Commission’s Consultation on Bank Failures – Too Little, Too Late?

The European Commission has launched a consultation on technical details underpinning a European crisis management framework for the financial sector. The main measures proposed:

• Preparatory and preventative measures such as a requirement for recovery and resolution plans and powers for authorities to require banks to make changes to their structure or business organisation where such changes are necessary to ensure that the institution can be resolved;
• Powers for supervisors to take early action to remedy problems before they get out of hand such as the power to change the managers;
• Resolution tools which empower authorities to take the necessary action, where bank failure cannot be avoided, to manage that failure in an orderly way;
• A framework for cooperation between national authorities.

The two main principles proposed by the Commission are:

• Effective arrangements which ensure that authorities coordinate and cooperate as fully as possible in order to minimise any harmful effects of a cross-border bank failure, and
• Fair burden sharing by means of financing mechanisms which avoid use of taxpayer funds.

Now, the problem is that we already have a situation that may well get out of hand. Fortune has quoted Scott Minerd, chief investment officer at Guggenheim Partners, who thinks the entire banking system of Europe could be on the brink of disaster (I recommend reading the whole article). If this is true, the Commission’s initiative will not have the time to translate into meaningful EU policy. More, the proposal is not sufficient to solve the problems of the EU banking sector, which is heavily exposed to sovereign debt.

Scott Minerd says that it’s now up to Germany to take leadership in organizing a fiscal union and creating a common EU bond. He rightly points out that this means a true federalization of the European Union, since fiscal policy will be, to some extent, managed on EU level.

In other words the impending banking crisis in the European Union could result in a true federalization – the dream of the founding fathers of the EU. But it sounds simpler than it actually is. Many things can go wrong, and the markets are not exactly ready to accommodate the Hamletian dilemmas of EU Member State governments. The recent approach of Germany and France to coordinate positions and try to sell them as unconditional proposals is not sustainable. EU governments should discuss options multilaterally, taking into account varying positions and nuances. We need true European consensus on fiscal governance, not empty declarations on the centrality of the Economic and Monetary Union.

Are Bank Resolution Funds Necessary?

The Commission proposes the establishment of ex ante resolution funds, funded by a levy on banks, to facilitate the resolution of failing banks in ways which avoid contagion, allow the bank to be wound down in an orderly manner and in a timeframe which avoids the “fire sale” of assets.

This should create a harmonized network of national funds linked to a set of coordinated national crisis management arrangements. The Commission also thinks that an EU Resolution Fund is possible in the longer term.

However, many think that the proposal institutionalizes moral hazard and will encourage banks to hold riskier asset portfolios. France and the UK in particular do not support the idea, and prefer to use the proceeds from any bank tax to finance their budgets.

So are bank resolution funds really necessary? It depends how you look at it. I very much like the analysis by Anthony M. Santomero and Paul Hoffman, saying that:

“(T)hese policy options may offer some hope to sustain the institutions’ lending capacity and consumer confidence for a short period of time. However, in the end, all of these options are no replacement for sound bank management and a sound balance sheet.”

I also don’t see how such funds will resolve typical weaknesses of the legal framework that have resulted in (i) incentives to postpone adequate treatment of failing banks; (ii) higher costs for bank resolution; and (iii) weaknesses in the banking system itself.

Stefano Micossi has said it quite clearly: if supervisors behave correctly, then large residual losses from bank failures become unlikely.