Draghi reveals how failing banks will be dealt, may cut interest rates soon

Olli Rehn, Member of the European Commission (EC) in charge of Economic and Monetary Affairs, (in the centre) and Michel Barnier, Member of the EC in charge of Internal Market and Services (on the right), participated in the conference on the theme “To strengthen the foundations of integrated and stable financial markets”. This was the second of a series of annual conferences that the EC organised jointly with the European Central Bank (ECB). Mario Draghi, Governor of ECB (on the left). (EC Audiovisual Services).

The governor of the European Central Bank, Mario Draghi, speaking yesterday in his regular monthly Press conference after the Governing Council meeting, was rather straight forward on two crucial fronts. First, he left to be clearly understood that if the now prevailing unfavourable economic conditions in the Eurozone continue, with recession dragging on and the resumption of economic activities looking uncertain, the ECB will reduce its basic interest rate below the present level of 0.75%. Presumably this measure will be taken before June that is in the next Governing Council’s regular meeting at the beginning of next month, May.

The second issue that Mario Draghi covered extensively was the procedures which were followed in the past and will be followed in the future in confronting bank failures. He observed that in the two recent cases of banks resolutions or rescues in Cyprus and Holland, two completely different methods were followed (bail-in and bailout). He commented on that by saying “the absence of ex ante rules gives the impression of an ad hoc approach in such situations, which is unavoidable in the absence of rules because there are differences in size – in the sense that Spain is not Cyprus – and differences in time in the sense that the events in Ireland and Spain took place at completely different times”. After that he concluded that the preferred way to act in such cases is the bail-in. But let’s see all that in detail, starting from the economy and the interest rates.

Economy and interest rates

Draghi by letting so openly to be understood that the ECB is ready to reduce its basic interest rates, made an indirect acknowledgment that the Eurozone economy is in a mess. All first year students of economics know that central banks reduce their interest rates in the bad times. This is done in order to support consumption and investments to resume a faster pace and help the economy start growing again.

His strong remark, “we stand ready to act”, meant clearly that the ECB is ready to further cut down its interest rates. The statement was so clear, that it could mean this may be realised at the beginning of next month. This almost certainty probably denounces a hidden fear in the ECB, that Eurozone’s economy may not recover during the second half of the year, as many predicted until now. Probably any sign of recovery is not visible at all in ECB’s crystal ball, because the governor also observed that recession is now touching on countries which have no financial problems at all (non-fragmented financial markets).

In this respect it’s very interesting to quote his exact words: “we acknowledge that developments recorded in last year’s fourth quarter (recession) have extended into this year and show weakness. Second, we now have confirmation that the HICP (headline inflation rate) is edging down, to well below 2%… Third, we can now see that this weakness (of the economy) is extending to countries in which (financial) fragmentation is not an issue…having said that, we will assess all incoming data and stand ready to act”. From the mouth of the central banker this reveals an obvious fear that the Eurozone economy may be heading towards a long recession period.

Bank rescues

Now concerning the resolution or the rescue of failing or about to fail banks, Draghi clarified in the most transparent way that the ECB favours the solution of bail-ins (using depositors money), not the bailouts (using taxpayers money). Before that however he rushed to note that the method used in the  Cypriot banks’ rescue and resolution, by bailing in their unsecured deposits, is not a template. He insisted on that for an apparent reason.

It goes like that. Draghi wanted yesterday to clarify at some point during his Press conference that he favours the bail-ins. But before 2015 when the bail-ins will predictably become compulsory and known ex ante to everybody, he didn’t want to create an additional question mark over Eurozone banks. The idea is that what happened with the two Cypriot banks, has cast a shadow on every Eurozone lender and depositors do not know what exactly will happen, if their bank becomes insolvent. So Draghi, while favouring the bail-in method didn’t want at the same time discourage depositors.

This is what Draghi said on that: “A bail-in in itself is not a problem: it is the lack of ex ante rules known to all parties and the lack of capital buffers or other “bail-inable” assets that may make a bail-in a disorderly event. The existence of buffers of “bail-inable” assets is therefore essential. In the case of Cyprus, one peculiarity was the fact that these assets were actually quite limited by comparison with the size of the banks’ assets…There is thus a need for rules. The European Commission is the one that writes the rules, no one else. A draft directive is now under discussion in the European Council and the European Parliament that specifies a pecking order of the categories of asset holders that could be bailed-in. In this context, we would really like to see these rules enter into force, not in 2018 or 2019 as is envisaged, but much earlier, for example in 2015”.

This is the Commission’s proposal for a directive, that the Sting presented exclusively on Sunday 31 March in an article by this writer, under the title “EU Directive makes haircut on uncovered deposits a standard in bank bail-ins”. It is clear by now that until this directive becomes law some time in 2015, failing banks will be dissolved or rescued either by the bailout or the bail-in or both methods. This will depend on time, size and the availability of “bail-inable” assets. Mind you Draghi said all that about bailouts and bail-ins, while answering a question about the instability in Italy.