Andrew Lilico: Thoughts on the European Commission proposals for imposing losses on bank bondholders

By Andrew Lilico

Avid readers of mine (you know who you are) will be aware that the EU's proposals yesterday closely match what I contended should have been the approach in late 2008, and that I've argued for ever since - e.g. in What Killed Capitalism?, in Incentivising boring banking, and most recently here.

There are a few of important differences between the EC proposals and mine:

• their concept of systemic risk is much less concrete than mine
• they consider depositor protection a priority, whilst I favour the storage deposits/investment deposits distinction and the use of a deposit access fund (so depositor liquidity, preferential creditor status for investment deposits, and state insurance restricted to gilts-backed deposits)
• they favour a strict asset class wipeout principle, whilst in the recent PX report I argued that dilution is often to be preferred.  (I actually distinguished between two classes of Special Administration: "solvent entity basis" (with dilution) and "insolvent entity basis" (with progressive asset class wipeout, and potentially with restriction of depositor access to 80% of funds during the period of Special Administration).)

There are a couple of reasons one might prefer dilution (in a solvent entity) over wipeout:

1) One thing about the wipeout principle is that because equity is considered dead, I think it would be (and ought to be) legally problematic to implement in a case when the bank is not actually insolvent (if there is residual value in the business, doesn't that value belong to the owners (the shareholders)?).  But we want to be able to place banks into special administration before they are actually insolvent.  If we've done that, I think conversion should occur with dilution (preserving some shareholder value) rather than wipeout.  (I raised this in late 2007 as an objection to the approach taken with Northern Rock.  Wiping out shareholders in entities one claims are solvent just seems wrong to me.)

2) Another problem with wipeout is the one I discuss in the December PX paper - namely that wipeout with conversion creates incentives for senior bondholders to purchase equity then "gamble for resurrection" because then if the gamble turns out well the shares will rise in value, whilst if it turns out badly then junior debt will be wiped out and the equity that senior debtors end up with could be worth more than their initial bonds!

Most of these issues can be addressed in the consultation period.  Storage deposits will happen, because Mervyn King is explicitly in favour of them.  Once they are in place, I hope that insurance of investment deposits will wither on the vine.

One interesting issue is whether the EU will be tempted to rush this through to save the euro.  They say at this stage that they intend for 2012 implementation and that nothing will apply to existing debt, but (a) I think that's a mistake in principle; and (b) I think there is a material risk of the whole thing blowing up before then.  The Eurozone bailouts are just banking sector bailouts under another badge.  If they introduced this mechanism, they wouldn't need Eurozone bailouts (with the possible exception of Portugal - I'm taking it as given that Greece gets kicked out anyway) and the whole thing would survive for a few more years (I leave it to others to conclude whether that would be a Good Thing or not...).