ECB headquarters -- no shrinking here.

Photographer: Martin Leissl/Bloomberg

The Incredible Shrinking EU Bank

Leonid Bershidsky is a Bloomberg View columnist. He was the founding editor of the Russian business daily Vedomosti and founded the opinion website Slon.ru.
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European regulators seem intent on making it harder for banks to fund themselves. The painful wind-down of Hypo Alpe Adria Bank in Austria shows government guarantees are no longer ironclad, the German government wants to make senior debt haircuts possible, and the European Central Bank is not disclosing the capital targets that it has set for financial institutions in its new role as their supervisor.

Combined, these developments suggest that buying bank debt is riskier than investors thought. When the European Union leaders debated the Single Resolution Mechanism, which went into effect in August, the idea of bank "bail-ins" before regulators would even think of bailouts felt theoretical. Now, ways of putting it into practice are emerging, and there's nothing for investors to like.

The ECB tells banks in private how much capital they should hold against possible shocks. That information is only revealed in Italy, where the financial market regulator has required it, and by some U.K. banks on a voluntary basis. Fitch Ratings pointed out last month that it would be nice to have the information so investors could assess the risks of buying potentially "risk-absorbing" securities, such as contingent convertible bonds, or CoCos, converted into equity when a certain minimum level of capital is breached. Banks, however, are hesitant to disclose the capital requirements so as not to scare off potential investors.

Germany, meanwhile, is about to set a precedent for other European countries that will make less risky debt instruments than CoCos "loss-absorbing," too. The proposal from the finance ministry is that investors in senior debt should no longer be first in line for repayment if a bank fails, falling behind depositors and those holding the other end of derivatives contracts. 

And, of course, there's the wariness after Austria refused to honor guarantees issued to a bank by one of its regions, Carinthia, for an amount exceeding five years of revenue. What if other European government guarantees are equally shaky?

According to the ECB, in February, 12.7 percent of the total liabilities of the euro area's financial corporations, including banks, took the form of debt securities. That's 4.1 trillion euros ($4.5 trillion) worth of debt, a growing part of which is, in regulators' parlance, "bail-inable."

At the same time, the Financial Stability Board recommends that big banks issue more such securities to create additional capacity for imposing losses on investors if things go wrong. Adhering to the guideline probably will drive up funding costs for banks, as will the growing risk of investing in bank bonds. 

Almost 53 percent of European financial corporation liabilities, or 17 trillion euros, come from deposits -- also an endangered form of funding because of ultralow interest rates. 

So, unless banks plan to start shedding assets (which have increased by almost 2 trillion euros since the end of 2013), financial institutions should look elsewhere for long-term and medium-term funding. The regulators' efforts leave few options other than increasing reliance on central bank money, as banks did during Europe's two financial crises before going back to market funding. 

That, however, isn't what regulators want: They are, quite consciously, trying to hold banks back, telling them to shrink. As Yves Mersch, a member of the ECB executive board, put it in a recent speech, "Many banks grew too quickly before the crisis and developed unsustainable business models, so a period of consolidation is both desirable and inevitable. The aim of the regulatory agenda, which is to make banks more resilient and reduce the burden of bank failure on society, is also fully justified."

In the ECB's January Bank Lending Survey, large banks reported that in the second half of 2014, their assets shrank a little in response to regulatory actions, though their lending standards relaxed slightly. This year, the retrenchment probably will be more pronounced, and banks that don't get regulators' hint will struggle to remain profitable. Other banks' customers should start exploring other funding opportunities -- the capital markets, "shadow banks" such as asset managers and pension funds -- because borrowing from banks will grow more expensive, reflecting a rise in their own funding costs. 

This column does not necessarily reflect the opinion of Bloomberg View's editorial board or Bloomberg LP, its owners and investors.

To contact the author on this story:
Leonid Bershidsky at lbershidsky@bloomberg.net

To contact the editor on this story:
James Greiff at jgreiff@bloomberg.net