The European Commission’s "Framework for Bank Recovery and Resolution" draws on Scandinavia’s hard-line approach during their banking crises in the early 1990s. The goal is to end the pattern of moral hazard and mispricing of risk that generated Europe’s debt woes.
"Banks will fail in the future and must be able to do so without bringing down the whole financial system," said Michel Barnier, the internal market commissioner Mr Barnier’s consultation paper will lead to a "legislative proposal for a harmonized EU regime" as soon as this summer, with an insolvency structure in place by 2012.
The final phase will be the creation of a European Resolution Authority by 2014, adding a fourth pillar to the EU’s new architecture of financial regulation. EU "authorities" typically have their own permanent staff and powers to override national bodies.
The document said regulators should be given "statutory power" to write down senior bank debt, by any amount necessary, or to convert debt into equity. "Such a power would only apply to new debt (or existing debt contracts renewed or rolled over) after entry into force of the power."
Worries over the exact shape of the bondholder haircuts caused credit default swaps on senior European bank debt to rise sharply earlier in the day, with the Markit iTraxx Senior Financials index rising 16 basis points to 196.
Spanish and Italian banks were hit hard, among them Banco Santander, with some lenders in the eurozone periphery at even higher levels than during Europe's so-called "Lehman moment" last May.
The jitters spread to sovereign debt as well. The CDS on Portugal rose 25 points to 525, Ireland rose 18 to 630, Belgium rose 17 to 240, and Spain rose 13 to 350.
The EU plan would apply to all classes of senior debt, with authorities given leeway to act on a case-by-case basis, depending on systemic risk. Some trade creditors and counterparties in swaps and derivatives contracts may be shielded under specific circumstances.
There would be a strict ranking of creditors. "Equity should be wiped out before any debt is written down, and subbordinated debt should be written down completely before senior debt holders bear any losses," said the document. Bonds would be bound by contracts giving the authorities power to impose losses once a "trigger" is activated.
The plans allow oversight bodies to place a "permanent presence" of inspectors in the offices of suspect banks, adopting a scheme already pioneered by Spain’s central bank. There will be annual stress tests, geared to shocks of "low probability but high impact".
Regulators will be able to order bank boards to fire directors, desist from any activity, reduce leverage, sell off assets, or restructure debt.
In extreme cases, they will have pre-emptive powers to take over the entire bank and decapitate top management, perhaps when Tier I capital ratios fall below an fixed level. Stronger banks will be required to help cover the costs of failure by weaker peers, creating a further buffer between the financial industry and the taxpayer.
Mr Barnier, a former French foreign minister and Savoyard ski enthusiast, has worked closely with the authorities in the UK, where similar plans are already under way. Britain is the first of the big EU states to introduce a resolution mechanism.
There were widespread concerns a year ago that Mr Barnier would pursue a "French agenda" to cut the City of London down to size, but he has since won plaudits as a man who genuinely wishes to bolster Europe’s leading financial hub – though on a sounder footing. Jonathan Faull, his right-hand man as director-general, is a British EU official of free-market views.
The concern for bondholders is that the screws may be tightened further as Germany and other states alter the text to alleviate populist pressures at home, or that the decision to seize banks and impose haircuts will become politicized. It is unlikely that either EU ministers or the European Parliament would go so far as to penalise existing debt, which might be construed as retroactive. The legal complications would be enormous.
Mr Barnier has to walk a fine line, doing enough to deter moral hazard without going so far as to cause investor flight from EMU bond markets. His paper says that creditors should be treated fairly, with scrupulous consistency, and in conformity with European rights law. But at the same time, the document recognises that it is hardly healthy if funding costs in Europe are held down "artificially".
Much grief might have been avoided if the EU had created this machinery long ago, before launching monetary union.
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