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Direct Recapitalization Instrument: Banks still die as national

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Banks with problems on their balance sheet normally resolve them through private recapitalization. Though, if it is not possible to find investors, the only way to avoid the collapse is using resolution mechanisms either to orderly restructure or liquidate them. However the too big to fail doctrine limited cases of liquidation to very small and insignificant banks, like it is happening with Banco Madrid, in Spain. Thus, resolution has become a synonym of rescue, and this last represents a dichotomy between banks that were not in too bad a situation and could be attractive for private investors if they received public financial support (for example public guaranties or the acquisition of trouble assets); and those that, directly, did not have any other alternative than public recapitalization.

In Europe a good number of entities that were in difficulties have been, finally, recapitalized by national States. Since rescues consumed huge amount of money, sometimes public figures have been severely affected by them. Regarding the impact of banking recues on sovereign debt, while in the US the reaction was more rapid, consistent and with little impact on sovereign debt, in Europe it was slower, divergent, and sometimes produced sovereign debt crisis.

There are, at least, two reasons that explain these differences. On one hand, unlike in Europe in the US there is a long experience in managing banking resolution at federal level. In the EU, naturally, there was not a common resolution strategy but, even at national level, very few States had comprehensive resolution mechanisms. On the other hand, in the EU the financial system is fragmented and dominated by banks with a high degree of concentration in their markets. This produced the wrong perception that banks in trouble were a national problem and, consequently, that the rescue should be covered by the national resolution funds or, if this would not be enough, by the national budget, increasing the “vicious circle between banks and sovereigns”.

For breaking this link, the European Council agreed the key building blocks of the banking union: the Single Supervisory Mechanism (SSM), the Single Resolution Mechanism (SRM) and funding arrangements, which includes the direct recapitalization of banks by the ESM, thereby shifting the liability of risks to the European level.

However this last instrument is so full of conditions for both banks and requiring states that, firstly, it is very unlikely that it will be used and, secondly, in case it is, it is possible that the only two advantages that it has, namely, not affecting public debt and deficit, would not be enough to cut the interdependence between banks and sovereigns.

Firstly, the instrument was designed as a last option for financially weak Member States that could not afford a national bail-out program but were not in such a bad condition as to have to ask for an ESM State rescue. It does not make sense to ask for State contributions when, in principle, since last December they are not in charge of the supervision of the banking system. This contradiction is even more evident when the instrument can only be used after passing through the European resolution mechanism. If this European crisis management has also failed, why should national Member States pay for the bail-out?

Secondly, since conditions to write-down and bail-in are much stricter in direct recapitalization rather than in traditional ESM-Loans, banking entities (and big depositors) will pressure national authorities not to ask them.

Thirdly, concerning the interdependence between banks and sovereign, it is still unclear whether the direct recapitalization instrument really could avoid it. This interdependence goes beyond the registration of the recapitalization in public figures. This formality is not enough to compensate all the negative effects that the instrument has on the national economy and public finances (contribution of at least 20% of the recapitalization, obligation for the requesting Member State of proving its incapacity to afford a national recapitalization process, European supervision in a similar manner as if it had asked for a ESM rescue). Consequently, apart from some technicalities, direct recapitalization and State bail-out would have similar impacts in markets.

Finally, the short-term lending capacity (€60 billion when, for example, the Spanish recapitalization program used 41.3 billion of European money) of the ESM direct recapitalization has no kind of utility for big banks, normally in big economies. This reduces significantly the target of the instrument and discourages any future reduction of the exigencies, necessarily agreed by big countries, since they will not see it as a useful tool for their own banking crisis. Once again, there is an important ideological background in the design. It always conduces to a marginal application in the peripheries, which would justify shared responsibility conditions to reduce the moral hazard, something that countries that can afford their own programs should not demand to their banks.

By Justo Corti Varela
Professor of EU Law and Post-doc researcher at the Institute for European Studies,
CEU San Pablo University, Madrid.

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