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Modest proposal on BRRD shows flimsy resolution grounds

Adding retail investors to the buyer base of subordinated bank debt, as was suggested to the European Parliament this week, wouldn’t be nearly enough to make the Bank Resolution and Recovery Directive (BRRD) a workable, practical resolution framework. If retail are going to be allowed into the market, it shouldn’t be because their lack of expertise makes them a good foundation for a stable financial system.

A recent study commissioned by the European Parliament suggesting retail investors must be allowed to buy bank subordinated debt, in order to preserve the credibility of the new bank resolution framework, shows that the Bank Resolution and Recovery Directive is poorly constructed in the first place.

The study, produced for the Economic and Monetary Affairs Committee, says that the existing framework, which went into effect at the beginning of this year, actually requires a retail investor base for subordinated bank capital, essentially because retail investors don’t have the knowledge and capability to act quickly in bond markets if something goes wrong.

That inability to run from the market translates to lower volatility and potentially greater financial sector stability, the paper argues.

The paper explains that allowing retail investors into the market would inherently put them at risks they likely don’t understand, but also offers an explanation of why financial stability requires that they be allowed into the market anyway.

On the face of it, the argument make sense, if for no other reason than that retail investors are already allowed to buy equities, which are, after all, the most subordinated instrument in the capital stack. And how many retail investors truly understand the myriad risks involved in equity investments?

So, sure, let retail investors buy sub debt, or give them the opportunity to get exposure via funds — as long as the reasoning behind allowing them to invest in equities still stands.

But the truth is that if you have to rely on an investor base’s lack of expertise and capability to keep a financial system propped up, you’ve got a very poorly constructed system.

And retail investors are just as, if not more, prone to panic as institutional investors, even if they don’t react as quickly. If depositors end up lining the streets to get their money out of a bank they think is going down, do you not also think they’ll be trying sell out of their subordinated bank debt positions en masse, as well?

The reasoning behind allowing retail in, then, amounts to this: if things get so bad for a given institution that even retail buyers know they need to dump their bonds, then things are actually very desperate indeed.

Add to this that there is already precedent for passing costs back to the state. The banking chaos in Italy last year that ended with the bail-in of retail investors, and the subsequent high-profile suicide of a pensioner, has since resulted in €100m of state-funded compensation to many of those investors. So the state was going to be on the hook either way.

That instance also provides a precedent for any further bail-ins that include retail-held subordinated debt. You can fully expect that the next time a bank goes down, and its retail investors with it, that the calls for government compensation will only be louder.

To rest BRRD on the assumption that just enough of banks’ investors are slow moving and lack expertise and capability to keep the system safe is obviously a bad idea.

On the other hand, the report may have been a disguised recommendation to parliament that they rethink the whole resolution framework from scratch. Good idea, but about as likely as the clean, over-the-weekend resolution of the next failed systemically important bank.

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