18 February 2013

Schoenmaker, Beck & Gros: On the design of a Single Resolution Mechanism

Even more important for the future of the banking system in Europe than the institutional design of the SRM will be the willingness actually to let banks fail, or at least bail in creditors before public funds are used to prop up institutions which cannot survive on their own.

This paper was prepared for the ECON Committee as part of the compilation PE 492.473 for the Monetary Dialogue.

Abstract

A single supervision mechanism requires a single resolution mechanism (SRM), i.e. supervision and resolution should be at the same level. The authors argue that the SRM i) should be responsible only for the banks under the direct supervision of the ECB; ii) should be an independent institution with its own funding and staff; iii) powers should dovetail those of the ECB so that the SRM can take over when the ECB has come to its limits; iv) procedures and powers need to be specified in a Regulation; and v) bank resolution and deposit insurance are best bundled within one institution.

Even more important for the future of the banking system in Europe than the institutional design of the SRM will be the willingness actually to let banks fail, or at least bail-in creditors before public funds are used to prop up institutions which cannot survive on their own. The present practice of an almost unlimited bailout of all bank creditors maintains overcapacity and an excessive leverage in the European banking system. It risks leading to a similar situation as in Japan where the so-called ‘zombie’ banks held back the recovery for a very long time.

Conclusion

Creating a Single Resolution Mechanism which deserves this name will be extremely challenging because a failure of any large bank might be dangerous for financial stability and an orderly resolution often requires substantial financial support from the public sector. Resolution powers and responsibilities thus cannot be divorced from its fiscal consequences.

How much public support is required to prevent a disorderly failure depends to a large extend on the bail-in regime. It is thus difficult to determine in advance burden sharing rules or even the size of the financing needed for any European resolution without knowing what the bail-in regime will be. For example, many banks in Europe finance a substantial part of their operations with so-called subordinated bonds and similar instruments. The treatment of these bonds has varied widely across countries. In the most recent case in the Netherlands, the holders of subordinated bonds of the bank SNS received nothing. By contrast, in Spain the holders of subordinates bonds (and even of preference shares) preserved a substantial part of their investment.

The financing needs of the SRM thus depend to a large extent on the bail-in regime that will govern the resolution of those banks directly supervised by the ECB. This regime will have to be determined by a Regulation which still has to be drafted. The principles for resolution contained in the Commission proposals of June 2012 covering national resolution mechanism should be followed. But this proposed directive alone is not enough. A separate regulation covering the ‘European banks’ (those supervised directly by the ECB) will be needed.

The best resolution mechanism will not work properly if the competent authorities continue to follow the principle that no bank should ever be allowed to fail, and that most creditors (including senior unsecured and large depositors) should always be guaranteed full payment. If this practice continues, investors will not price the risk of banks properly. The actual practice in resolution followed today is thus more important than the bail-in regime formally enshrined in legislation.

Full paper

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