• Mario Cerrato, University of Glasgow
• Rosaria Cerrone, University of Salerno
• Moorad Choudhry, Recognise Bank Limited (mooradchoudhry@gmail.com)
• Zafer Kanik, University of Glasgow

In this article the authors introduce their current work on developing proposals for a new EU institution for managing bank resolutions using the private resources of banks instead of public resources.

According to the International Monetary Fund (IMF), losses faced by European banks between 2007 and 2010 were around one trillion euro, or the equivalent of 8% of EU GDP, while the EU GDP contraction in 2009, following the financial crisis, was about 6%. The approved state aid measures, including government guarantees, between 2008 and 2012 amounted to 1.6 trillion euro or 13% of EU GDP (European Commission, 2015).

One of the main reasons behind the deteriorating financial stability in this period was that the monetary policy transmission channel has not accomplished its role due to mainly soaring borrowing costs amongst banks and lack of trust in the banking system.

Following the new regulations after the 2007-08 financial crisis, European banks have built more capital and liquidity buffers and reduced non-performing loans from banks’ balance sheets, although these remain at a high level in certain countries. These regulations include the Basel Committee on Banking Supervision’s Basel III guidelines. In addition, three new European Supervisory Authorities were set up:

• the European Banking Authority (EBA)
• the European Securities and Market Authority (ESMA), and
• the European Insurance and Occupational Pension Authority (EIOPA).

The onerous approach to regulation in banking after the 2008-2009 period has provided the basis for a more solid and safer European banking sector.

Recently, the COVID-19 pandemic outbreak has pushed the world economy into recession with significant drop in GDP and rise in unemployment. Governments and central banks (CB) have intervened in support of the economy and the banking system by expanding public deficits and “non-conventional” CB operations, (which also, ultimately, are further calls on the public purse). Thanks to ten years of the Basel III regulatory framework, banks had comfortable capital and liquidity buffers in place and strong balance sheet resources before the pandemic started, however a prolonged period of economic turbulence in combination with a more active role of banks in support of the economy, might lead to weaken the solvency position of banks in Europe.

Even though the recent developments in banking regulation and resolution mechanisms strengthen financial stability, a balanced plan for the completion of a banking union is still far from being achieved. In particular, creating the Banking Union was one of the major goals following the financial crisis. Currently, the Banking Union rests on two pillars: the Single Supervisory Mechanism (SSM) and the Single Resolution Mechanism (SRM). Both are contributing to financial stability and a level-playing field for banks in the Eurozone. EU policymakers have reshaped and harmonised how major banks in EU area are supervised and they have further aligned the application of the EU’s Single Rulebook. The centralised resolution planning introduced after the financial crisis has provided confidence that a crisis in a significant bank can be managed more efficiently. As a result, the SRM takes a crucial step in effective resolution of distressed financial institutions. However, a main criticism to the mechanism is the source of the funds and its capability against large losses of financial institutions. The final steps to complete a banking union should be taken between now and 2027 and rests on building a European Deposit Insurance System (EDIS) as a Banking Union’s third pillar. This is taking longer than initially expected since a first legislative attempt to create an EDIS in 2015 did not find sufficiently broad support (Cerrone, 2018). Moreover, some underlying divergences between the Members States need to be significantly reduced for the integration of the Eurozone’s banking sector to progress. Based on experience gained over the last years, European policymakers and banks are now reviewing the structures in place which might require some corrections and additional building blocks. Moreover, this proposal has been strongly opposed by Northern EU countries but supported by Southern European countries as it entails losses to be shared amongst European countries. This is the so called “third Pillar” of the Banking Union and it is necessary to complete the mechanism. The lack of international convergence about deposit insurance schemes raised concerns among bank regulators and policymakers, particularly after the failure of some cross-border banks. This highlighted the domestic prerogative of protection systems and the composition of banks’ trading book (Miglionico, 2020; Howarth, 2020).

In this project, we propose a new EU Institution for managing banks’ resolution that is based on using private resources of banks instead of reliance on public resources. The proposed regime aims to overcome the main limitations of SRM and does not rely on mutualisation of losses amongst member states in Europe. The model is easy to implement and similar to the existing mechanism that is used to mitigate counterparty risks in the derivatives market via the Clearing Counterparty (CCP) mechanism. The recent developments on bank resolution policies take important steps toward reducing the burden on the taxpayers via implementation of new policies such as mandatory bail-in power of the resolution authorities, however the existing policies are still far from addressing the resolution issues completely. In a model of bailouts and bail-ins by banks, Kanik (2019) shows how banks’ transfer resources to each other to prevent bank failures in the presence of counterparty exposures and how bailout costs to the government can be reduced via implementing interbank regulations.

The resolution regime proposed in this study institutionalizes the framework in rescue models such as in Kanik (2019). In particular, we offer a centralized risk-sharing mechanism that can be used effectively to prevent bank failures against various sources of risks. A new vision of bank risk sharing as the one we discuss in this project should also boost a new era of banks’ recovery plans. Critically, it removes the liability of the taxpayer to failing banks and knock-on systemic risk.

References

• European Commission, (2015), Completing Europe’s Economic and Monetary Union: Commission takes concrete steps to strengthen EMU
• Cerrone, R., (2018), Deposit guarantee reform in Europe: does European deposit insurance scheme increase banking stability? , Journal of Economic Policy Reform, 21(3):224–239.
• Miglionico A., (2020), The ESM Treaty and the Single Resolution Fund: The Unfinished Reform, Open Review of Management, Banking and Finance, vol. 6, issue 1, pp.106-117.
• Howarth D., Quaglia L., (2020), “The difficult construction of a European Deposit Insurance Scheme: a step too far in Banking Union?”, in The Difficult Construction of European Banking Union, ed. David Howarth, Joachim Schild, Routledge.
• Kanik, Z., (2019), “From Lombard Street to Wall Street: Systemic Risk, Rescues, and Stability in Financial Networks,” University of Glasgow, working paper series.

More information

Draft policy proposals from this project are in development and will be shared later this year.