Governments are hesitating over how to resolve the financial distress of banks, leaving fragile banking structures in place. This problem is particularly pressing in the Eurozone; governments expect the ECB to continue providing cheap funding, undermining the bank’s independence. The ECB is presented with a dilemma; it has to choose between either financial instability if the failure of the respective bank endangers the financial system, or ongoing emergency lending with reduced collateral standards.
A necessary step to reduce undue forbearance is to establish a workable resolution regime for financial institutions. Such a regime should follow common rules and be handled by a “Restructuring Authority”1, separate from the ECB, using funds from industry and government to recapitalise banks when the system is endangered.
Operational separation between the ECB and the Restructuring Authority, however, is not sufficient in itself to ensure central bank independence because the Restructuring Authority may opt for undue forbearance.
A policy framework is needed that would reconcile the need to keep the ECB separate from bank-restructuring activities with its need to have a say in them. We propose a setting in which both the ECB and the Restructuring Authority:2
(i) initiate bank restructuring on their own (that is, ‘triggering power’); and
(ii) have access to the relevant information about the financial status of the banks (that is, ‘information power’).
Besides triggering power, the ECB and the Restructuring Authority must have access to the same information about banks’ financial health because, otherwise, they cannot convincingly establish whether bank restructuring is needed (even if a violation of regulatory rules is proven). As banking supervision will be partially entrusted to the ECB, the ECB will have some triggering power and easier access to information. However, the policy framework outlined in this column does not depend on whether Eurozone banking supervision will be shifted fully towards the ECB or not3.
Once the restructuring of banks in financial distress has been initiated, the details of the restructuring plan would be left to the Restructuring Authority, following pre-established principles. The losses caused should first be borne by the shareholders, and then by the creditors. Viable parts of the bank should be sold and other parts restructured or closed. Affected banks could also be recapitalised. The necessary funds would be provided by the industry and the fiscal authorities funding the Restructuring Authority.
Improvements and institutional arrangements
Allowing two authorities to initiate a bank restructuring process would yield two immediate benefits:
- Undue forbearance declines in a diarchic system (in which there are two authorities).
For the ECB, there are incentives to trigger restructuring early, as inactivity may cause capital losses and higher inflation in the intermediate term. These, in turn, could harm the central bankers’ reputation and would threaten their independence. However, the ECB also faces difficult tradeoffs when deciding whether to trigger the restructuring of weak banks to whom, in the past, it has lent funds against collateral that might be of less value today. Thus, it would be essential to grant triggering power to two institutions instead of one.
- Granting the ECB the right to initiate the process would also motivate the Restructuring Authority to act, as it would certainly prefer to keep the initiative.
The Restructuring Authority's reputation would suffer from being forced into action continuously. Ideally, the ECB’s threat to act would be sufficient to reduce undue forbearance from the Restructuring Authority. If, however, the ECB decides to act and requires a restructuring, it is important to make this single-handed move from the ECB public, but only with a delay (e.g. 6-12 months).
Overall, we expect such a diarchic organisation to strengthen the Eurozone banking systems. It would also help ensure the ECB’s independence. Otherwise, the ECB would remain subservient to the fiscal authority (‘fiscal dominance’)4 and/or the financial industry (‘financial dominance’)5. We further expect this diarchic organisation to enhance the credibility of the ‘no-bailout principle’.
Of course, the coordination of these two institutions in the diarchy will be a central factor in assuring optimal functioning. In particular, it is important that the two decision-making bodies have the opportunity to undertake such coordination themselves, before one of them triggers restructuring.
Moreover, the capital providers’ rights should be protected. This can be achieved by decision-making rules in which votes are weighted according to the capital shares of member states.
Central bank participation in bank restructuring has been customary at many junctures in the history of financially distressed banks. Central banks were created to supervise banks and to manage recurring liquidity crises in the banking system6. Where central banks have become independent, however, the separation of their operations from the fiscal authority has been the guiding principle. Many observers think that operational independence ensures that central banks can focus on price stability and, to varying degrees, on output stabilisation. This kind of independence is expected to reduce the risk that central banks could be forced to do the bidding of fiscal authorities.
Our main argument is that central bank independence has to be taken a stage further in the presence of possible financial dominance, i.e. when central banks might be forced to print money to preserve the stability of the financial system. In such a scenario, complete separation of operations is not the best way of safeguarding independence.
Naturally, our conception of independence raises several issues. We address three of them in this column:
- In principle, the two authorities that have triggering power might give too much weight to pessimistic assessments of a particular bank’s recovery potential.
That is, one of the two authorities may rush into hasty bank restructuring. However, this is not a major concern, as both authorities have no incentive to react overhastily on the question of restructuring, and each of them can use the assessment of the other authority when it decides whether to restructure a bank or not.
- Granting triggering power to the ECB within a diarchy may not be sufficient to safeguard independence.
Indeed, ongoing discussions about the appropriate role of central banks – such as the Fed or the Bank of England – in special bank resolution regimes have highlighted the fact that such a framework must ensure that the treasury assumes full fiscal responsibility for bank restructuring. Otherwise, the central bank’s independence might be jeopardised (Nier 2009). This conclusion also applies to our proposal. An appropriate resolution mechanism, together with funds obtained through a levy on the industry and from fiscal authorities to support that mechanism is a precondition for tackling financial dominance in the Eurozone (Sapir, Hellwig and Pagano 2012). In fact, it is a precondition for any type of arrangement that aims at protecting the ECB’s independence.
- Adding triggering power to the ECB’s competencies may seem an accumulation of powers that should be subject to close, democratically legitimated control.
Such concerns can be addressed by transparency requirements, as mentioned above, coupled with appropriate accountability standards. Moreover, triggering power is meant to be a defense for the ECB against financial dominance.
Against the background of fiscal and financial dominance risks, central bank independence has to be taken further. Otherwise, true independence would vanish. Giving the ECB triggering power within a diarchy appears to be the core element of a new framework for central bank independence that aims at the sound functioning of fiat money systems. It seems likely that the Eurozone system would gain much from such a change.
Brunnermeier, M K and Y Sannikov (2012), “Redistributive Monetary Policy”, Federal Reserve Bank of Kansas, Jackson Hole Symposium 2012.
The Economist (2011), “Central Banks – A More Complicated Game”, 19 February 2011.
Board of Academic Advisors at the Federal Ministry of Economics and Technology, Berlin (2012), “On the Stability of the European Financial System”, Translation of: “Zur Stabilität des Europäischen Finanzsystems”, Brief des Wissenschaftlichen Beirats beim Bundesministerium für Wirtschaft und Technologie an Bundesminister Dr. Philipp Rösler vom 16. Oktober 2012.
Gersbach, H (2011), “A Framework for Two Macro Policy Instruments: Money and Banking Combined ”, CEPR Policy Insight 58.
Nier, E W (2009), “Financial Stability Frameworks and the Role of Central Banks: Lessons from the Crisis”, IMF Working Paper, 09/70.
Sapir, A, M Hellwig and M Pagano (2012), “A Contribution from the Chair and Vice-Chairs of the Advisory Scientific Committee to the Discussion on the European Commission’s Banking Union Proposals”, Reports of the Advisory Scientific Committee, ESRB – European Systemic Risk Board, 2, October.
1 This authority could be a new European institution and/or a cluster of national supervisory and restructuring authorities.
2 This requires careful legal arrangements, as both the ECB and the Restructuring Authority would have the right to revoke a bank’s authorization to do business.
3 Indeed, there were – and still are – good reasons to keep banking supervision and monetary policy separate, as this would also have helped secure the independence of the ECB (see Board of Academic Advisors at the Federal Ministry of Economics and Technology, Berlin 2012; and Gersbach 2011).
4 Fiscal dominance can take many forms. The recent pressure exerted on Greek banks to purchase sovereign Greek debt, for instance, implied a weakening of those banks’ balance sheet, which would ultimately force the Eurosystem to assume additional risk.
5 Fiscal and financial dominance is analyzed in the framework outlined in Brunnermeier and Sannikov (2012).
6 The Economist quotes Charles Goodhart: “The monetary (macro) functions of central banks were largely grafted onto the supervisory functions” (Economist 2011).