April 21, 2010 4:58 pm

Why we need a resolution authority for Europe’s banks

Dependence between banks and governments needs to be broken

The global economic crisis has exposed serious gaps in the EU’s ability to act when a bank runs into trouble and its problems threaten to spill across borders.

Europe’s leaders have responded and an overhaul of the EU’s financial stability architecture is underway. Notably, an EU-wide system of financial supervisors and a systemic risk board are being established. Important as these steps are, they deal only with prevention. To complement them, IMF staff have proposed the creation of an integrated framework for crisis management and resolution, including a European Resolution Authority (ERA) for cross-border banks.

Why is such a body, which should be independent but accountable, needed for Europe? Developing an integrated market in financial services has been central to economic integration in the EU. But a single banking market should be matched with a single resolution authority to underpin financial stability. As observed over the past two years, relying on national approaches to cope with crisis situations tends to fragment markets.

For the EU’s deeply integrated single banking market, supra-national solutions are inherently superior for dealing with the resolution of cross-border institutions. Co-ordination is a pervasive challenge in such resolutions because of the number of decision-makers involved, the different rules and incentives under which they work, and the high stakes at play. Establishing an independent ERA with a strong mandate based on the agreed priorities of the member states would help minimise these costly coordination problems.

A key objective for the ERA should be to handle failures cost effectively — minimising costs to depositors, the economy and governments. This is key to deal with moral hazard and avoid taxpayer-funded bail-outs.

How would the ERA achieve cost efficiency in practice? Details are spelled out in a recent IMF staff paper on Crisis Management and Resolution for a European Banking System, but three points are worth highlighting. First, early intervention will be critical and should take place well before insolvency occurs in accounting terms, and as soon as the ability of a bank to survive without public sector support is seriously in doubt. The ERA would then take the bank in “official administration” moving immediately to stabilise the institution and assess its true state.

Second, ERA administration would provide time to devise a resolution strategy that maximises value. Allowing distressed banks to continue operating as a going concern would avoid the disruption and value destruction of an ordinary bankruptcy procedure. With the pressure to engage in fire sales at deeply discounted prices removed, an orderly resolution strategy — which may involve recapitalisation, restructuring, partial sales, or liquidation of unviable units — can be designed and implemented. Market conditions allowing, the bank’s viable operations can then be returned expeditiously to private ownership and control.

Third, losses should be allocated to shareholders and creditors. If a bank is insolvent, even the most cost effective resolution process will leave a shortfall. In ordinary bankruptcy, this loss is borne first by the shareholders and then by the creditors on the basis of the priority of their claims. A special resolution regime could seek a similar outcome through an orderly restructuring of the balance sheet, including the relevant liabilities. This may require a limited moratorium while the full extent of the losses is determined. The ERA’s focus on cost efficiency should minimise its net costs, but it will need access to adequate gross financing to facilitate resolution and stabilise a bank in administration. In addition, back-up mechanisms should be available for exceptional cases when the resolution proceeds are insufficient to cover insured deposits or when additional direct outlays can substantially reduce the overall cost of a crisis. An industry-financed European Deposit Insurance and Resolution Fund should be a first recourse for these cases, but some form of last-resort backing by government budgets will also be necessary.

Why is the framework we have outlined both good and necessary for Europe? First, it provides a sound basis for the single banking market by avoiding a need for country-related restrictions on bank operations, promoting impartial resolution decisions, and focusing on the common interest. Second, it strengthens discipline for large systemic banks by giving bank creditors a credible prospect of losses while minimising the extent of these losses. Third, it breaks the mutual dependence between banks and national government budgets, reducing the risk of twin fiscal-financial crises of the kind that are currently afflicting several EU members. Building this framework will be well worth the effort.

Marek Belka is director of the IMF’s European Department and a former prime minister of Poland

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