A few days ago, the European Parliament adopted the Single Resolution Mechanism (SRM), the second pillar of the emerging ‘banking union’ for Europe. Yet, the project is fraught with difficulties and initial enthusiasm is long gone. Although the prevailing view holds that an effective banking union requires three pillars – supervision, resolution, and deposit guarantee – the current political situation suggests that they are unlikely to be achieved. Political agreement for a common supervision framework has been reached with some difficulty, but agreement on the SRM was much more complicated than anticipated. In particular, the funding of the resolution mechanism proved to be very controversial, and the outcome jeopardises the credibility of its operation. Further, some EU member states have made it clear that they are not at all willing to support calls for a joint deposit guarantee scheme, and this third pillar has now been dropped accordingly (O’Donnell and Körkemeier 2014).
The compromise version on the table has many shortcomings.1 Most importantly, it will fail in its essential mission of managing the failure of a systemically important bank in a way that overcomes the fatal link between sovereigns and their banks. The SRM simply provides no strategy to avoid contagion from a bank failure because depositors and short-term creditors are not adequately protected, due to an insufficient resolution fund and the absence of a credible, centralised deposit insurance scheme. If bank resolution is not a credible threat, then the Single Supervisory Mechanism of the European banking union will be a paper tiger.
A proposal to more effectively deal with bank failure
In a recent article, we argue for an organisational and capital structure substitute for the SRM’s flaws that can minimise the systemic distress costs of large bank failure (Gordon and Ringe 2014). Our proposal is that banks should effectively be made to ‘self-insure’ against failure, instead of being state-insured. We borrow from the approach the US Federal Deposit Insurance Corporation (FDIC) has devised to deal with large bank failure pursuant to the ‘Orderly Liquidation Authority’ granted by the Dodd-Frank Act.
The FDIC’s implementation strategy has three important lessons:
- First, systemically important financial institutions need to have in their liability structure sufficient unsecured (or otherwise subordinated) term debt so that in the event of bank failure, the conversion of debt into equity will be sufficient to absorb asset losses without impairing deposits and other short-term credit.
- Second, the organisational structure of the financial institution needs to permit such a debt conversion without putting core financial constituents through a bankruptcy.
- Third, a federal funding mechanism deployable at the discretion of the resolution authority must be available to supply liquidity to a reorganising bank. These elements are critical to avoiding debilitating bank runs and other sorts of financial system breakdowns.
The European SRM currently on the table does not even come close to this model. European institutions have been negotiating over the size of a resolution fund, which will reach a maximum size of €55 billion over eight years. This is a far cry from what is required for a credible resolution framework.
Our approach, inspired by the FDIC model, suggests a way forward.
- Essentially, we would require European banks to self-insure against failure by holding sufficient term debt at the holding company level.
This would shield deposits and other short-term credit provision at operating subsidiaries and also avoid disruptive bankruptcy proceedings in the operating subsidiaries. The problem is European banks are currently not normally organised in a pure holding company structure (Masters and Oakley 2012, Penn undated) and, where they exist, holding companies of banking groups often do not account for a sufficient proportion of the entire group’s debt (Liikanen et al. 2012, Institute of International Finance 2012). But regulation can change the relevant incentives. Stimulated by regulatory incentives, Swiss and UK banks are reported to be among the first European banks to currently change their organisational structure.2 Similarly, we would propose changes on the European level, most appropriately to the forthcoming implementation of the Liikanen report and the Bank Recovery and Resolution Directive to accommodate incentives for banks’ structural changes and to require them to hold a sufficient layer of bail-in debt.
- Liquidity provision for the resolution procedure should come from the ECB as the only financially credible player in the EU.
Here, the Fund created by the SRM framework could play a useful role as providing first loss protection to the ECM in its role of liquidity provider to a reorganising financial institution. This is much like the way that the US TARP programme provided first loss protection to the Federal Reserve in support of some of its crisis-era liquidity facilities. Together, these measures would facilitate a ‘single point of entry’ approach to resolution at the holding company level. As a by-product, prescribing such a holding company structure for banks would make cross-border resolution much easier, both for EU-wide and also for transatlantic and global situations (FDIC and Bank of England 2012).
A critical realisation is this: Without agreement among the member states to a federal deposit insurance scheme to mutualise losses, the only effective approach is our self-insurance scheme. Moreover, given the foreseeable deposit insurance caps, self-insurance and a protective organisational structure will still be necessary to avoid debilitating runs by wholesale short-term credit providers.
Taken together, our proposals would strengthen the current banking union project, overcome political difficulties, and ensure a consistent approach to bank resolution across the western world. This would enable large and complex cross-border firms to be resolved without threatening financial stability and without putting public funds at risk.
FDIC and Bank of England (2012), “Resolving Globally Active, Systemically Important, Financial Institutions” 10 December.
Finma (2013), “Resolution of global systemically important banks,” Position Paper, 7 August.
Gordon, Jeffrey N. and Wolf-Georg Ringe (2014), “Resolution in the European Banking Union: A Transatlantic Perspective on What It Would Take”, Columbia Law and Economics working paper No. 465, Oxford Legal Studies Research Paper, No. 18/2014.
Institute of International Finance (2012), Making Resolution Robust—Completing the Legal and Institutional Frameworks for Effective Cross-Border Resolution of Financial Institutions, p. 52.
Liikanen, Erkki et al. (2012), Final Report of the High-level Expert Group on reforming the structure of the E.U. banking sector, 2 October, pp. 52 and 137.
Masters, Brooke and David Oakley (2012), “UK ready to “trust” U.S. in event of cross-border banking failure”, Financial Times, London, December 11, p. 1
O’Donnell, John and Tom Körkemeier (2014), “Europe strikes deal to complete banking union,’’ Reuters, March 20
Penn, Bob (undated), “Single point of entry resolution: a milestone for regulators: a millstone for banks?”, Allen & Overy memorandum.
Shotter, James (2013), “Credit Suisse to overhaul structure’’, Financial Times, 21 November.
1 European Parliament, Legislative Resolution of April 15, 2014 on the SRM, Document P7_TA-PROV(2014)0341.
2 Finma, the Swiss Financial Market Supervisory Authority, has said it prefers the SPOE approach for cross-border banking resolution. See Finma (2013) and Shotter (2013). In the UK, the recently adopted Financial Services (Banking Reform) Act 2013 links a bank’s regulatory capital requirement, in part, to its resolvability.