Markets Insight: Bail-in regime risks old-style bank runs The newly agreed bank recovery and resolution directive swings Europe from one extreme - a system laden with implicit government guarantees that protected bank creditors from bearing losses - to the other. The regime creates a serious time inconsistency problem by requiring private bank creditors to cover any significant losses without first cleaning up legacy debt problems. Without comprehensive efforts to restructure corporate debt, clean up banks" balance sheets and fortify the European Stability Mechanism, bail-in will leave Europe much more prone to old-fashioned bank runs than in the past. In 2010-11, most of the periphery economies ran large current account deficits. When foreign funding for these deficits dried up, the periphery experienced a sharp rise in public and private borrowing costs that plunged their economies into deep recession and, in several cases, threatened default and exit from the euro area. Foreign ownership of public debt fell by a third in Italy and by half in Spain. Not only did the periphery experience a sudden stop in capital flows, but the stocks of past foreign investment began to unwind. The outright monetary transactions programme stopped the stock unwind, but did little to generate a return of foreign investment. The risks ahead are twofold. First, given the need to deleverage, periphery GDP growth will be weak and persistently vulnerable to shocks. But in the context of the new bail-in regime, a second, arguably more urgent risk has been introduced: that of a renewed unwind of past foreign investment, and indeed capital flight by domestic bank creditors intent on avoiding being bailed-in. Bail-in increases the loss that prospective creditors suffer in the event of a bank failure or resolution event. Against that backdrop, what should periphery bank creditors do in response to the threat of bail-in? Holders of senior unsecured debt should feel least secure, since they are now at the top of the pecking order. Given the persistence of high sovereign borrowing costs, this form of debt may well disappear in the riskier parts of the euro area. Uninsured depositors will move one step closer to being bailed in. Secured lenders to banks will still lend against good assets, and the banks will in turn need to rely more on such funding. As the share of encumbered assets rises, unsecured creditors, including depositors, become ever more nervous. The bank is, after all, pledging its best assets to minimise its cost of funding. Having moved another step closer to being bailed in, uninsured depositors will demand more compensation to remain committed to a periphery bank. As the vicious cycle turns full circle, higher funding rates will raise the cost of capital for periphery banks, and banks will respond by cutting back lending rather than paying more for funding and capital. Despite the risks posed by the new bail-in regime, the alternative of bailout by taxpayers is not the better answer. Instead, in the transition to the bail-in regime the banking system must be fortified in three ways. First, clean up the banks once and for all. This involves not just certifying asset quality and stressing the assets, but actually getting the bad and unprofitable assets off banks" balance sheets. Second, develop a comprehensive strategy to facilitate corporate debt restructuring as a means to work down excessive debt levels. Third, create a credible pan-European backstop for bank recapitalisation needs. European leaders have not only curtailed the ESM's ability to backstop banks" recapitalisation efforts; they have also retained governance control over the process. The ultimate decision on which banks are eligible for support will be subject to the unanimous consent of finance ministers. Europe's cumbersome governance process, which tends to slow down crisis decisions and lead to suboptimal compromise, has thus been embedded into the fledgling banking union. Direct ESM bank recapitalisation is limited to €60bn and is only available after the Single Supervisory Mechanism is launched, at best in late 2014. There is, accordingly, no backstop to cope with the consequences of a surprise negative outcome to the ECB's asset quality review, nor indeed any other negative shocks that arise prior to the SSM's launch. Most importantly, markets are again being led to believe in implicit guarantees: that despite German constitutional constraints over the size of the ESM, the facility would be enlarged in the event that more money is needed. These fortifications may not be sufficient to backstop the system against the sovereign fragmentation that lies at the centre of the euro area's fissures, but they are necessary to avoid a return to the acute phase of the crisis. Gene Frieda is a global strategist for Moore Europe Capital Management