EU proposes overhaul to stop bailouts

THE EU released a set of proposals yesterday that would give regulators the power to take over failing banks and impose haircuts on senior bondholders.

The European Commission, headed by Michel Barnier, published the 100-page document, which is to form the basis for consultation submissions until 3 March.

The document outlines plans to create a “resolution authority” for national regulators, giving them the power to assume control of systemically important financial institutions that are insolvent or failing to comply with the Basel III capital requirements.

Such a rule would enable regulators such as the Financial Services Authority (FSA) to appoint a regulator which would take over the board’s responsibilities with a mandate to protect the stability of the financial system.

In order to achieve stability, the regulator could be able “to write down by a discretionary amount or convert to an equity claim, all senior debt deemed necessary”.

The proposal is intended to ensure that taxpayers do not have to assume the cost of expensive bailouts for collapsing banks that are “too big to fail”.

It would mean that senior bondholders, as well as shareholders, could see their investment wiped out in the event of a bankrupty.

In order to pay for the cost of winding up a failing bank, the document also proposes the creation of national deposit guarantee schemes. These would be funded by the banking industry to “ensure that for both resolution and deposit guarantee there are robust arrangements that impose the costs of any intervention on the banking sector and not on taxpayers”.

In addition to unwinding the bank, the document also suggests that the resolution authority has the ability to transfer assets from a failing institution to others willing and able to take on the risk.


Purpose of the regulations
The European Commission (EC) has released a consultation document laying out a framework for regulations intended to prevent taxpayers having to bear the huge cost of bailouts when systemically important credit institutions go bust. The rules would apply to all financial firms, however, and not just those currently deemed “too big to fail”.

Those concerned have until 3 March to submit responses to the consultation. The new regulations will come into effect in 2013 and the document attempts to reassure current bondholders by stating that any debt issued before then will not be affected. However, if an institution cannot pay back its debts and they are restructured, the new rules could apply.

Resolution authority
The centre-piece of the new regulations would be a “resolution authority” for national regulators. This would give bodies like the UK’s Financial Services Authority (FSA) the power to take over insolvent institutions that threaten the financial system and to either restore them to stability or wind them down in an orderly manner. The aim is to avoid the panic that followed the sudden default of Lehman Brothers in October 2008.

Funding the wind-down
Since winding down a huge institution can incur considerable costs, the proposals also suggest the creation of national deposit guarantee schemes: a fund to meet these costs. The EC suggests that the scheme is funded by a toll on banks so that taxpayers do not have to pay for it.

Imposing losses on bondholders
The resolution authority would also give regulators the power to impose losses on bondholders when a bank collapses. Currently, although shareholders can lose everything, bondholders very rarely suffer a wipe-out. Under these proposals, a regulator in charge of an insolvent bank could decide that even senior bondholders must be forced to take losses or that their bonds be converted into equity.

Transferring assets
A regulator winding down a bank could also be able to transfer its assets to other willing institutions that she deems able to take on the risk.

Prevention of certain activities
In a more contraversial suggestion, the proposals also state that regulators should be able to force a financial institution to stop engaging in certain activities that they think are too risky.

The EC’s struggle will be to craft rules that enable regulators to effectively prevent bailouts, but to avoid making regulators overly powerful for fear of irresponsible use of the new powers.

European Banking Authority
It is not yet clear how the rules will relate to the newly established European Banking Authority, the successor to the current Committee of European Banking Supervisors (CEBS). The EBA could be responsible for overseeing implementation of the rules in European nations.