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Friday, 18 November 2016

Bank resolution in the European financial architecture

Ivaylo Iaydjiev (St Antony’s College, Oxford)

Speakers: Joanne Kellerman, Single Resolution Board
Chair: Charles Enoch, St Antony’s College, Oxford

The euro area crisis is often described as ‘vicious circle’ between sovereigns and banks. At its core, this is generated by a dilemma regulators face when a bank is likely to fail – should they leave the bank to go bust and face the consequences or should they use public money to provide a bailout? As Joanne Kellerman argued in her talk, at its core is a question of whether there is a trade-off between financial stability and market discipline. In response, Kellerman analyzed the role of the Single Resolution Board (SRB), the new European agency charged with taking decisions on resolution, of which she had been a member since its inception in 2015.

Kellerman began by reviewing briefly the crisis experience and the regulatory response. Given the lack of centralized supervision and resolution, when the crisis hit states intervened through the ring-fencing of assets and the provision of taxpayer lifelines to banks. This in turn transformed a banking crisis into a sovereign debt crisis and unleashed the ‘vicious circle’. The EU, after taking a set of emergency measures, sought to overhaul the structure of financial supervision by the creation of set of new bodies. Meanwhile, the problem of ‘too big to fail’ received increasing attention in global forums such as the FSB, which were in the process of being translated into European legislation. The aim of this new financial architecture is to align the goals of financial stability and market discipline. On the one hand, market discipline dictates that banks which cannot stay on the market should exit; on the other hand, financial stability leads often to the use of public money to prevent contagion, but increases moral hazard and places a burden on the sovereign. The key to protecting taxpayers money, according to Kellerman, is to make sure there is a credible resolution framework for systemic institutions so that they can fail without generating financial instability. Such a framework should overcome the painful choice and allow banks to fail, while giving rules and tools to restructure them in order to preserve stability during the process. This needs to be done with strong market safeguards, including full compliance with state aid rules and favour private sector solutions if they can secure the goals of resolution.

What is the role of the SRB in achieving this? As an independent agency, it serves as a centralized resolution authority for euro area banks. Its main goal is to ensure orderly resolution with minimum impact on the economy and public finances of EBU states. In practice, it operates as a central body in a ‘hub and spoke’ system, with a key role for national resolution authorities in the planning and execution of actions. The SRB has overall responsibilities for 141 banks in the euro area, with national authorities responsible for smaller banks. It also works with the ECB, which, as a single supervisor, determines whether a bank is likely to fail, and with the European Commission, which can object to SRB decisions and checks for compatibility with state aid rules.

The main goal of the SRB is to make all banks resolvable. Resolution occurs when three conditions are met: 1) a bank is likely to fail; 2) no private sector solution is available; and 3) resolution is in the public interest as normal insolvency proceedings would threaten financial stability. The overall aims of resolution is to maintain functions that if disrupted would lead to negative impacts on third parties, to limit contagion, to protect depositors and to make sure guaranteed deposits are accessible, and to minimize the use of public funds. To make this process orderly and credible, the SRB undertakes a number of activities, such as drawing up resolution plans with important ex-ante choices, assessing the resolvability of banks and impediments to this, and ensuring sufficient loss-absorbing capacity in case of resolution (so-called MREL requirements).

The final task of the SRB is to manage the joint financing arrangements to fund resolution known as the SRF. The SRF will gradually replace national resolution funds, pre-funded by banks, with a fully mutualized European fund in order to limit the ‘vicious circle’ between banks and sovereigns. The money in the fund can only be used for specific purposes, such as funding loans under resolution, capitalizing bridge banks, or compensating creditors, but not absorbing losses or up-front recapitalization (which can only happen after creditors covering at least 8% of total liabilities worth of losses are ‘bailed-in’). 

Overall, Kellerman concluded, financial stability and market discipline are not mutually conflicting – provided a resolution framework that is both feasible and state aid compliant is in place. The goal for the SRB is to achieve that at the EU level by planning for the orderly resolution of failing banks. Crucially, this can only take place after private solutions have been exhausted, thus placing the burden of failure on creditors and owners, not taxpayers. In turn, making banks resolvable should both make them more resilient and improve growth outcomes.

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