Resolution in Europe: The Unresolved Questions

Andreas Dombret, Patrick S. Kenadjian, Andreas Dombret, Patrick S. Kenadjian

• Publisher: De Gruyter
• Year: 2019
• Print ISBN: 9783110640212
• eBook ISBN: 9783110640502
• Edition: 1
• Topic: Law
• Subtopic: Financial Law
• Index: Law

IResolution Issues in Europe

Elke König

Keynote: The journey to resolvability

Elke König, Chair Single Resolution Board

In early 2010, Paul Calello and Wilson Ervin wrote in The Economist1: “What should policymakers do when faced with the potential failure of a large bank? In 2008 officials had to choose between taxpayer bail-outs (bad) or systemic financial collapse (probably worse). Various ideas to make finance safer, like contingent capital and living wills, are circulating today. But the central issue of bank resolution, perhaps the most vexing aspect of the financial crisis, has not been clearly addressed.”

Eight years on, it is fair to say that the journey to making banks resolvable is well under way. At the international level, the G20 granted the Financial Stability Board (FSB) the mandate to steer the reform process. This effort culminated in 2011 with a framework2 setting out the core elements that the FSB considers necessary for an effective resolution regime.

The work of the FSB has served as the blueprint for the European resolution framework, consisting of the Bank Recovery and Resolution Directive (BRRD) and the Single Resolution Mechanism (SRM) Regulation, which establishes the Single Resolution Board (SRB) as the central resolution authority within the Banking Union.

The SRB has been operational as an independent European Union (EU) Agency since January 2015, and became fully operational, with a complete set of resolution powers, on 1 January 2016. Together with the National Resolution Authorities (NRAs) of participating Member States, it forms the SRM. Its mission is to ensure an orderly resolution of failing banks with minimum impact on the real economy, the financial system, and the public finances of the participating Member States. The role of the SRB is proactive: rather than waiting for resolution cases to handle, the SRB focuses on resolution planning and preparation, with a forward-looking perspective to avoid the potential negative impact of a bank failure on the economy and on financial stability, and most of all to protect the European taxpayer.

It is worth underlining, however, that resolution is a specific procedure, introduced as an alternative to national insolvency regimes, and which under the EU regulatory framework would only apply where resolving the failing bank is in the public interest – be it out of financial stability concerns or because of the critical functions performed by the bank in the Member State.

In this context, the SRB’s goal amounts to a paradigm shift seeking to end the notion that banks are “too big to fail” by ensuring that all institutions under its remit are resolvable.

Making banks resolvable

One of the key starting points to making banks resolvable is to ensure that ailing banks have sufficient funds to absorb losses and recapitalise the entity internally, thereby replacing the need for a taxpayer-funded bail-out with a privately financed “bail-in”.

At EU level, the BRRD introduced the Minimum Requirement for Own Funds and Eligible Liabilities (MREL). MREL should ensure there is sufficient loss-absorption capacity by shareholders and creditors at all times to enable an effective bail-in and an orderly resolution in case a bank fails. MREL is set by the resolution authority and forms a key part of the resolution plan.

The SRB has taken a gradual, multi-year approach to MREL that takes into account the specificities of the banks under its remit, with the goal of maintaining proportionality in the system while preserving a level playing field and upholding high resolution standards across the Banking Union.

The initial approach has been to set informative MREL targets, to allow banks to prepare for their future MREL requirements. In 2017, the SRB started to address both the quantity and quality of MREL with binding requirements and bank-specific features. In the ongoing and future resolution planning cycles, we will broaden the scope to develop binding MREL targets for all major groups and also for significant entities within the groups. Building internal loss-absorbing capacity is crucial to ensure that, within a group, losses are passed from the entities where they originate to those entities where resolution action is coordinated.

MREL is a key tool to achieve resolvability, but cannot be put in place overnight. It is important for the resolution authority to retain a certain level of flexibility and realism about the capacity of particular banks to meet MREL requirements immediately. Our goal, however, is clear, and each bank must arrive at a situation where it is able to absorb losses and restore its capital position, allowing the continued performance of its critical economic functions during and after a crisis. This will call for further refinements – in quantity and quality – in the continued development of the SRB’s MREL policy. Banks should be aware that MREL is here to stay, and that future requirements – in particular with regards to the quality of MREL – will increase rather than decrease.

Impediments to resolution

Resolvability, however, is not limited to MREL: it should be understood as a broader concept that embraces the manifold aspects of a bank’s operations. Sufficiently high MREL levels alone cannot underpin a successful resolution if, for example, access to financial market infrastructures (FMIs) cannot be guaranteed. Indeed, a crucial task of the SRB’s resolution planning involves identifying for each bank possible impediments to resolution and ensuring these are adequately addressed.

The findings from our first resolution planning cycles have revealed the following areas, among others, as potential obstacles to resolution: (i) management information systems; (ii) operational continuity; (iii) funding in resolution and (iv) group structures.

Inadequate management information systems can result in a lack of timely information essential for resolution planning and execution, or for valuation purposes. Developing the technological and operational capability to provide relevant information to resolution authorities and for supporting the implementation of resolution measures is therefore a key challenge for banks. While this may entail some investment expenditures and may impact existing systems, these costs should be weighed against the benefits in terms of supporting the day-to-day management, increased transparency and enabling a coherent management, both in business as usual and in resolution.

Secondly, ensuring operational continuity in resolution and maintaining access to financial market infrastructures and FMI intermediaries ahead of, and during resolution is another important element of ensuring resolvability. This requires, among others, banks to identify and map all services necessary for the provision of critical functions and critical business lines; setting up a repository of all service level agreements and contracts with critical internal and external service providers, which should be resolution-proof; and identifying and mapping all critical FMI services from FMIs and FMI intermediaries.

Furthermore, financial arrangements must be in place to ensure that during and after resolution access to liquidity and funding is maintained or regained to safeguard the continuation of the bank’s critical functions, regardless of whether they will remain within the bank under resolution or will be transferred to a third party purchaser or to a bridge bank. In the period leading up to the failure of the bank, it is likely that liquidity needs have increased, funding has become more expensive and collateral requirements have increased.

Finally, banks, particularly large cross-border ones, are characterized by complex group structures which can present a barrier to their resolvability. A resolution authority must therefore ensure that the legal and funding structures of the group facilitate the implementation of the preferred resolution strategy. This implies identifying and removing sources of undue complexity in the legal structure, as well as developing plans for achieving a sufficient amount of appropriate loss-absorbing instruments in the right location.

Building resolvability together

Building resolvability is not a task for the regulator alone. The SRB relies on the good cooperation and compliance of the industry: the SRB will set the focus and provide the impulse, but banks themselves are expected to make changes in their organisational structure and operations to facilitate their orderly resolution in case of crisis. The SRB will subsequently monitor and assess the progress made in achieving banks’ resolvability.

The banks are well aware of the different aspects that should be addressed to make themselves resolvable and should therefore proceed without waiting for detailed regulators’ instructions. Responsible bank management teams will already be working on these areas, and we encourage those lagging behind to follow the lead of others in the industry. Given the favourable economic climate, now is the time to address such issues.

Moreover, the SRB cooperates with the national competent authorities. This close relationship with authorities who have their finger on the pulse locally is essential to our work, as it allows us to address the specific issues related to particular banks and to adequately reflect national specificities.

Completing the jigsaw

Making banks more resolvable also requires strengthening the regulatory framework and finalising the institutional architecture.

The revision of the BRRD, with the transposition of the international total loss absorbing capacity (TLAC) standard in EU legislation, is a key milestone towards finalising the rules under which the SRB operates and providing clarity to the industry and investors, particularly on MREL. Complexity should be avoided where possible; transparency and predictability are of utmost importance for the institutions and for the markets. Yet, it is important that the SRB retain discretion and flexibility for the purpose of MREL setting and calibration, to ensure a level playing field for credit institutions in the Banking Union.

More broadly, completing the Banking Union must be a priority for the European Union in the months ahead. This entails setting up a common backstop to the single resolution fund (SRF) and establishing a European Deposit Insurance Scheme, as the third pillar of the Banking Union.

A well-designed backstop, available as a last resort, will give markets the confidence that large, complex banks are truly resolvable, and reduce stress on the financial system in the event of a bank failure.

A backstop, however, will not solve by itself the key issue of funding in resolution, which needs to be addressed jointly with other authorities. While the resolution framework provides for powers and tools to restore the solvency of failing institutions, even if the bank is well recapitalised after the resolution week-end, it is expected that it will still experience liquidity stress as market confidence might take some time to reappear.

The SRF can contribute to the provision of funding in resolution. However, considering its capacity, articulation with other sources of funding is required to handle the failure of a large complex bank or a series of banks. Cooperation and a common understanding with central banks to address gaps in the current framework will be of vital importance to make progress. Developing an effective solution would give market participants the confidence to provide funding to banks soon after the resolution weekend, and in turn may limit the need to access such facilities.

Finally, we are currently faced with 19 different insolvency regimes in the Banking Union alone. This makes the analysis of the insolvency counterfactual for a cross-border bank in resolution highly challenging, and results in diverging outcomes depending on the home country of the institution. Bank insolvency procedures should be elevated to a common best standard and practice at EU level. The ideal solution would be EU wide rules on insolvency proceedings for the banking sector, with the development of national handbooks by the resolution authorities as just a ‘second best’ option.

Conclusion

At the peak of the crisis, large banks were considered too big, too complex and too interconnected to fail, raising a moral hazard issue as bail-outs were chosen for lack of a better alternative.

The regulatory response has determined a fundamental paradigm shift, and bail-in rather than bail-out is now the norm. According to a simulation by the European Commission, the benefits to the real economy of higher bank capital requirements introduced under CRD IV and the new bail-in rules deliver combined macroeconomic benefits amounting to 0.6%-1.1% of EU GDP per year, while the macroeconomic costs of these reforms amount to a mere 0.3% of GDP.

Some are arguing that the regulatory tightening which occurred in the wake of the crisis has been excessive and that a loosening of the screws is now warranted. On the contrary, we maintain that regulatory backsliding, when many new rules are still panning out, would be a mistake. Given the current favourable economic climate, now is rather the time to continue implementing the post-crisis rules to make sure the system is better prepared against future shocks.

The regulations that have been adopted since the crisis, and the technical work undertaken on resolution, mean that many banks can now safely enter insolvency without causing disruption to financial stability. The work to make banks resolvable, however, is not over. As we are keen on saying, resolution is a process, not a product. The combined efforts of the regulators and the industry to refine resolution plans and address impediments to resolvability must go on.

Andreas Dombret

A brief progress report on the resolution framework in Europe

Andreas Dombret, Member of the Board of Deutsche Bundesbank (May 2010-May 2018)
Member of the Board of the Bank for International Settlements

Introduction

One of the key lessons of the financial crisis was understanding the dangers of banks that are “too big to fail” and their costs to the taxpayer in terms of public bailouts. In Europe, legislative responses to this included the adoption of a new European resolution framework and the introduction of a European resolution authority, thus transposing into European law the FSB Key Attributes of Effective Resolution Regimes for Financial Institutions. Today, with the European resolution framework now fully implemented and in force, a crucial question arises: does the new resolution regime fulfil its initial objectives? Recent events have led some to doubt the general approach of the new regime. This article argues that instead of questioning the general direction of the resolution framework, analyses have to carefully distinguish between different cases and identify specific impediments to the regime. Also, it has to be acknowledged that even though the legal framework has been established, the sector is still in the process of transitioning to the new resolution regime.

Background

In order to properly assess the new resolution regime in Europe, we need to recall how things were prior to its introduction. In the grand scheme of things, the flaws in the former regulatory framework can be summarised as major inconsistencies in a market economy. There were banks that were too big to fail and some were bailed out by governments, showing that the path of least resistance was to use taxpayers’ money to stabilise the financial system. Indeed, under the conditions at the time, this may have been the only tenable course of action at all. For managers and investors, this worsened existing bad incentives such as “gambling for resurrection” – which means focusing on the unlikely prospects of recovery.

As a consequence, and on top of an overhaul of capital and liquidity regulation, the “new” resolution regime for banks was developed to overcome these market economy inconsistencies. Restoring the principles of the market economy provided a solution to the political dilemma of having to decide between systemically risky insolvency proceedings on the one hand, and economically and politically questionable bail-outs on the other.

To overcome this, the basic idea is that if an institution fails, its shareholders and creditors should be the first in line to take on the risks and absorb the losses. While the actual realisation of a cr...

Table of contents

• Cover
• Title Page
• Copyright
• Introduction
• Contents
• The Authors
• I Resolution Issues in Europe
• II Insurance Company Resolution
• III Cross-Border Issues
• IV CCP Resolution
• V Conclusion