Six lessons for Europe from the nationalization of SNS Reaal

Recently the Dutch government nationalized the Dutch financial conglomerate SNS Reaal. The intervention was the first use of the Intervention Act introduced in the beginning of 2012. This law is meant to implement the EU draft Directive establishing a framework for the recovery and resolution of banks. The Dutch government decided to bail-in both shareholders and subordinated creditors. The latter contribution reduced SNS Reaal’s deficit by circa €1 billion. The costs to the Dutch taxpayer were still substantial, resulting in a deterioration of the budget balance (excessive deficit procedure definition) for 2013 with 0.6% and an increase in EMU debt of 1.6%. The case provides six lessons for Europe.

First, Institutional arrangements can create externalities. One of the central reasons for the Dutch government to save SNS from bankruptcy was – somewhat paradoxically – the existence of the Dutch Deposit Insurance (DI) Scheme. Other banks participating in the Dutch DI scheme have to repay insured depositors of the failed bank. In a letter to the parliament, the Dutch Central Bank (DNB) argued that this would represent a claim on other major Dutch banks of around 10 billion euro’s per bank. Any shortfall in value of assets would have to be paid for by the other banks. This would create uncertainty in the market that could jeopardize the health of major Dutch banks. The lesson is that the set-up of any DI scheme should be thought-through carefully. Financing the deposit insurance scheme ex ante would surely help. Even then, however, a fiscal backstop remains crucial to be able to guarantee consumer deposits at large banks.

Second, implicit guarantees for too-big-to-fail banks create cross-border spillovers of bank resolution and restructuring. The Dutch government wanted to go further in its bail-in than it eventually did. One of the reasons it abstained from doing so was the threat that a bail-in would raise financing costs for other Dutch banks, but also for banks in other countries (this post looks at the effect of the nationalization on spreads between senior and subordinated bonds). This spillover effect is a direct consequence of the implicit subsidies received by large banks. If one country tries to bail-in a particular class of creditors, markets will consider other countries also more likely to do so. This raises large banks financing costs by reducing implicit subsidies, resulting in spillovers from one country’s restructuring operations to other countries. The lesson is that if countries do not succeed in coordinating they may be caught in a bad equilibrium without restructuring. Unifying resolution schemes across EU countries provides a short-term remedy. The long-term remedy, however, involves addressing too-big-to-fail subsidies. In my view, the only long-term solution is to raise equity levels to higher levels.

Third, there may be double leverage hidden in the European financial system. How does this work? SNS Reaal, the owner of SNS Bank, financed its equity stake in SNS bank partly with debt. By end of June 2012 the amount of double leverage of SNS Reaal was €850 million (see this so-called non-paper) and by the end of 2012 it amounted to €909 million. Consequently, equity in the conglomerate as a whole was lower than the equity in the separate entities. According to the Dutch Ministry of Finance double leverage is ‘often found in bank-insurance conglomerates’. The lesson is that the European banking system may be less healthy than it seems.

Fourth, regulatory forbearance should be considered a serious problem. The CDS spreads of SNS were higher than those of other European banks with balance sheets of the same size. This indicates that markets were already for a longer time suspicious of the health of the Dutch bank. In fact, since the nationalization the Dutch press has regularly published pieces that show how the commercial real estate has been mismanaged for a substantial time period. Did this go unnoticed by the regulator? Why did it not intervene? An independent enquiry into these issues has been initiated. Also here the national point of view might diverge from the European one. The lesson is that we need institutional arrangements that minimize forbearance. FDIC-style prompt corrective action would help.

Fifth, governments may want to nationalize even relatively small banks. While SNS bank is the fourth largest bank in the Netherlands, its balance sheet measures only 82.3 billion euros. From a European perspective, it does not feature in the list of Eurozone 50 largest banks. Direct spillovers from bankruptcy to other EU countries would be small if not non-existent as SNS was a purely local bank. From a European perspective, resolution instead of nationalization might have been preferable because nationalization creates its own issues of maintaining a level playing field, engineering exit, and preventing the state from determining how banks invest. In the US, the FDIC routinely resolves banks with assets of 40 to 50 billion dollars. The biggest bank placed in receivership was Washington Mutual with $307 billion euro of assets. The lesson is that the European view on how to treat problem banks may differ from the national one. Lower entry barriers and more competition could alleviate this issue by allowing governments to find private sector solutions to resolve problem banks more easily. A banking union with centralized supervision will contribute here.

Sixth, nationalization is fought vigorously in court. The Dutch Council of State ruled that the expropriation of shareholders and junior bondholders was justified, but also that future claims of shareholders could not be expropriated. Thus, shareholders and junior bondholders retain the right to go to court claiming the bank has mismanaged their interests when it was still private. As a result, the government and ultimately taxpayers may be held liable for mismanagement of the bank in the past. In the case of SNS Reaal, for example, some holders of junior debt were repaid only months before SNS was nationalized. Lawyers may focus on such issues and argue that similar claims were treated unequally. The lesson is that prudence in the run up to nationalization is essential.