Why the rush? Short-term crisis resolution and long-term bank stability

Thorsten Beck, 16 October 2012

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The recent crisis has exposed a critical gap in financial safety nets across Europe and many other developed countries, i.e. a deficient if not absent bank resolution framework. This gap in the financial safety net has become even more critical in the case of cross-border banks. The crisis has shown that the traditional approach of home-host country supervisory cooperation in the form of Memorandums of Understanding and Colleges of Supervisors falls short in case of bank failures. Memorandums of Understanding are non-binding documents and have turned out to be very patient paper. Colleges of Supervisors make for good coordination in good times, but break down in crises, because the ultimate decision is with the home-country supervisor, especially in the case of branches, and the representative of one major stakeholder – the minister of finance on behalf of taxpayers – is typically not included in these colleges. As any national reform of the financial safety net has to improve the resolution component, any reform of the regulatory framework for cross-border banking should start from the resolution part.

Not only is bank failure the moment when co-operation between home and host countries is most important, a properly designed resolution framework can also set important incentives against excessively aggressive risk-taking by banks ex-ante. Critically, the bank resolution framework has to contain both feasible options for resolving failing banks as well as sufficient funding for covering possible shortfalls. On the national level, resolution and recovery plans and the creation of possible bank resolution funds are therefore being discussed or even implemented.

A new regulatory framework for cross-border banking

On the cross-border level, this might involve a move from college of supervisors to a college of bank resolution authorities that include all relevant parties of the financial safety net, including ministries of finance. This should also include ex-ante burden-sharing agreements. For large systemically important financial institutions, this can also include resolution and recovery plans jointly commissioned and supervised by the relevant home and host country supervisors and resolution authorities. The example of the Nordic-Baltic agreement goes in this direction by including all relevant authorities within a college and outlining a specific burden sharing formula. It is interesting to note that this has been agreed upon in a region with not only high cross-border links in banking, but also a long joint history and culture. Such agreements can go a long way towards reducing incentive problems arising from the mismatch of banks’ and regulatory geographic perimeters (Beck et al. 2013), as well as the higher risk of systemic failure since cross-border banking increases the similarities of banks across countries and their interconnectedness (Wagner 2010).

The construction of a joint supranational supervisor is trickier for larger areas. While colleges can be created for individual banks, a supranational supervisor might not be relevant for all banks in her specific perimeter of authority. Also, different legal systems, and political opposition to yielding ‘sovereignty’ over a sensitive sector, such as banking, might make the establishment of a supranational supervisor difficult if not impossible. This sheds doubt on the feasibility and desirability of an EU wide supranational supervisor, which would be responsible for 27 countries with different legal cultures and regulatory systems, and very different financial systems.

A banking union can strengthen the euro

Compared to the EU at large or the global financial system, the Eurozone faces additional challenges in terms of cross-border banking. The recent crisis has shown the close linkages between monetary and financial stability (Allen et al. 2011). While monetary policy should take into account asset and not only consumer-price inflation, one tool is simply not enough to achieve both goals, especially not in a currency union, where asset price cycles are not completely synchronised across countries. In addition, the close link between governments and banks through government bond holdings by banks, while banks at the same time might have to rely on governments for support in crises, is exacerbated in a currency union, where certain policy tools are no longer available to national policymakers. A third problem is that of regulatory and political capture, where regulators get too close to the regulated entities and/or are influenced by politicians in the regulatory process, be they national or local government authorities (see Garicano in this volume for a discussion in the context of Spain). This is exacerbated by the tragedy of commons, referred to by other contributors to this eBook (Frank Westermann, Charles Wyplosz), whereby national authorities are interested in sharing the burden of bank failure with other members of the currency union.

To address these concerns, there have been increasing calls for a banking union. While initial suggestions were for large cross-border banks to be regulated under separate supranational legislation and a supranational supervisory and resolution authority (e.g. Fonteyne et al. 2010), the more recent proposals have been for all banks within the Eurozone to fall under Eurozone-wide regulation and supervision. This is also in recognition that the interaction between monetary and financial stability goes as much through small banks as through large cross-border banks. Take the example of the Spanish cajas who are at the core of the vicious cycle between sovereign and bank fragility in Spain. Similarly, the banks with some of the most toxic exposure to cross-border claims in Germany were Landesbanken or smaller specialised lenders (e.g., Hypo Real).

These arguments imply that a banking union that complements the currency union should not only focus on cross-border banks, but on all banks. It does not imply that supervision is centralised in one institution; rather it means that the ultimate responsibility lies at the supranational level – the buck stops at the Eurozone level. The critical issue is that the establishment of a supranational supervisory authority alone will not be sufficient. Rather, and in line with the arguments above, bank resolution, i.e. both the powers and the resources to be able to intervene in failing banks is critical for the success of such a banking union, as also argued by Dirk Schoenmaker and others in this eBook. The exact institutional structure and distribution of responsibilities across different institutions goes beyond the scope of this column, but the critical issue is that powers and resources to intervene failing banks have to go hand-in-hand. Independence of the institution from both political sphere and from the regulated entities is critical.

One additional advantage of a banking union could be that the resolution framework can be constructed on the European level and therefore leaves more resolution options that can involve the private sector. A bank that is too big for the Netherlands to resolve without bailout might well be of a reasonable size for a banking union.

Long-term reforms, short-term needs

While some see banking union as crisis-management tool, to address the current wide-spread private and public-sector overindebtedness in many peripheral countries, there are several reasons to not use it this way. First, building up the necessary structures for a Eurozone regulatory and bank resolution framework cannot be done overnight, while the crisis needs immediate attention. Second, the current discussion on banking union is overshadowed by distributional discussions, as bank fragility is heavily concentrated in the peripheral countries. This can also be seen as the motivation for the retraction by several northern governments of an agreement achieved in June that the European Stability Mechanism would fund bank resolution and recapitalisation in several peripheral countries, most prominently Spain, directly, to thus break the link between bank and sovereign fragility. Starting a new EU institution with such a large redistributional character at the startup seems unwise both for economic and political reasons.

Constructing a banking union will take a long time; the resolution of the current crisis, on the other hand, has already taken too much time. The US has shown how aggressively addressing bank fragility can turn banks from a source of crisis into a potential source of recovery. Europe, on the other hand, has muddled through, with semi-strong stress tests and much leeway for recapitalisation. National sovereign budget restrictions have further delayed recognition and resolution of bank fragility. Together with Daniel Gros and Dirk Schoenmaker, I have therefore suggested the establishment of a temporary European Resolution Authority, for which the ECB can make staff and offices available (Beck et al. 2012). This Resolution Authority would sort out fragile banks across Europe, both small and large; strongly capitalised banks go ahead; and weak banks are either recapitalised or (partly) liquidated. Where possible banks should be recapitalised through the market; if not feasible, the Resolution Authority recapitalises by taking an equity stake in the bank (by straight equity or hybrid securities). The resolution authority, however, would need a fiscal backstop from the European Stability Mechanism to gain the necessary credibility not only with the banks it is tasked to restructure but also with the markets. This resolution authority would be specifically tasked with addressing the current banking crisis, while at the same time the necessary structures for a supranational bank supervisory and resolution authority would be built up.

Conclusions

I have argued that the topic of banking union contains three very different dimensions. First, there is the immediate need for crisis resolution. Together and interlinked with sovereign fragility, bank fragility is at the centre of the current crisis. Recognising losses and allocating them, while separating bank and sovereign crises is the most immediate task to resolve the crisis. A sound and efficient banking system is an important component of the growth compact European politicians have been discussing. Resolving the banking crisis is therefore critical for the Eurozone. Second, there is the medium-term task to strengthen the currency union with a banking union. Monetary and financial stability are too closely interlinked to leave bank regulation and supervision completely on the national level. Third, there is the need for broader reforms of cross-border regulatory cooperation, which should focus on the resolution component and should imply stronger ex-ante commitments for the resolution of large cross-border banks. This agenda goes beyond the Eurozone and even beyond the EU.

References

Allen, F, T Beck, E Carletti, P Lane, D Schoenmaker and W Wagner (2011), Cross-border Banking in Europe: Implications for Financial Stability and Macroeconomic Policies, CEPR, London.

Beck, T, D Gros and D Schoenmaker (2012), "Banking Union instead of Eurobonds- disentangling sovereign and banking crises", VoxEU. 24 June 2012.

Beck, T, R Todorov and W Wagner (2013), "Supervising Cross-Border Banks: Theory, Evidence and Policy", Economic Policy, forthcoming.

Fonteyne, W, W Bossu, L Cortavarria-Checkley, A Giustiniani, A Gullo, D Hardy and S Kerr (2010), "Crisis Management and Resolution for a European Banking System", IMF Working Paper 10/70.

Wagner, W (2010), "Diversification at Financial Institutions and Systemic Crises", Journal of Financial Intermediation 19, 272-86.

Topics: EU institutions, Europe's nations and regions
Tags: banking stability, EZ banking union, EZ crisis

Thorsten Beck

Professor of Banking and Finance, Cass Business School; Professor of Economics, Tilburg University; Research Fellow, CEPR