This article analyses the reform of the European institutional framework for bank supervision and crisis resolution in the aftermath of the Euro area bank and sovereign crises. The reform aimed at centralizing the decision-making structures for bank prudential supervision and resolution. Mutualization of bank risk is a cornerstone to ensure financial stability and to lend credibility to the Banking Union. To this purpose, the European Stability Mechanism (ESM) – preceded by the European Financial Stability Facility (EFSF) – was created as a mechanism of mutualisation of sovereign risks in the Euro area, which was followed soon after by a clear push toward the centralization of the decision-making structures of bank prudential supervision and crisis resolution. The Single Resolution Fund (SRF), and the single euro area deposit insurance scheme (EDIS) were created as two further Euro area private mutualisation mechanisms in the context of the Banking Union, to cover all banks in the euro area and in future participating countries. Neither the SRF nor the EDIS have the ESM as a fiscal backstop in the steady state as yet. In order to limit moral hazard, mutualization takes place hand-in-hand with burden-sharing with bank private investors in crisis resolution as per the Bank Recovery and Resolution Directive (BRRD). This article also compares the European and US regulatory frameworks based on the ultimate objectives of limiting moral hazard and preserving market discipline in bank resolution.
In the aftermath of the financial crisis, the European Union designed a new legislative and institutional framework to manage banking crises. This new framework is an answer to the situation where the banks could have been perceived as “too big to fail”. It aims to make a bank failure possible without any public bail-out while preserving the critical functions for the economy. To meet this objective, the legislation notably provides the European resolution authorities for a new tool which should be used in most of the resolution schemes in the future: the bail-in.
The principle of the bail-in is to use the banks liabilities to absorb the losses once the equity is exhausted and to recapitalize the banks through the conversion of liabilities into equity. However, if the principle of the bail-in is straightforward, its implementation in practice raises challenges. This is the reason why the resolution authorities will have to analyse through the resolution planning how the bail-in tool could be applied in order to anticipate as much as possible any possible hurdle to implement it in practice. In that regard the setting of a Minimum Requirement of own funds and Eligible Liabilities (MREL) to bail-in is a priority for the resolution authorities in the EU in the coming months. However, if the MREL will enhance the banks loss absorbing capacities, it is not in itself the unique answer to crisis times as it is part of the resolution planning and can require time to be properly implemented.
In the post-crisis environment, the new European policy orthodoxy insists on avoiding state-funded bailouts of banks in distress under all but the most exacting circumstances. This is reflected in the two distinct but interrelated sets of norms governing bank resolution actions: The Commission’s norms on state aids in the banking sector as reflected in the Banking Communication of July 2013; and the new special resolution regime for credit institutions and investment firms adopted in May 2014 in the form of the Bank Recovery and Resolution Directive. The paper discusses the anti-bailout objective of the two frameworks, the way in which this is reflected in their operative provisions, and the degree to which the latter result in a truly binding regime, or admit exceptions and variations. It is shown that the overall effect of the provisions is to render outright bailouts almost impossible. Even when an intervention is permitted, this may take place only in prescribed forms and at a late stage within the resolution system’s financing cascade, which insists on substantial bail-in of ailing banks’ private claimholders, amounting to at least 8% of total liabilities, as a prior condition. The only exception is precautionary recapitalization; but this applies only to solvent institutions and cannot cover past losses. It may be wondered, however, whether a policy of strict insistence on bail-in in all cases of undercapitalization is wise. The problem has recently come to a head due to the troubles of the Italian banking system, with its huge pile of bad assets and numerous weak banks. The Italian banking system has a sufficient volume of bail-inable junior debt, thus making bail-in technically feasible. But at what cost?
Bail-ins could prove an effective way to replace the unpopular bail-outs. In the EU the doom-loop between bank and sovereign indebtedness left governments with a major conundrum. Thus, the EU resolution regime requires the prior participation of bank creditors in meeting the costs of bank recapitalisation before any form of public contribution is made. But, there is a danger of over-reliance on bail-ins. Bail-in regimes will not remove the need for public injection of funds, unless the risk is idiosyncratic. This suggestion raises concerns for banks in the periphery of the euro-area, which present very high levels of non-performing assets, crippling credit growth and economic recovery. To avoid pushing Eurozone banks with high NPL levels into bail-in centred recapitalisations, we have considered the benefits from and legal obstacles to the possible establishment of a euro-wide fund for NPLs that would enjoy an ESM guarantee. Long-term (capped) profit-loss sharing arrangements could bring the operation of the fund as close to a commercial operation as possible. Cleaning up bank balance sheets from NPLs would free up capital for new lending boosting economic recovery in the periphery of the Eurozone.
Since the crisis a vast amount of work has gone into ensuring that major cross-border banks are no longer too big to fail. This paper summarises that work, describing progress made in developing resolution regimes and resolvable bank structures in the major banking jurisdictions, in providing incentives to those jurisdictions to cooperate in resolving failed banks and in requiring banks to have enough loss absorbing capacity to ensure that the answer to the question of “who pays?” when a major bank fails is no longer the taxpayer. The paper illustrates these issues by reference to the UK’s recently-published proposals on loss-absorbing capacity, which seek to link the quantum and quality of loss-absorbing capacity to the preferred resolution strategy for each bank. And the paper also emphasises that, notwithstanding the UK’s pending withdrawal from the EU, the UK will continue to cooperate with partners in the EU and elsewhere to ensure that global standards on bank resolution are respected and to promote robust arrangements to deal with the failure of large cross-border banks.
This section of the journal indicates a few and briefly commented references that a non-expert reader may want to cover to obtain a first informed and broad view of the theme discussed in the current issue. These references are meant to provide an extensive, though not exhaustive, insight into the main issues of the debate. More detailed and specific references are available in each article published in the current issue.