— blog published on 1st April 2023 and the underlying article by IREF Europe on 29th March 2023 —
The template created after the Global Financial Crisis of 2007/8 to shield taxpayers from direct bailouts of failed banks has already folded – authorities dare not use it.
The template is to put failed banks into ‘resolution’, with retail and small business depositors receiving compensation up to €100,000 each from a Deposit Insurance scheme, which would then emerge as the sole creditor of the new, resolved bank.
Stakeholders in the old, failed bank would be treated as follows:
| Stakeholder | Treatment | Status in new bank |
| Qualifying depositor with up to €100,000 | Paid out by the Deposit Insurance scheme | None |
| Qualifying depositor with over €100,000 | €100,000 paid out by the Deposit Insurance scheme; the excess is converted into ‘capital-like instruments’ in the new bank | Owner |
| Non-qualifying depositor | Entire investment converted into ‘capital-like instruments’ in the new bank | Owner |
| Holder of debt instrument ranking as ‘Tier 2 Capital’ | Cancelled | None |
| Holder of debt or hybrid instrument ranking as ‘Additional Tier 1 Capital’ | Cancelled | None |
| Holder of ‘Common Equity Tier 1’ | Cancelled | None |
| The Deposit Insurance scheme, insuring qualifying deposits | Pays out up to €100,000 per qualifying depositors | Sole creditor – has a priority claim over the new bank’s assets |
The template cannot be used, though.
Firstly, new national debt would have to be issued to fund the Deposit Insurance scheme and enable the pay-out to depositors. Increasing the national debt would present political as well as financial problems: the resolution would look exactly like ‘taxpayer support’ when the new debt was the liability of all taxpayers.
Secondly, the exit route for the Deposit Insurance scheme might be closed. Resolution should be a process to relieve the failed bank of the sums owed to non-qualifying depositors and holders of capital instruments, resulting in a comfortable surplus of assets over liabilities. The new bank can then be sold or floated, enabling the Deposit Insurance scheme to be repaid and any new national debt retired.
However, banks’ capital cushions are thin. Nor are there metrics to ensure a minimum layer of ‘non-qualifying depositors’ in the old bank. The holdings of these depositors should be ‘bailed in’ to the new bank, making them the new bank’s owners and its suppliers of the new capital cushion, replacing the thin one in the old bank that has been cancelled.
What happens if the new capital cushion is also thin? The claim of the Deposit Insurance scheme might still exceed the value of the new bank’s assets. Part of the addition to national debt then becomes permanent. This risk is acute where the failed bank had a large portfolio of Non-Performing Loans.
The upshot is that authorities dare not implement the ‘resolution’ process. Instead there is a rescue by a ‘white knight’ and at a discounted price (or even a net negative price): Santander’s purchase of Banco Popular, and Intesa SanPaolo’s of Veneto Banca and Banca Popolare di Vicenza.
Now rule-bending is being added to speed things along. The proposed ‘white knight’ deal for UBS to rescue Credit Suisse incorporates a ‘resolution’ action – the cancellation of Credit Suisse’s Additional Tier 1 Capital bonds – but without Credit Suisse being in resolution and without the simultaneous cancellation of Credit Suisse’s Common Equity Tier 1, which should take the first loss.
This feels extra-judicial: the holders of Credit Suisse’s Additional Tier 1 Capital bonds are bound to take legal action and may cause the deal to be delayed, fall through or be materially altered.
The UK government’s solution to Silicon Valley Bank UK is extra-judicial, permitting HSBC UK Bank plc – HSBC’s ‘ringfenced bank’ – to be the acquiring entity when ‘ringfencing’ rules preclude it from banking complex corporates, SVB’s client base.
Authorities act speedily in all these cases, but not necessarily advisedly. They have killed off Bank Resolution and indulged in rule-bending in their haste to declare a rescue. Rule-bending kicks away a fundamental underpinning of a capital market: investors must enjoy legal certainty over how their holdings will be treated. Riding roughshod over such concerns may serve authorities in the short term, but it risks the destruction of capital markets.