An MPS resolution would not be make or break for the BRRD
Europe’s bank recovery and resolution directive (BRRD) could face an important first test this month if Banca Monte dei Paschi di Siena fails to complete its rescue plan. But market participants should not completely write off the new framework, even if the bail-in process does not pan out how they had hoped.
One end to a turbulent 2016 could be that a still-solvent Monte dei Paschi (MPS) is unable to drum up €5bn of fresh capital, is declared failing or likely to fail, and is placed in resolution.
In such an event, market participants will be looking for a clean and clear application of the Bank Resolution and Recovery Directive rules, supposed to lay out how resolution works across Europe. Any whiff of the unpredictable could rattle markets and leave investors wondering how they can price risk reliably across different banks and instruments.
But the situation at MPS is neither clean nor clear.
A particular point of concern is whether the Italian lender will be able to exclude retail-owned debt from "burden sharing" — the regulatory euphemism for taking a write-down.
Though some commentators believe the bank should not be able to protect retail accounts by sparing either individual bonds or individual bondholders from bail-in, the rules are hardly inflexible on the issue.
For example, Article 44 of the BRRD states somewhat vaguely that, in “exceptional circumstances”, “certain liabilities” may be excluded from bail-in where necessary to avoid “widespread contagion” that would “severely disrupt” the functioning of financial markets — meaning any conclusions drawn by resolution authorities could end up being based on semantics as much as any precise reading of the rules.
It is also difficult to see how the BRRD can be applied smoothly when much of the supporting work is yet to be completed.
To using BRRD’s bail-in tool, for example, banks are supposed to meet a minimum requirement for own funds or eligible liabilities (MREL).
While some larger banks have made good progress in raising the necessary quantities of loss-absorbing debt, a substantial part of MPS’s subordinated debt still belongs to the old regime, including upper and lower tier two bonds, for which there is no distinction under the BRRD.
Likewise, the new resolution directive is formed on the principle that no creditor should be worse off under resolution than they would have been under normal insolvency proceedings, but many EU countries are still modifying those very insolvency proceedings to help minimise the probability that investors claim they have been treated unfairly. Nobody knows how legally watertight the no-creditor-worse-off provisions will be in practice.
These caveats do not render any resolution of MPS using BRRD meaningless as an example.
The bank could easily find itself made an example of. If regulators want to use an MPS resolution to demonstrate they are serious about BRRD strengthened, they must make sure they bail bonds in by strictly following the order of the bank’s capital structure, with attendant damage potential for other Italian lenders.
But it is important to recognise — even though the BRRD is technically already in effect — that all the pieces aren't properly in place yet. There's still work to be done to the framework before European authorities can properly put their tools to a real-world test.
That means the market should avoid seeing MPS as a test case, on which the strength and quality of BRRD depends, or as a worked example for resolution in practice.
MPS's troubles have hit too early for the full BRRD package to be ready, so even if the Italian government and European authorities fudge the situation, we shouldn't read it as make or break for BRRD.