower bail-in buffer from banks with limited access to capital markets. The equivalent proposal by the European Parliament includes the same wording on discretion.

The affected institutions will want assurances that supervisors will actually use this discretion. If not, the BRRD II will make banks safe to fail, but prevent many from succeeding.

This might be exactly what policymakers want. One European Commission official has already suggested tougher prudential rules could drive more bank consolidation in the EU. The bail-in rules, which put smaller banks at a disadvantage, may well prompt banking mergers and acquisitions.  

The result does not have to be a return to ‘too big to fail’ though. If you can make banks systemically safe, no matter their size, then making them big enough to succeed might not be such a bad idea after all.

Editing by Olesya Dmitracova