Europe’s Newest Steps Forward to Deal with Failing Banks

After 16 hours of marathon negotiations, the European Union struck a deal on March 20 to create a single resolution mechanism (SRM) and single resolution fund (SRF) for failing European banks. In theory, the contours of how to shut down such a bank are now clearer, but we still need the fine print. On substance, the agreement is not even close to an optimally designed banking resolution institution. Inevitably it reflects the splintered fiscal sovereignty and complex institutional structure of the European Union and the euro area. Institutional simplicity is a luxury that Europe has never enjoyed.

The deal was the product of the so-called “institutional trialogue” involving EU member states, the EU Commission, and the EU Parliament. Under the pressure of a self-imposed deadline, negotiators had to rouse Germany’s 71-year-old finance minister Wolfgang Schäuble in the dead of night to get final approval. There was no need for acute financial market pressure to compel a deal this time, just the risk of future volatility jeopardizing the euro area’s newfound stability.

There was a little bit for almost everyone in the agreement, which resembled what EU finance ministers accepted in December. This reflected the continued strong role of member state governments in EU decision making, but the new agreement was improved because the European Parliament — assisted by the European Central Bank (ECB) and the European Commission — exercised its influence over member states (especially reluctant Germany). Coming ahead of the European Parliament elections, members’ hard line was to be expected, and parliamentarians will be satisfied.

At least three issues have been improved upon.

Accelerated Mutualization of the SRF. The national components of the SRF will be fully mutualized after eight instead of ten years, with 40 percent after the first year and 60 percent after the second*, rather than the 10 percent annually envisioned in December. This accelerated incrementalism is generally good news.

SRF Borrowing Capacity. The SRF remains capped at €55 billion (1 percent of covered deposits) after eight years, a small amount for a large banking system. Yet the fund can borrow in financial markets if necessary, against incoming cash flows of future banking sector contributions to the SRF, giving it access to large additional resources. How much it can borrow is not clear, but this capacity lets it avoid reliance on taxpayer funds or guarantees. The absence of taxpayer involvement enables the mutualization of the contingent fiscal liabilities of member states. The actual decision for the SRF to borrow funds must be made by the single resolution board (SRB), though the voting rules remain unclear: simple majority of member states, some sort of qualified majority, or perhaps even unanimity? The fine print will tell.

Somewhat Streamlined Decision Making. When EU leaders lack an institutional solution to a financial or regulatory problem, they usually hand over the responsibility to the ECB. So too this time, as Frankfurt’s role has been strengthened. The fine print again remains to be seen, but it will now be more difficult for member states and the EU Council to try to block an ECB requested/triggered shutdown of an ailing bank. In the words of Mario Draghi, president of the ECB, the central bank is in the “leading role” in the assessment of whether a bank is failing. Does this mean that political interference is still possible? No. Member states remain excessively involved in the work of the SRB when the ECB asks it to deal with a domestic bank.

Has the link between member states and their banks, the infamous “doom-loop,” been completely broken in Europe? No. But the link is reduced not only because of the ECB’s new regulatory responsibilities but also because of the new rules requiring future costs imposed on creditors and the latest steps on the SRM/SRF.

Does this mean that the new system can deal on autopilot over a weekend with a collapse of one of Europe’s real megabanks? Of course not. But as argued before, such an expectation is unrealistic. It is irrational to expect any regulatory framework to deal flawlessly over a weekend with the potential collapse of a genuine megabank and/or a truly systemic banking crisis. The US government did not just hand over Citibank to the Federal Deposit Insurance Corporation (FDIC) in 2008. A new settlement and backstop had to be created first. And the Royal Bank of Scotland (RBS) — Britain’s largest bank — had to be taken over by the UK government through a new act of parliament. It is mistaken to demand that new European institutions now accomplish what the two oldest and most established financial centers in the world failed to do in 2008.

It would be institutionally desirable to have the SRF backstopped by a single euro area treasury. But the euro area still lacks the political integration to enable such an entity. But the argument that the SRM is fatally flawed because of its lack of an explicit access to the public funds like those backing the FDIC** is erroneous. To make such an argument would imply that future euro area leaders would let their banks and entire financial system melt down in the next crisis. They did not do that from 2008-13, and there is no reason to expect them to do so in the future. If no private sector sources extend credit to the SRF in the midst of the next crisis, which is not unlikely, public credit from a euro area institution like the European Stability Mechanism (ESM) would likely be available, irrespective of what policymakers state publicly today. After all, Article 19 in the ESM Treaty [PDF] states that the ESM Board (i.e., the euro area finance ministers) may change the rules for what the ESM can lend to at any time. The ECB will have been regulating such a future troubled bank, so the legacy asset issue would be void by definition. The option of letting an individual member state pay does not apply.

Moreover, it is overly alarmist to assume than an SRM without a public backstop would be so publicly discredited as to permit bank runs. After all, with the exception of the United Kingdom’s Northern Rock in 2007, no bank runs have occurred in Europe during this crisis. Even lacking an explicit deposit guarantee or resolution authority, the European threshold for such retail bank runs is higher than generally assumed.

With all these new elements in place, the new banking union will be able to deal with most future failures of medium and large banks in Europe more expeditiously and without costs to taxpayers. This includes individual cases of megabanks collapsing due to internal faults, like Credit Lyonnais in the 1990s. Only in cases of another systemic crisis like the one in 2008 will public funds be required and a new political settlement necessary in the euro area. But that is no different from what remains the case in the United States or the United Kingdom.

That is no trivial achievement for the euro area, even if the institution-building process has come at a cost of years of economic stagnation. Yet compared to the experience of the US political system, which created the FDIC after 4,000 commercial banks and 1,700 savings and loans institutions failed in 1933, the euro area birth pains have not been so great.

The SRF represents the first gradual mutualization of what were previously national fiscal obligations in the euro area. In eight years, Europe will have a common banking industry-financed fund, replacing the haphazard system of national governments and their taxpayers dealing with the cost of shutting down all but the largest banks in a systemic crisis in Europe. This experience suggests that a path toward government debt mutualization (eurobonds) might follow a similar course.

First, in the banking union negotiations, “legacy assets” had to be dealt with by national government resources, except when national governments accepted bailouts and subjected themselves to external conditionality. Thus a national government will likely have responsibility before the fact to reduce government debts to sustainable levels (say 60 to 80 percent of GDP), before any pooling of such debts into eurobonds. Many euro area countries will thus have to adhere to the new Fiscal Treaty’s debt stock reduction requirements*** for some time if they want access to common eurobonds.

Second, in the banking union there has been a political requirement for the regulatory aspect in the Single Supervisory Mechanism (SSM) to take force before any move towards mutualization of banking sector contingent liabilities. Deeper political union in the euro area will therefore have to precede any mutualization of government debts in the euro area.

Finally, the banking union — including the new SRM/SRF compromise — has been one long institutional aggrandizement of the ECB, the euro area’s indispensable institution and the only one that is federal in its decision making (with one country, one vote). With ever more European regulation carried out by an institution with that type of decision-making procedures — as opposed to the EU Council with its qualified supermajority or occasional unanimity requirement — European integration has been substantially, if stealthily, strengthened.

The ECB has repeatedly shown its institutional independence and political power to say no to member states’ requests for financial aid. Hence it remains the most powerful central bank in the world. Compared to bank regulators in other countries, it will have the same institutional and political independence in this area as well.

* The remaining 40 percent would be mutualized over the last six years in a straight line. See the European Parliament Website.

** During the crisis in 2008-10, the FDIC was authorized to borrow up to $500 billion. See the FDIC website.

*** The Fiscal Treaty in principle requires that any member state reduce its debt in excess of 60 percent of GDP by one-twentieth each year.

Copyright ©2014 the Peterson Institute.

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