Michael Quicke is the chief executive of CCLA, investment managers of the Public Sector Deposit Fund and Local Authorities’ Property Fund
At the height of the financial crisis, the UK Treasury, like many other finance ministries around the world, took unprecedented action to protect all depositors in banks suffering insolvency or a severe decline in market confidence. The central banks maintained liquidity to allow banks to function, ensured they had sufficient capital and where necessary injected public funds to keep them going. In the UK, billions were injected into RBS and Lloyds, Northern Rock and Bradford & Bingley as they were nationalised.
However, in practice, central banks and governments didn’t really want to protect all depositors, they just wanted to protect some: the small retail depositors (because they vote in elections), and inter-bank depositors (because fear of inter-bank losses spreads panic around the system). Unfortunately, whoever they are, in legal terms all of the depositors were the same, just another unsecured creditor. As a result, the only legal way that they could protect their favoured depositors, was to protect them all, and stand full square behind the system. When the depth of government support became clear, this made the job of selecting banking counterparties relatively simple.
Having wheeled the system out of intensive care there was agreement between the international monetary and financial authorities that they should not be forced to provide this kind of support again. As a result, in most developed markets, preparations began to formalise “bank bail-ins”. In the UK this has resulted in the Financial Services (Banking Reform) Act 2013. The purpose of the new legislation is to allow the Bank of England to select the depositors they want to protect, and enforce a hair-cut on the rest to ensure that the government no longer picks up the tab.
In technical terms, a bail-in involves shareholders of a failing institution being divested of their shares and creditors of the institution having their claims cancelled or reduced to the extent necessary to restore the institution to financial viability. The shares can then be transferred to affected creditors to provide the necessary compensation. Alternatively, where a suitable purchaser is identified, the shares may be transferred to them, with the creditors instead receiving compensation in some other form.
The bail-in regulation will help to ensure that shareholders and creditors of the failed institution, rather than the taxpayer, meet the costs of failure. In the event of a bail-in it will also ensure that the failed institution
can continue to operate and provide essential services with limited disruption to its customers. At the same time, the process should maintain public confidence in the banking system.
The rating agency, Fitch recently commented that the progress being made in implementing these legislative measures will reduce the implicit sovereign support in most of the major global bank ratings. Fitch therefore expects a number of financial institutions to be downgraded over the next two years, resulting in some banks’ short-term rating actually falling below the prestigious highest level ‘F1’. A large number of banks will probably also see their Support Rating Floor changed to “No Floor” status.
This means that we will all have to assess the creditworthiness of banks on their own independent merits, and not be able to rely on the “too big to fail” test, as wholesale depositors, such as local authorities, will be able to lose money on their deposits without the bank failing.
In practice, it will make careful monitoring of counterparties and diversification of deposits much more important. Either a lot more work, or a another good reason to use an AAA money market fund, such as The Public Sector Deposit Fund.