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Will Germany flout Europe’s bail-in rules if Deutsche Bank needs rescuing?

Troubled towers: the HQ in Frankfurt. Kiefer, CC BY-SA

Will Deutsche Bank need rescuing? It’s a question that is being asked as this big beast of global banking gears up to announce its third quarter results on October 27. With losses expected to be north of €600m (£534m), the backdrop is dismal: Deutsche Bank is in talks with the US Department of Justice (DoJ) about a massive fine following an investigation into mis-selling toxic assets by the bank’s US division in the run up to the financial crisis of 2007-08.

The DoJ requested US$14 billion (£11.4 billion) from Deutsche Bank to settle the case last month. The final settlement, which is due any time, may come in somewhere around half that. But that would still be more than the €5.5 billion Deutsche Bank has set aside as a litigation reserve, and there are further losses still expected.

With shares down by close to half since the start of the year, albeit recovered a bit recently, there have been reports that the German government is planning a rescue by buying a stake if the DoJ fine is too onerous. The government denied this, but it raised an interesting question about what will happen if Deutsche Bank does fail.

Under EU rules that came into effect in January, there can be no government bailouts of banks until there has been a bail-in – meaning other creditors to the bank such as bondholders and large depositors taking a share of the pain. The rules are highly controversial and I suspect the Germans will not want to impose them. If so, it will set the scene for an almighty row about double standards.

Bailouts and bail-ins

The new bail-in rules, known as the Bank Recovery and Resolution Directive, are a response to the 2007-08 banking collapses. They were inspired by the UK’s Banking Act 2009, which was passed in the wake of the bailouts of the likes of RBS and Northern Rock.

Britain had previously been shamefully lacking in legislation to cope with bank insolvencies. The new act gave the Bank of England draconian powers to cope with future crises, including the right to modify the amounts owed to creditors on a struggling bank’s balance sheet. This was designed to avoid the need to inject public money in future by making others foot the bill instead.

Who rescues who? Lisa S.

Under the EU’s 2014 directive, there can be no government bailout of a bank until at least 8% of its liabilities have been absorbed. This is a complete break from the past. It means that if a bank becomes insolvent and can’t raise fresh funds from its shareholders, certain liabilities may be reduced by the management in consultation with the country’s financial authority.

One of the main ways in which banks and other businesses raise capital is to issue bonds. Saving vehicles such as pension funds buy these in the expectation they will get the full amount back with interest at the maturity date. But not any more. Now even in a better scenario, the right of these most cautious of savers to be repaid might merely be downgraded to rank the same as all the ordinary creditors waiting to get their money back. The only bank liabilities that cannot now be modified are customer deposits up to roughly £90,000 and a few untouchable exceptions such as employee salaries.

Double standards?

Bailouts essentially protect bondholders to the detriment of the taxpayer, whereas bail-ins do the opposite. Before the new rules were introduced, several test cases showed how divisive bail-ins can be. Cypriot depositors were furious to lose savings en masse when Brussels insisted on a bail-in as a condition of bailing out Cyprus in 2013. There was similar uproar and threats of lawsuits when bondholders of Novo Banco of Portugal had their assets written down last year.

Italians do it different. Niyazz

And while it might make sense from a northern European legal perspective that taxpayer interests should prevail over bondholders, not all countries see it that way. In my native Italy, for instance, public saving has been heralded as a fundamental value for decades. Italy’s banking association questioned whether the EU bail-in mechanism is consistent with the country’s constitution.

There is also the feeling in southern Europe that there are double standards at play with the new rules. Where German and British banks needed bailed out after 2007-08, goes the narrative, the likes of the Italian banks weathered the crisis. They caught a different virus from 2011 onwards after being forced to buy toxic sovereign bonds issued by their governments to stay solvent during the eurozone crisis.

The sense is that British and German politicians and their respective bankers cleaned their respective “houses” with bailouts and promoted the bail-in once the job was done, thinking their banks wouldn’t have to deal with it.

Yet as Deutsche Bank is finding out, you never know what is around the corner. If the worst comes to the worst, I doubt the Germans will follow these Anglo-Saxon rules. It is more likely that there will be a German exception.

If so, it will be a classic example of how hard it is to make rules for the whole of the EU. I can hear the objections from the south of Europe already. Had it been an Italian or Spanish bank, they will say, it would have sparked the traditional tantrum against the peculiar Mediterranean way of interpreting rules and ultimately circumventing them. Unfortunately it will be hard not to agree with them.

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