Banking

Testing Europe's Resolve on Failing Banks

The Single Resolution Board was off to a good start, but there are causes for concern.

Easy resolution.

Photographer: Lluis Gene/AFP/Getty Images

Here is the most important European institution most people have never heard of -- and they won't hear about it until a crisis hits. But is it ready?

These were my thoughts as I attended the second annual conference held by the Single Resolution Board in Brussels last Friday. This body, set up in 2015 as part of the so-called "banking union," has the powers to wind down a medium-sized or large lender after the European Central Bank declares it "failing or likely to fail." The idea is to remove the ability to pull the plug on a troubled bank from the hands of national supervisors, who may have a vested interest in delaying the decision -- such as hiding a past supervisory failure.

The SRB faced its first major test this year, when it closed down Banco Popular, a Spanish lender, wiping out shareholders and junior bondholders and selling the bank to rival Banco Santander for one euro. The rescue was rightly hailed as a success, since it spared taxpayers from losses and did not cause any significant contagion. However, the SRB also got lucky: There was a willing buyer, prepared to step in just as Popular was experiencing a bank run. There is no guarantee this will occur again in the future.

The resolution of Banco Popular does not therefore address all the doubts about the SRB's ability to handle a crisis. There are three sets of questions which still need to be answered. First, can the SRB handle a messy bank failure? Second, can it find sufficient liquidity when the market is unwilling to provide it? Third, can it be even-handed, especially with regard to politically sensitive mid-sized banks? In all these areas, there are reasons for concern.

In theory, the SRB should have sufficient funds to take over a bank and then auction it (or parts of it) to a willing buyer. The problem is that the Single Resolution Fund, the SRB's war chest, has a capacity of only 55 billion euros ($64.7 billion). It is not clear this will be enough if a string of larger banks get into trouble.

Of course, in theory there is no need to use the fund. The SRB has to first impose losses on shareholders and debt-holders. For this reason, it must guarantee that there are enough securities which can be wiped out to restore sufficient viability. The forthcoming creation of a buffer -- the so-called "minimum requirements for eligible liabilities and own funds" (MREL) -- addresses that problem. Unfortunately, the banking lobby, particularly from countries with weaker lenders such as Italy, is already asking that these new rules are watered down. The SRB and the European Commission will need to stand firm, even if national governments lobby on behalf of the banks.

The SRB's ability to handle a bank failure will also hinge on whether it is able to convince investors that they should continue to provide liquidity. This was the case with Banco Popular, but there may be instances where investors choose to cut off the new institution from funding. There, the only option would be to knock at the ECB's door and request funds; there is no guarantee the ECB, which will be mindful of moral hazard, will oblige. The risk is one of a disorderly failure, which would damage severely the SRB's credibility.

Klaas Knot, the Dutch central bank governor, set out in a speech the conditions which he thought were necessary for a bank to access emergency liquidity from the ECB. For a start, he argued, the bank must be considered solvent: This will avoid good money being thrown after bad. Second, it should have enough assets of sufficient quality which can be posted with the central bank as a guarantee. While a resolved bank will, by definition, have enough capital, it is far from obvious that it will have enough collateral. In fact, a troubled bank will have probably used up a lot of its best assets to secure funding during its crisis. "Don't forget about funding in resolution," Knot said, adding that this issue should be dealt with in a "timely manner" -- a clear message to the SRB not to leave it too late before shutting down a bank.

The third issue relates to the treatment of mid-sized banks. Here, the past actions of the SRB offer some guidance. Unfortunately, it is not encouraging. Shortly after the resolution of Banco Popular, the SRB chose not to intervene in the cases of Banco Popolare di Vicenza and Veneto Banca, even though these banks are large enough to come under the direct supervision of the European Central Bank.

The decision raised questions about whether the SRB had taken this route to allow the two banks to be liquidated under Italy's insolvency procedures. Intesa Sanpaolo, a rival lender, was then able to scoop up the good assets of the two banks and receive a hefty subsidy from the Italian government. Most importantly, senior bondholders were spared -- a key objective of the Italian authorities who were afraid of the political fallout from a painful "bail-in."

Elke Koenig, the SRB's chair, rejects the view that the SRB should publish a list of the banks it can resolve in order to give investors greater clarity. She defends the agency's decision on the Veneto banks, saying their assets had shrunk in size to such an extent that they were no longer eligible for resolution. Yet her words may not be sufficient to dispel a sense of uneasiness among investors who believe there is a degree of arbitrariness over the way the SRB operates. For such a young institution, this is a genuine and troubling challenge.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

    To contact the author of this story:
    Ferdinando Giugliano at fgiugliano@bloomberg.net

    To contact the editor responsible for this story:
    Therese Raphael at traphael4@bloomberg.net

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