ELA, Cyprus, Argentina and the IIF: the structural bull run in creditor confusion
The IIF lashes out over the re-privatization of banking liabilities amid the Cyprus bailout and calls for more transparent restructuring principles. But it's not clear there is an alternative.
In 2012, fears that private eurozone sovereign bond holdings were subordinate to the official sector triggered market distress, given the perception in the market that public officials will change the rules of the game to ensure their holdings were insulated from write-downs, come what may, as was the case in Greece. Fast-forward to 2013 and the Argentina and Cyprus debt-crisesconfirm this oft-cited fear held by creditors: sovereigns and official-sector creditors have substantial freedom and, thus, a self-interest in determining the creditor priority structure that suits them.
The initial and maddening Cyprus sovereign-bank bailout proposal to force losses on insured depositors but not senior unsecured bondholders makes this all too clear.
Although the eurozone crisis underscores the need for a framework to make the relative priority of creditor claims on sovereigns more transparent, it’s vexing task to develop a system that can be agreed and enforced on an ex-ante basis, and that’s not just down to sovereign immunity laws, as in the case of Argentina.
For claims on banks, restructuring is supposed to be clearer but the ECB press conference on Thursday revealed this structural tension once again. Governor Draghi– who reiterated that political commitment to the euro remains “vastly under-estimated”, boosting the euro – was decidedly frustrated over the tone and nature of questioning.
In particular, Draghi argued the Cyprus bailout is neither a turning point nor a template. But he inadvertently confirmed an obvious truth: in the absence of “explicit policy statements by the Eurogroup about the criteria and procedure to decide on how burden sharing is done, market participants could be left to assume that the process might have been driven opportunistically: go where the money is”, the IIF said in a report before the ECB meeting.
Take Draghi’s comments on the emergency lending assistance (ELA) on Thursday, following the controversial decision to move Laiki's ELA to the revamped Bank of Cyprus, along with insured depositors, suggesting official sector seniority of claims. Draghi said: "there is nothing in the market that says that the ELA is senior, but if you want to remain as a counterparty in the ECB’s monetary policy operations, it should certainly be treated as such."
As Marc Chandler, currency strategist at Brown Brothers Harriman in New York, noted, in response to Draghi’s comments: “ELA is loans from a national central bank to local banks, with the ECB’s approval, but at the risk of the local central bank.
“Banks turn to the ELA facility when they do not have collateral acceptable to the ECB. This [and Draghi's comment] seems to throw the ELA out of the official sector and toward the sector that can participate in haircuts and losses.”
With the ELA’s position in creditor hierarchy norms simply one example of market uncertainty over future debt-crisis resolution plans, like a broken record, the IIF published its monthly capital markets report on Wednesday with a focus on sovereign-bank debt restructuring in Cyprus and Argentina, vaguely emphasizing core principles of transparency, debtor-creditor dialogue, good-faith, and fair treatment of all creditors. (The same IIF mission – to flesh out a set of procedures for sovereign bailouts amid a disconcerting lack of harmonized principles – took root in 2004 after the outbreak of the Argentine debt fiasco.)
Amid fears over the re-emergence of private-sector liability for sovereign and bank-bailout costs, the IIF verdict on the Cyprus bailoutwas particularly damning.
It charged: “The rationale for bailing in creditors in bank resolution to protect taxpayers also rings hollow in this case as many taxpayers are depositors and all will suffer greatly from the deeper and longer recession.
“There should be a clear distinction in the discussion between resolving financial institutions in normal circumstances – where the overall banking system is still healthy and the financial system can absorb the losses arising from a few institutions – and during a systemic crisis when most, if not all, of the banking system is under stress and imposing losses on creditors may fuel panic and necessitate capital and banking controls, which could inflict extensive economic damage.”
“Instead of mutualization of bank liability in case of need, it has become about bailing in bank creditors and depositors. Such concerns could exacerbate the current outflow of deposits from troubled countries (Chart 6), adding to bank funding strains.”
The IIF notes that since there will now be no deposit guarantee scheme across the eurozone, combined with the fact the ESM will not be authorized to make direct recapitalization to banks suffering losses from legacy assets, it is now clear that “the liability for potential banking losses remains national and not mutualized within the euro-area”.
The bank lobby group effectively argued that markets have not yet priced in a potentially new – and threatening – dawn for banks: taxpayer funding for their liabilities is now less tolerated in the court of official-sector opinion, a realization that would no doubt please Dutch Finance Minister Jeroen Dijsselbloem, head of the eurogroup.
As a result: “To the extent that expectation of such mutualization of potential national banking losses and/or recapitalization burdens has played a role in the improvement of sovereign debt markets, realization to the contrary may test currently benign market sentiment – particularly given the scale of the banking industry in the euro-area.”
It concluded: “At present, bank creditors and uninsured depositors face a high level of legal uncertainty in the absence of clear resolution provisions. Consequently, weak banks in weak countries will continue to face funding and market pressures (Chart 9), contributing to the ongoing decline in bank lending to non-financial borrowers in problem countries.”
This conclusion is hardly controversial at face-value. But the group is swimming in politically hot waters. Global banking officials have privately told Euromoney that after the IIF’s bearish report on the capital costs of new global bank-regulation, they now hold IIF warnings in low esteem. If the Cyprus bailout fails to trigger wider contagion then the IIF's credibility will be further undermined. What's more, the lobby group's policy prescriptions are unclear.
Although it’s in draft form, it’s unclear that the eventual Cyprus bailout violated standard insolvency guidelines, according to the upcoming EU directive on the recovery and resolution of financial institutions, save for, perhaps, theranking ELA financing above insured depositors, which, in any case, the IIF does not refer to. (This EU directive is designed to provide the IIF with the clarity it is asking for on eurozone bank-resolution procedures fleshed out on ex-ante, rather than ad-hoc, basis.)
What's more, if the IIF is arguing that, for systemically important banks, it is the troika’s job to intervene with taxpayer money it's an overt call for too-big-to-fail to remain structurally embedded in the eurozone financial system. Or, if the IIF is arguing that the troika should have altered the relative priority of creditor claims by protecting all depositors in the Cyprus bailout, it would have, in fact, increased uncertainty over creditor-hierarchy norms. In any case, Berlin has concluded Cyprus is not systemic to the eurozone and the IIF has just forecast that growth, banking stability and the transmission of monetary policy in the eurozone will now be held under siege thanks largely to the precedent established in the Cyprus bailout. That's a big call.