23 March 2017

VOX EU: New ICMB/CEPR Report: Bail-ins and bank resolution in Europe

Nine years since the Global Crisis of 2008 and two and a half years after the launch the banking union in November 2014, some European countries are still struggling with significant banking problems. The total amount of non-performing loans (NPLs) in the EU is around €1 trillion and its allocation is far from equal. The rates of non-performance range from less than 5% in strong countries to 16% in Italy, 20% in Portugal, and 45% in Greece and Cyprus (EBA 2016). More than a third of EU countries have NPL ratios above 10%. These non-performing legacy assets present a challenge for the newly created banking union.

The debate regarding the justification of the bailouts is unlikely to ever be settled because it is almost impossible to assess the systemic consequences that disorderly failures would have had on the financial system and the broad economy. What is clear, however, is that citizens around the world do not want to be presented with a ‘too big to fail’ dilemma again. The job of regulators is therefore to make the system safer, and to create a process whereby systemically important financial institutions (SIFIs) can fail in an orderly manner. To preserve public finance ex post and market discipline ex ante, the guiding principle of the post-crisis financial regulations is that no private financial institution should be viewed by markets as being too important to be allowed to fail. Another issue in resolution is the distinction between individual bank failure and systemic crises. Avgouelas and Goodhart (2014) discuss the shortcomings of the bail-in regime, and argue that bail-out would still be necessary in extreme cases.

With these goals in mind, authors review the EU resolution framework and discuss the desirability and feasibility of bail-ins as opposed to bailouts (Philippon and Salord 2017). Banking resolution involves difficult trade-offs between creditors and taxpayers, between market discipline and financial stability, and between sovereign solvency and political risk. Allocating losses to private creditors improves incentives and protects taxpayers, but it can fall disproportionately on some investors and create short-term financial instability

They start by comparing the US and EU frameworks for dealing with troubled banks. In the US, the Dodd-Frank Act is split between Title 1 (oversight of large financial institutions) and Title 2 (new resolution powers). The EU regime includes state aid rules and the Bank Recovery and Resolution Directive (BRRD). The main objective of the BRRD is to provide a framework whereby financial firms can be repaired or resolved without public money. It has become an important building block of the banking union. The US and EU frameworks have much in common, from their emphasis on financial stability to the resolution powers of the administrative authorities. There are also some significant differences, such as the lack of a restructuring option in the US or the uncertainty surrounding the precautionary recapitalisation measure in the EU. A major issue in the EU is the fact that the BRRD has been phased-in before the completion of other critical features of the banking union, such as a European deposit insurance scheme (EDIS) or the minimum requirement for own funds and eligible liabilities (MREL).

They find that European taxpayers have covered more than two-thirds of the cost of resolving and/or recapitalising distressed banks. The goal of the new framework (i.e. BRRD and state aid) is to increase effective private sector involvement, in particular via bail-ins. This would be a significant improvement.

The third part of their report focuses on policy recommendations. Although much improved relative to the pre-crisis period, they argue that excessive forbearance is still an issue and we recommend improvements in the governance of the Single Supervisory Mechanism, its coordination with the Single Resolution Board, and the design of stress tests, as well as the monitoring of exposures to bail-inable instruments. Europe also needs to address important cross-border issues in terms of resolution planning, liquidity and capital. Finally, in their report authors propose some changes to improve the predictability of resolution for financial contracts.

Overall, they are cautiously optimistic about the future of bail-in in Europe. The main issue is the transition from the old regime to the new resolution framework. For several years to come, the new resolution tools will have to be applied to balance sheets that are not quite ready for it. This is bound to create bitter legal and political fights. But the evidence suggests that bail-in can work – in fact, it is already producing significant changes in some dimensions – and with the help of hard-headed policymakers, it can become credible and effective.

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