28 January 2015

Vox EU: Bank resolution in Europe - The unfinished agenda of structural reform

Column by Georg Ringe, Professor of International Commercial Law, Copenhagen Business School, and Jeffrey N. Gordon, Richard Paul Richman Professor of Law, Columbia Law School; Co-Director, Millstein Center for Global Markets and Corporate Ownership.

The project of creating a European Banking Union is arguably one of the most important steps on the post-Crisis regulatory agenda. The goal is, inter alia, to provide a sound and unbiased legal framework for resolving global banks, so that the threat of a rescue with taxpayer’s money can be mitigated.

The legal instruments that have been adopted so far are insufficient in many ways (see, for example, Fox 2013 and Ruparel 2013). One aspect which has been largely overlooked in the current debate is that the structure of EU banks does not sit easily with those regulatory goals – on the contrary, the myriad of structures of European banking groups jeopardises the effectiveness of a resolution process. The risk is that resolution of cross-border banks will fragment along national borders, undermining the goal of providing an effective pan-European system. This has dramatic consequences for the preservation of systemic stability:

• First, short-term credit claims will be insufficiently protected, meaning that financial distress could easily lead to an exacerbating spiral of runs, fire sale asset dispositions, and credit market freezes
• Second, financial distress may have uneven impact along national dimensions, which will lead to national ring-fencing ex ante and ex post

The consequence will be an unacceptable risk of a disorderly resolution that will, in prospect, produce regulatory forbearance and may well lead to a more calamitous failure later, a bail-out, or some other form of taxpayer rescue.

A ‘holding company’ structure for large European banks

In a recent paper, we argue that large European banks should be required to reorganise into a ‘holding company’ structure where the parent holds unsecured term debt sufficient to cover losses at an operating financial subsidiary (Gordon and Ringe 2015). This would allow resolution to focus on the holding company level, minimising disruption of the ordinary business of the operating financial subsidiaries. This would facilitate a ‘single point of entry’ resolution procedure that would minimise knock-on effects from the failure of a systemically important financial institution. Resolution through such a structure would minimise run risk from short-term creditors and minimise destructive ring-fencing by national regulators.

Such a holding company structure arose by accident in the US, but has provided the basis for the current implementation of Dodd–Frank’s mandate for orderly resolution of a failed financial firm, using a ‘single point of entry’ approach. The perceived credibility of this resolution approach has been reflected in the reduced funding advantage for large US financial firms over smaller ones, suggesting that a credible resolution threat can mitigate ‘too big to fail’ (US Government Accountability Office 2014).

Implementing such a holding company structure could be achieved through a number of different channels.

Full article on Vox EU

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