OREANDA-NEWS. Recent calls by the IMF and Bank of Italy's Governor, Ignazio Visco, for greater flexibility for authorities implementing the EU's bank resolution and state aid rules raise important issues about financial stability in a systemic crisis. However, they are unlikely to alter our view that senior bondholders of EU banks cannot rely on sovereign support, says Fitch Ratings.

In May 2015 we took rating actions following a review of sovereign support to reflect our view that legislative, regulatory and policy initiatives had substantially reduced the likelihood of sovereign support for US, Swiss and EU commercial banks. This led to the downgrade of 48 EU banks and their subsidiaries.

The EU's Bank Resolution and Recovery Directive (BRRD) rules have now been implemented in almost all EU countries, providing a framework and minimum set of tools for dealing with failed banks. The rules include a presumption that creditors should bear losses and a provision that a public recapitalisation of a failed bank can only come after shareholders and creditors participate up to a minimum of 8% of liabilities and own funds. BRRD also requires institutions to build up additional loss-absorbing buffers to facilitate orderly resolution under so-called 'minimum requirement for own funds and eligible liabilities' (MREL) rules. Only a few liabilities are mandatorily excluded from the scope of bail-in, such as insured deposits.

Although the framework allows some limited discretionary exceptions to the normal rule that creditors should bear losses, recent comments made by Governor Visco and the IMF imply greater flexibility could be desirable, especially during the period when buffers are built up. A review of the BRRD is expected by June 2018.

Governor Visco said that the provision of public support in systemic bank crises should not be ruled out when bail-in is insufficient to achieve resolution objectives and compromises financial stability instead. He also said that the resolution of four small Italian banks, representing 1% of banking sector assets, in November 2015 was a "(bad) experience". We think the write-down of subordinated debt held by retail investors and the associated domestic media coverage weakened retail confidence in bank bonds and may have undermined confidence in parts of the banking sector. This led to deposit outflows from weaker banks in late 2015 and early 2016. Laws passed in April in Italy means some retail investors will now be eligible for partial compensation.

The BRRD rules allow for precautionary, temporary state guarantees to be provided to solvent banks where there is a major threat to financial stability and they even permit a "precautionary recapitalisation" by the government of banks without triggering resolution. But the latter requires a stress test or other assessment to be conducted by the authorities and can only be provided to solvent banks. It also needs approval under EU State Aid rules. Such an approach was used for two of the major Greek banks in 2015.

It is possible that a review of BRRD could result in a differentiated approach to retail investors in bank debt or increased flexibility on the 8% bail-in rule during the MREL buffer build-up phase. But it is hard to predict whether a bank is likely to fail for systemic or idiosyncratic reasons and difficult to envisage amendments that would result in Fitch concluding that extraordinary sovereign support for all senior bondholders/creditors of most EU banks had again become sufficiently likely to reflect in ratings. On that basis, most EU banks' Support Ratings would likely remain '5', meaning extraordinary support is 'possible, but cannot be relied upon' and Support Rating floors remain 'No floor'.

Ratings of the majority of EU banks are now driven by their standalone financial strength, measured by our Viability Ratings, and not by external support.