Bank resolution in Europe: The unfinished agenda of structural reform

Georg Ringe, Jeffrey Gordon

Bank resolution is a key pillar of the European Banking Union. This column argues that the current structure of large EU banks is not conducive to an effective and unbiased resolution procedure. The authors would require systemically important banks to reorganise into a ‘holding company’ structure, where the parent company holds unsecured term debt sufficient to cover losses at its operating financial subsidiaries. This would facilitate a ‘single point of entry’ resolution procedure, minimising the risk of creditor runs and destructive ring-fencing by national regulators.

The project of creating a European Banking Union is arguably one of the most important steps on the post-Crisis regulatory agenda. The goal is, inter alia, to provide a sound and unbiased legal framework for resolving global banks, so that the threat of a rescue with taxpayer’s money can be mitigated.

The legal instruments that have been adopted so far are insufficient in many ways (see, for example, Fox 2013 and Ruparel 2013). One aspect which has been largely overlooked in the current debate is that the structure of EU banks does not sit easily with those regulatory goals – on the contrary, the myriad of structures of European banking groups jeopardises the effectiveness of a resolution process. The risk is that resolution of cross-border banks will fragment along national borders, undermining the goal of providing an effective pan-European system. This has dramatic consequences for the preservation of systemic stability:

First, short-term credit claims will be insufficiently protected, meaning that financial distress could easily lead to an exacerbating spiral of runs, fire sale asset dispositions, and credit market freezes.

Second, financial distress may have uneven impact along national dimensions, which will lead to national ring-fencing ex ante and ex post.

The consequence will be an unacceptable risk of a disorderly resolution that will, in prospect, produce regulatory forbearance and may well lead to a more calamitous failure later, a bail-out, or some other form of taxpayer rescue.

A ‘holding company’ structure for large European banks

In a recent paper, we argue that large European banks should be required to reorganise into a ‘holding company’ structure where the parent holds unsecured term debt sufficient to cover losses at an operating financial subsidiary (Gordon and Ringe 2015). This would allow resolution to focus on the holding company level, minimising disruption of the ordinary business of the operating financial subsidiaries. This would facilitate a ‘single point of entry’ resolution procedure that would minimise knock-on effects from the failure of a systemically important financial institution. Resolution through such a structure would minimise run risk from short-term creditors and minimise destructive ring-fencing by national regulators. Such a holding company structure arose by accident in the US, but has provided the basis for the current implementation of Dodd–Frank’s mandate for orderly resolution of a failed financial firm, using a ‘single point of entry’ approach. The perceived credibility of this resolution approach has been reflected in the reduced funding advantage for large US financial firms over smaller ones, suggesting that a credible resolution threat can mitigate ‘too big to fail’ (US Government Accountability Office 2014).

Implementing such a holding company structure could be achieved through a number of different channels.

First, supervisors could insist on such a structure for individual banks in the course of the “recovery and resolution planning” exercise under the Bank Recovery and Resolution Directive (BRRD).

Second, incentives could be given by charging capital surcharges for non-holding company banking groups pursuant to the supervisory assessment of the systemic risks of particular global systemically important banks, as contemplated by Basel III (as implemented in the Capital Requirements Regulation and Directive CRR/CRD IV).

Third, supervisory assessment of extra capital charges for a firm without a holding company structure could be a result of the ECB’s stress tests, another incentives-based approach.

Nevertheless, concerns for the stability of the system as a whole would argue for a more prescriptive approach through addition to the EU’s proposed Structural Measures Regulation, which is currently under consideration. This follow-up project to the Liikanen Report (High-level Expert Group 2012) chiefly considers whether to adopt a form of the US ‘Volcker rule’ to limit proprietary trading by large credit institutions and to require a separately capitalised subsidiary for trading activities that remain permissible. Our argument is that a vital addition to structural renovation is the requirement of a holding company form for systemically important financial institutions in the EU.

The adoption of a holding company structure for systemically important financial firms would minimise a resolution shock. Precisely because the resolution of any systemically important financial firm carries risk of a systemic shock and high externalities, global systemically important banks should not have the option of persisting in an organisational form that increases such risks. There is a better structural alternative – a public HoldCo parent for the operating subsidiaries of the banking group, set up so that the assets of HoldCo consist of shares in its subsidiaries, and that its liabilities are confined to unsecured term debt. This is the missing piece of the proposed Structural Measures Regulation and a missing piece for a credible Single Resolution Mechanism in the European Banking Union.

References

European Commission (2014), “Proposal for a Regulation of the European Parliament and of the Council on structural measures improving the resilience of EU credit institutions”, COM(2014) 43 final, 29 January.

Fox, B (2013), “Eurozone bank fund needs credit line, Draghi says”, EU Observer, 24 September 24.

Gordon, J N and W-G Ringe (2015), “Bank Resolution in Europe: The Unfinished Agenda of Structural Reform”, forthcoming in D Busch and G Ferrarini (eds.), The European Banking Union.

High-level Expert Group on Reforming the Structure of the EU Banking Sector (2012), Final Report, October.

Ruparel, R (2013), “Second pillar of banking union looks insufficient to hold Eurozone up in crisis”, OpenEurope Briefing.

US Government Accountability Office (2014), “Large Bank Holding Companies – Expectations of Government Support” (GAO-14-621), July.