EU Lawmakers Put Senior Bank Creditors in Line for Losses

Senior unsecured creditors in European banks may be forced to take losses before public money can be injected to prop up a lender, as lawmakers’ two-year push to prevent a recurrence of the bailouts that followed the collapse of Lehman Brothers Holdings Inc. nears completion.

The European Parliament approved a bill today that requires 8 percent of a failing bank’s liabilities to be wiped out before recourse can be made to industry-financed resolution funds and other backstops. The rules must also be passed by the EU’s 28 national governments.

“The EU is putting in place some of the clearest, toughest rules in the world on who should take the hit when a bank fails,” said Michel Barnier, the EU’s financial services chief. “Our guiding principles are to protect taxpayers and honor the promises given to depositors by public guarantee schemes.”

EU governments provided 592 billion euros ($818 billion) to support banks from October 2008 through the end of 2012, according to the European Commission. The approach to banks in crisis has varied. The Netherlands nationalized SNS Reaal NV last year without writing down unsecured senior debt holders, while such creditors were targeted as part of the euro area’s bailout of Cyprus.

German Finance Minister Wolfgang Schaeuble has said the writedown rules, as set out in the Bank Recovery and Resolution Directive, are “the best instrument to make sure that the bill is taken by the industry and not by the taxpayer.”

Common Fund

In addition to BRRD, the parliament voted today on a slew of interlocking bills intended to rein in and shore up the financial industry to prevent taxpayer-funded bailouts. Lawmakers approved legislation to create a Single Resolution Mechanism for euro-area banks with a common 55 billion-euro fund to cover the cost of saving or shuttering lenders. Levies on banks will fill the fund over eight years.

“A fully fledged Single Resolution Mechanism is an essential pillar for an effective banking union,” said Martin Schulz, president of the European Parliament. “From now on, taxpayers will not systematically foot the bill for bank losses. Bailout will not be the default setting.”

Lenders will also have to contribute to standing national funds equivalent to 0.8 percent of guaranteed deposits after lawmakers gave final approval to the Directive on Deposit Guarantee Schemes.

‘Key Parts’

The levies place an extra financial obligation on lenders at a time when the European Central Bank is struggling to free up credit for small businesses to boost the euro-area economy.

BRRD also provides powers for regulators to impose legal and structural changes on banks to ensure they can be smoothly wound down, and to remove a stricken bank’s management.

“Agreement on the BRRD and SRM are key parts of the regulatory reform agenda,” said Simon Lewis, chief executive of the Association for Financial Markets in Europe, an international industry group that represents lenders including Deutsche Bank AG, BNP Paribas SA, and Goldman Sachs Group Inc.

“They are crucial steps that will address the issue of ‘too-big-to-fail’ and provide the authorities with the powers to ensure that all banks in Europe can, when required, be resolved in an orderly manner without resorting to taxpayer bailouts,” he said.

For all the EU’s attempts to take taxpayers off the hook for failing banks, the current legislation leaves important questions unanswered, said David Ereira, a partner at Linklaters LLP in London.

‘New Credit’

“The key issue of how failing banks will be paid for remains” even when the Single Resolution Mechanism bill becomes law, Ereira said. The planned common fund “may need more resources than it has, and the fear of bail-in could in turn have a knock-on effect on bank funding costs as markets price for greater risk, so limiting the capacity of the banking system to provide new credit.”

Under the creditor-loss rules, holders of ordinary shares would face losses first, followed by holders of other instruments that count as capital, such as preferred shares and junior bonds. Should this be insufficient, senior unsecured creditors would be targeted.

Creditors will be protected from suffering losses heavier than those they would have incurred had the bank been put through normal insolvency proceedings.

Special arrangements would apply for bank depositors, with holdings of as much as 100,000 euros automatically shielded from writedowns.

Capital Markets

Parliament’s vote on the rules “again highlight the need for banks to continue to bolster their overall capital position,” said Richard Reid, a research fellow for finance and regulation at the University of Dundee in Scotland.

“It’s probably also true that tougher writedown rules will not hit all banks equally, as some are able to tap capital markets much more readily than others,” he said.

Caveats in the rules include that secured liabilities, such as covered bonds, and also short-term inter-bank loans, should be protected from forced losses.

Authorities would be handed some powers to shield other creditors if they considered that writing them down would do more harm than good.

Nations would also have some scope to escape imposing further writedowns beyond the 8 percent minimum, and resort to taxpayer money, on the grounds that state support is needed to tame a systemic crisis. Such steps would need approval from the European Commission in its role as a competition regulator.

State Aid

The plans go beyond existing EU rules on state aid to banks, which state that a bank’s shareholders and junior bondholders should face losses before public money is used to restructure the lender.

“It can’t be that bondholders only see the upside of their investments, but pass on the downside to taxpayers,” Barnier said. “It is socially unacceptable. Banks’ creditors can’t be allowed to privatize the gains but socialize the losses.”

While the EU puts in place its rules, work is also under way at international level on how to handle a crisis at global banks.

Bank of England Governor Mark Carney, who chairs meetings of the Financial Stability Board, a group of central bankers and regulators, said earlier this month that “further intense work” is needed.

The FSB plans include setting common minimum rules to ensure that banks have enough capital and other liabilities that can be targeted for writedowns.

The EU rules leave it to authorities to set such rules, with the caveat that the European Commission and the European Banking Authority will study options for a common standard.