How would the resolution of a bank work, in practice? Let’s go step by step.









This article was prepared for the Brussels Think Tank Dialogue – The EU’s New Leaders: Key Post-Election Challenges on January 28th. Registrations are now open.

On the 19th December 2013, the EU finance ministers reached an agreement on the proposal for a Single Resolution Mechanism (SRM), which will now have to pass the scrutiny of the European Parliament. The President of the European Parliament has been very critical of the agreement, pointing especially at the complexity of the resolution process and at the absence of a role for the ESM as an insurer of last resort during the transition phase. “If we were to implement the ECOFIN decisions on a banking union in this way” Schulz said “it would not only be a lost opportunity. It would be the biggest mistake yet in the resolution of the crisis. If the resolution mechanism for banks does not work properly, it could jeopardise financial stability. A Banking Union is something which must either be done right or not done at all. The European Parliament will therefore not support the ECOFIN decisions in this form.”

But how would the resolution of a bank work, in practice? Let’s go step by step.

When will a bank be put into resolution?

According to the Regulation, three conditions need to be satisfied (all of them) for a bank to be put into resolution:

The bank is failing or likely to fail, and; Given that the bank is failing or likely to fail, there are basically no alternatives to resolution, and; Resolving that bank is also in the public interest.

The public interest criterion is considered satisfied if the operation “achieves and is proportionate to one or more of the resolution objectives specified in the regulation and if the winding up of the entity under normal insolvency proceedings would not meet those resolution objectives to the same extent”.

When is a bank “failing, or likely to fail”?

To establish whether a bank is failing or likely to fail the text lists a number of criteria:

“The entity is in breach or there are objective elements to support a determination that the institution will be in breach, in the near future, of the requirements for continuing authorisation in a way that would justify the withdrawal of the authorisation by the ECB or national competent authority”

“The assets of the entity are or there are objective elements to support a determination that the assets of the entity will be, in the near future, less than its liabilities.”

“The entity is or there are objective elements to support a determination that the entity will be in the near future unable to pay its debts as they fall due.”

“Extraordinary public financial support is required except when, in order to remedy a serious disturbance in the economy of a Member State and preserve financial stability” the above-mentioned extraordinary public financial support takes some specific forms

The criteria are relatively vague, consistently with the fact that the matter is not clear-cut in practice and there is no mechanistic formula that could tell us exactly whether a bank needs to be resolved. In the end, it will be a decision based on a supervisory assessment. And this is the reason why it would be fundamental to ensure a decision process that can deliver quick agreement.

Who decides, then, if a bank is to be placed in resolution?

The assessment of the criteria is conducted by the Board of the Single Resolution Mechanism, which can start on its own or after receiving a communication by the ECB that the bank is failing or likely to fail and that there are basically no alternatives to resolution. Assuming that the ECB will conduct its job of supervisor properly, it seems reasonable to expect that the process will normally be triggered by the ECB.

What happens, in practice, when a bank is resolved?

IF all the conditions in step 1 are met, then the Board adopts a resolution scheme, which places the entity in resolution and at the same time shall:

Determine the details of the resolution tools to be applied to the institution. The resolution tools available are: Sale of business Bridge institution tool Asset separation tool Bail-in tool Determine the specific amount and purposes for which the Resolution Fund will be used to support the resolution action;

Who decides on the resolutions scheme?

The resolution scheme is adopted by the Board of the SRM, but within 24 hours the Council can, on proposal by the Commission, object or request amendments to the resolution scheme. In case of disagreement, a back and forth interaction would start between the Council and the Board [5]. The Council, can object or request amendment only on a set of specific matters, but these matters are fundamental ones, such as for example “the assessment made by the Board on whether the criteria [triggering resolution] are met” or “ the adequacy of the resolution tools chosen by the Board including […] any use of the exemptions” and “the extent to which the use of the Fund respects its purposes”. It should be self-evident that these are politically sensitive issues that could trigger discussion, disagreement and dangerous delay.

And so, what?

The decision-making process envisioned in the SRM Regulation is therefore potentially problematic. Assuming the that the process will be triggered by the ECB, then the decision to place a bank in resolution would involve the SSM Board (24 members), the ECB Governing Council (24 members), possibly the SSM Mediation Panel (minimum 3 members) and Executive Boards (up to 10 members) and the Board of the SRM (23 members). Even if these two steps were to go smoothly – which seems hard to believe, given the high political sensitivity of the elements to be included in the resolution scheme – the next level could be a back-and-forth-arguing between the Board and the Council (28 members), on a proposal by the Commission (28 members).

What is worse, all this would be unfolding before the eyes of reasonably nervous investors and depositors, in the absence of a credible backstop. The deal of 19th December includes a commitment to establish a common backstop of 55bn by 2025 at the latest but it will take time to build up the pot and no common backstop will effectively be available in the coming years, when it may be needed the most because of the possible consequences of the ECB exercise. During the transition the EU’s fund will be split into national compartments to be merged over time. Countries in need of extra funding for resolution can inject money into the domestic compartment or ask other nation’s resolutions funds to willingly lend money to the national compartment. Otherwise, the alternative is a traditional ESM loan like it was done in the Spanish case (because ESM direct recap remains unavailable). In the immediate future, this construction will not differ much from the status quo, with the consequence that the link between banks and sovereigns will not be weakened and that different member states position could still lead to potentially very large heterogeneity in the approach to financial sector problems.

When speaking of resolution, time is money. And not only in a figurative way: rapidity is really the essence to prevent massive withdrawals of funds. At the same time, confidence is likely to drop the faster in the absence of a credible backstop. Such credible backstop is missing for the immediate future in the European deal and the resolution process envisioned would require a large number of actors who would need to agree quickly on matter that are politically very sensitive. It’s really hard to see how the resolution of a bank in Europe could be carried out over a weekend. Unless of course if it was a very long weekend, like in Cyprus.

[1] Proposed Regulation 18070/13, available at http://register.consilium.europa.eu/doc/srv?l=EN&t=PDF&gc=true&sc=false&f=ST%2018070%202013%20INIT&r=http%3A%2F%2Fregister.consilium.europa.eu%2Fpd%2Fen%2F13%2Fst18%2Fst18070.en13.pdf

[2] “Having regard to timing and other relevant circumstances, there is no reasonable prospect that any alternative private sector or supervisory action […], taken in respect of the entity, would prevent its failure within a reasonable timeframe”;

[3] Including but not limited to because the institution has incurred or is likely to incur losses that will deplete all or a significant amount of its own funds.

[4] (i) a State guarantee to back liquidity facilities provided by central banks according to the central banks’ conditions; (ii) a State guarantee of newly issued liabilities; (iii) an injection of own funds or purchase of capital instruments at prices and on terms that do not confer an advantage upon the entity, where neither the circumstances set out in points (a), (b) and (c) of paragraph 2 nor the circumstances set out in Article 14 are present at the time the public support is granted.

[5] “In case the Board does not agree with one or more of the directives formulated by the Council it may, during the deadline fixed by the Council, address a notice to the Commission and to the Council requesting their amendment and explaining the reasons for disagreement, in which case the referred deadline shall be suspended. The Council may, in a deadline of 24 hours after reception of the Board’s notice, on proposal by the Commission, amend its directives in line with the views expressed by the Board. If, during the deadline referred to in this subparagraph, the Council has not acted or if the Council expressly rejects the request for amendment by the Board, the latter shall incorporate the Council’s directives in the resolution scheme. Where the Council objects to the placing of an institution under resolution on the ground that the public interest criteria referred to in paragraph 2(c) is not fulfilled, the relevant entity shall be orderly wound up under normal insolvency proceedings within the meaning of Article 2 point 40 [BRRD]”.

[6] Moreover, if the resolution action involves the granting of State aid or of Single Resolution Fund aid, the adoption of the resolution scheme shall not take place until the Commission adopts a positive or conditional decision concerning the compatibility of the use of public aid with the internal market. But this can be a conditional decision, so it could be rapid.

[7] The FT Brussels Blog recently produced a striking visual representation of the agents involved at http://blogs.ft.com/brusselsblog/2013/12/how-to-shutter-a-bank-in-europe/