IMF Urges EU to Mull Banking Burden Sharing, System Risk

The cost of bank failures in the European Union should be spread wider, even to senior unsecured bondholders, International Monetary Fund staff said today in a report that also suggests a closer look at U.S. approaches to systemic risk.

Shareholders and other creditors, potentially including senior unsecured bondholders, generally should absorb losses before taxpayers step in, IMF staff said. Today’s report called on the EU to lay out “clear ex ante burden-sharing mechanisms” as it builds a common system for supervising banks and for handling failing lenders.

Bank bailouts might remain an option in an emergency, if policy makers are faced with the prospect of bank runs, asset fire sales or other contagion, staff said in the report, noting that the U.S. already has such an emergency procedure in place. At the same time, “systemic risk” triggers would need to balance national and collective concerns.

The IMF staff said it may be “instructive” for the EU to look at a U.S. law that allows regulators to override a requirement to shut down banks with the “least cost” to taxpayers. “Given evident moral hazard, the law sets a high bar to invoke the exception,” the IMF staff said.

The Washington-based lender broadly welcomed EU efforts to create a single supervisor within the euro area and overhaul its procedures for handling troubled financial firms. The next challenge will be following through on their commitments, Mahmood Pradhan, deputy director of the fund’s European Department, said on a conference call with journalists.

Common Supervisor

“I would say that the implementation and continuing to sustain progress in this area is probably the most important aspect,” he said when asked about risks around the banking union.

EU leaders decided last year to create a common euro-area bank supervisor at the European Central Bank as part of efforts to contain the sovereign debt crisis. The EU also raised the prospect of offering banks direct aid from the 500 billion-euro ($672 billion) European Stability Mechanism as a way to break the crisis cycle of banks and nations exacerbating each others’ borrowing woes.

The IMF said the EU needs to empower the ECB’s single supervisory mechanism, address its implications for non-euro nations, and make progress on how to handle failing banks. Needed steps include creating resolution funds to absorb the costs of individual bank failures, as well as plans for handling broader problems.

Safety Nets

“Progress is required on all elements,” according to the staff report. “Without common resolution and safety nets and credible backstops, an SSM alone will do little to weaken vicious sovereign-bank links.”

The IMF endorsed EU proposals that would require all nations to have plans for handling resolution costs and deposit insurance, paid for by assessments on the banking sector. These funds would be in place to handle individual bank failures.

The ESM could take on direct aid powers as part of efforts to “ensure frail, domestically systemic banks have adequate capital, access to funding at a reasonable cost and positive profits,” IMF staff said in the report.

The ESM is not set up to absorb losses and should be able to exit any aid agreements speedily, albeit on a flexible timetable, according to the report. “Fortunately, there are unlikely to be large insolvent banks currently in most economies.”

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