Cause and Effect in European Politics and Law

"Too big to fail" is no longer to save banks

Ralitsa Kovacheva, January 12, 2011

Saving failing banks will no longer be necessarily, on the contrary - banks should be allowed to fail as any other business. The death of a bank, however, especially if it is large and operates in different European countries, will certainly not be a "lonely business” (after Ray Bradbury). This is why the European Union needs a mechanism to allow orderly organised bank failures, so as to avoid risks to the financial system as a whole, to depositors and public finances. Taxpayers should no longer pay for the problems of banks, this should be a responsibility of their shareholders and creditors, is one of the greatest lessons from the financial crisis. The other is that no bank should be treated as too big or too important to fail.

Because of all this the European Commission proposed to establish an EU Framework for Crisis Management in the Financial Sector, that would set common rules for banking crises reaction within the EU. Based on its Communication of October 20th 2010, where the Commission presented its views on the topic, Brussels has launched a consultation on the technical details underpinning that framework. The parties concerned should give their opinion on all matters related to the process of resolution of a failing financial institution: who is responsible for its resolution, when the authority has the right to intervene and under what procedures, who pays the costs of a resolution and how the process will be coordinated in terms of cross-border banks.

The aim of the exercise

“The overriding objective of a European resolution framework should be that ailing institutions of any type and size, and in particular systemically important institutions, can be allowed to fail without risk to financial stability whilst avoiding costs to taxpayers”, the Communication notes.

Therefore, the European framework for crisis management in the Financial Sector should:

- Provide prevention and preparation, as well as credible resolution tools, so as to minimise the risk of contagion and to ensure continuity of essential financial services;

- Clearly ensure when and how the authorities could intervene and what action could be taken;

- “Reduce moral hazard by ensuring an appropriate allocation of losses to shareholders and creditors and protecting public funds. This implies, at a minimum, the costs of resolution should be borne by the shareholders and, as far as possible, the creditors of the institution in question reflecting the normal order of ranking and if necessary by the banking industry as a whole”;

- Contribute to a smooth resolution of cross-border groups ensuring minimum damage to the internal market, fair sharing of costs and preservation of essential banking services;

- “Ensure legal certainty, appropriate safeguards for third parties and restrict any interference with property rights to what is necessary and justified in the public interest. The framework should aim to ensure that creditors receive a treatment similar to that which they would have received if the bank had been wound up”;

- Limit distortions of competition on a European level, including regarding to state aid.

Who is responsible for the resolution?

The European Commission did not provide a mandatory answer to this question, because currently there are different practices in the Member States. Under the new rules they will preserve the right to determine which national body should act as a resolution authority. “The Commission notes, however, that in many jurisdictions resolution authorities are appropriately separated from supervisors and considers such separation to be important to minimise the risks of forbearance.”

Preparatory and preventive measures

According to the Commission, resolution authorities should have a number of tools and measures for preventive intervention in order to avoid resolution, where possible. Preventive measures include increased surveillance and more stringent risk assessment. Any financial institution (all credit institutions and investment firms) should have a recovery and a resolution plan according to different scenarios, but the plans “should not assume access to any support from public funds”. Among the preventive measures may be “requirements to limit or modify exposures; to increase reporting; to restrict or prohibit certain activities; or to change to group structures”. Firms, in turn, will be entitled “to challenge any requirement for restructuring imposed by the supervisor or resolution authority.”

At an early stage the procedure involves extended powers of the supervisors - to prohibit payment of dividends, to require replacement of managers or directors; or to require a bank to divest itself of activities or business lines that pose an excessive risk to its financial soundness. The authority may also have the right to appoint a special manager to take over the management of a bank for a limited period of time - up to 1 year. At this stage it is supervisor's and institution's responsibility to implement the recovery plan.

Resolution of troubled banks

However, if the recovery plan does not work, the resolution plan has to be applied. To be effective, the resolution process must begin “before a bank is balance sheet insolvent” but at the same time, not “before all other realistic recovery options are exhausted and that the intervention is in the public interest”, the Communication reads.

“Possible threshold conditions aimed at the solvency or liquidity of an institution include an assessment by supervisors that the institution has incurred or is likely to incur losses that will deplete its regulatory capital; that its assets are likely to be less than its liabilities; that it is likely to be unable to pay its obligations in the normal course of business; or, more broadly, that it does not have adequate resources to carry on its business.” There are also other, qualitative assessments, such as whether the institution meets the conditions of its license to conduct banking or investment activities.

In addition, “the Commission proposes to include a further condition that resolution is necessary in the public interest.” This means that the liquidation of an institution under the ordinary procedure would endanger the stability of the financial system or the continuity of essential financial services. Given that “in public's interest” criterion is not fulfilled, “the institution should be wound up once the threshold for insolvent liquidation is reached”.

In case that all other options have been exhausted and resolution is needed, the Commission proposes a set of tools to be applied by a regulator, including transferring assets and liabilities of a failing bank to another institution or to a bridge bank, writing down the debt of a failing bank, or converting it to equity. The aim of such recapitalisation measures is to strengthen the financial position of the institution concerned and enable it to remain a working entity, subject to appropriate restructuring.

Thus bondholders will bear some of the losses of a bank, unlike the present situation when their investments are guaranteed the same way as the money of savers. Creditors are endangered to suffer losses in terms of government debts too, according to the draft European Stability Mechanism. In both cases, however, the new rules will not apply to current debts, but only after the entry into force of the new legislation, which is expected in 2013.

The Commission explicitly states that these proposals should not be considered in the context of the current debates related to the debt crisis. “Any legislative proposal for a debt-write down mechanism that might be made in the wake of this Consultation would only apply in relation to relevant classes of debt issued by banks. It would not apply to debt issued by governments.”

Who pays?

“The cost of resolution should primarily be paid by shareholders and creditors but in most of the cases this would not be enough”, the Commission noted. For this purpose, it will propose the establishment of national funds to support bank resolution. euinside already wrote in detail on this topic in May, when the Commission published its first Communication. At this stage, its ideas on how the fund to be organised and on what basis to be financed have not marked any special developments.

The main points are that bank resolution funds should be funded on an ex-ante basis and these pre-collected funds should be spent only on necessary actions for failing institutions resolution. As to the basis on which contributions will be calculated, the Commission recommends bank liabilities. However, harmonisation between national funds is needed, because as the Commission notes, this is only the first stage - the ultimate goal is to create a single European Bank Resolution Fund.

For cross-border banks and groups, the Commission proposes to create “resolution colleges” for each cross-border bank that would include all relevant national supervisory and resolution authorities, and would be built on the existing supervisory colleges. The newly established European Banking Authority will play a coordinating and supportive role in crisis situations.

What's next?

Based on the consultations, the Commission will prepare a legislative proposal by the summer of 2011. It will apply specifically to banks and investment firms. By the end of the year the Commission will report on possible measures in relation to other types of financial institutions, including clusters and central counterparties. In 2014 the possibility of achieving a more integrated framework for the resolution of cross-border groups will be assessed, including the creation of a single EU authority, which would act under EU resolution and insolvency regimes and would be financed by a common EU resolution fund.

Yet in 2013, however, after the adoption of the necessary legislation for Crisis Management in the Financial Sector and for the European Stability Mechanism, the EU will have the necessary tools, both in terms of failing banks and failing countries. The common logic of both mechanisms is the absence of the presumption of compulsory saving and sharing of responsibility by private lenders.

Then it would be theoretically possible (even if perhaps it will never happen in practice for political reasons), large banks, suffering heavy losses because of possible “haircuts” of government debts, to be quietly and orderly resolved without having to save the entire system. Only their shareholders and bondholders will lose, so losses will be distributed along the chain as with profits. However, this is just a theory. Practice depends, aside from the rules, on two uncertain variables: politics and money.