Bank failure management in the European banking union ...

Financial Stability Institute

Occasional Paper

No 15

Bank failure management in the European banking union: What's wrong and how to fix it

By Fernando Restoy, Rastko Vrbaski and Ruth Walters July 2020 JEL classification: G01, G18, G21, G33 Keywords: European FDIC, bail-in, bank resolution, bank insolvency, transfer, sale of business, purchase and assumption, P&A

FSI Occasional papers aim to contribute to international discussions on a wide range of topics of relevance for the financial industry and its regulation and supervision. The views expressed in them are solely those of the authors and do not necessarily reflect those of the BIS or the Basel-based standard-setting bodies.

This publication is available on the BIS website (). To contact the BIS Media and Public Relations team, please email press@. You can sign up for email alerts at emailalerts.htm. ? Bank for International Settlements 2020. All rights reserved. Brief excerpts may be reproduced or

translated provided the source is stated.

ISSN 1020-9999 (online)

Contents

Executive summary ........................................................................................................................................................................... 1

Section 1. Introduction.................................................................................................................................................................... 3

Section 2. The status quo: Two discrete regimes for failing banks ............................................................................... 4 The resolution framework under the BRRD................................................................................................................... 4 National insolvency regimes................................................................................................................................................ 8

Section 3. Three problems with the current framework ..................................................................................................11 A legacy problem: Inefficient insolvency ......................................................................................................................12 A problem of alignment: Inconsistencies between resolution and insolvency .............................................12 A structural problem: The middle class .........................................................................................................................13 Addressing the problems....................................................................................................................................................15

Section 4. A basic reform .............................................................................................................................................................16 Feature 1: Harmonisation of some aspects of bank insolvency ..........................................................................16 Feature 2: Facilitate funding for orderly market exit................................................................................................17 What would be achieved and what challenges would remain? ..........................................................................18

Section 5. An integrated framework for bank failure management ...........................................................................20 Feature 3: A European Deposit Insurance Scheme (EDIS) .....................................................................................20 Feature 4: Enlarging the SRB's decision-making capacity to all banks.............................................................21 What would be achieved and what challenges would remain? ..........................................................................21

Section 6. Concluding remarks ..................................................................................................................................................22

References .......................................................................................................................................................................................... 23

Bank failure management in the European banking union: What's wrong and how to fix it

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Bank failure management in the European banking union: What's wrong and how to fix it1

Executive summary

Despite the significant progress made in establishing a single resolution mechanism, the European banking union's current framework for bank failure management still has shortcomings. As exposed by several recent bank failures, these shortcomings prevent the framework from fulfilling the aims of both the resolution regime and the banking union.

The problems arise from four features peculiar to the European framework: (i) a conceptual distinction between resolution, which is available following a positive public interest assessment, and insolvency under the applicable national framework for all other bank failures; (ii) varying national insolvency regimes that are often ill-suited to dealing with banks; (iii) reliance on the bail-in of creditors as a condition for use of resolution funding arrangements; and (iv) stringent financial caps on the use of funds from deposit guarantee schemes (DGS) to support orderly bank failure management.

While each of those features may individually have a sound policy rationale, their combination has at least three effects that undermine the effectiveness of the overall framework. First, the default insolvency procedures for failed banks whenever the public interest threshold for resolution is not met are, in many cases, inefficient. Second, tensions and inconsistencies exist between the common resolution framework and national insolvency regimes. Third, there are no adequate strategies for dealing with the failure of mid-sized banks that are too large to be liquidated but too small and too traditional to be resolved using bail-in. In particular, banks that rely on deposits for their funding may have difficulty in issuing sufficient amounts of bail-in-able securities.

A transfer of business is arguably the most suitable strategy for facilitating an orderly market exit for failed small and medium-sized banks, but its use is currently restricted by restrictions on the funding available to support such sales. The minimum writedown requirement for use of the single resolution fund (SRF) is a core element of the EU resolution framework, aimed at reducing the moral hazard that might otherwise arise. However, even without modifying that condition, two minimum changes to the resolution framework and to national insolvency procedures would go some way to addressing the current shortcomings. First, some alignment of specific elements of national insolvency regimes is desirable to make them more effective and compatible with the resolution framework. Second, certain conditions need to be put in place to facilitate a more effective use of transfer transactions, both in resolution, using the sale of business tool under the EU resolution framework, and in insolvency.

A basic reform would therefore entail two main components: (i) a harmonisation of some key aspects of bank insolvency regimes, including the conditions for the availability of public support (if any); and (ii) a less restrictive financial cap for the use of funds from the national DGS to support a sale of business in both insolvency and resolution. The latter could be achieved by replacing the current superpreference for DGS-covered deposits by general depositor preference, while ensuring that the least-netcost constraints on the use of DGS funds can be applied with appropriate flexibility.

1 Fernando Restoy, Rastko Vrbaski and Ruth Walters. The views expressed are solely those of the authors and do not necessarily reflect those of the BIS or the Basel-based standard-setting committees. The authors are grateful to Claudio Borio, Alberto Casillas, Andrea Enria, Edouard Fern?ndez-Bollo, Eglantine Flori, Luis Garicano, Mariano Herrera, Kumudini Hajra, Eva H?pkes, Mathilde Janfils, Kerstin af Jochnick, Ernesto Mesto, Patrick Neilan, Jaime Ponce, Alexandros N Rokas, Sofia Toscano, Nicolas V?ron and David Walker for helpful comments and insights and to Christina Paavola and Dmitrijs Randars for administrative support.

Bank failure management in the European banking union: What's wrong and how to fix it

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Such a "basic reform" would improve the effectiveness of national insolvency regimes and reduce any inconsistencies with the resolution framework. By facilitating a transfer of viable business, this reform could reduce dependence on bail-in in resolution plans which in turn would permit a reduction in the levels of MREL required for mid-sized-traditional banks. For those banks, MREL requirements could be calibrated to take account of the increased availability of DGS funds to support a sale of business that is expected to result from the (reformulated) financial cap.

However, these changes would result in decision-making and funding being institutionally unaligned, since any use of the sale of business tool in resolution would be decided by the Single Resolution Board (SRB) but funded by the relevant national DGS. Moreover, those arrangements would not help to break the links between banks and sovereigns that remain, in spite of the progress made in establishing the banking union.

A more ambitious approach would aim for an integrated bank failure management regime within the banking union. Inspired in part by the US framework for failing banks and the role of the Federal Deposit Insurance Corporation, this approach would supplement the basic reform, in due course, with two additional measures: (i) the establishment of a European Deposit Insurance Scheme (EDIS) with powers not only to pay out covered deposits in the event of liquidation but also to support transfer measures to facilitate an orderly market exit of failing banks, subject to a reasonable financial cap; and (ii) centralisation in the SRB of decision-making powers in relation to all bank failures in the banking union and the administration of EDIS.

The new framework would retain the current levels of MREL requirements for banks for which an "open-bank" bail-in is the preferred resolution strategy. It would also keep the current minimum bail-in conditions for SRF funding. However, for those medium-sized banks and smaller banks that would be expected, in the event of failure, to be subject to sale of business transactions, supported by EDIS, MREL requirements would be calibrated more moderately to reflect that expectation.

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Bank failure management in the European banking union: What's wrong and how to fix it

Section 1. Introduction

The current EU framework for dealing with non-viable banks is the result of legislative action and political choices in the wake of the Great Financial Crisis and the European sovereign debt crisis. Largely following the international standards set out in the FSB's Key Attributes of Effective Resolution Regimes, EU policymakers and legislators adopted the EU Bank Recovery and Resolution Directive (BRRD). The aim was to provide "a credible set of administrative tools to intervene sufficiently early and quickly in an unsound or failing institution so as to ensure the continuity of the institution's critical financial and economic functions, while minimising the impact of an institution's failure on the economy and financial system. [....] Those objectives should help avoid destabilising financial markets and minimise the costs for taxpayers".2 The BRRD has been transposed into national law by all EU Member States.

A particular feature of the European framework is that it combines two distinct procedures ? resolution and insolvency. The resolution regime is harmonised across Member States. In contrast, the legislative reforms that resulted in the BRRD made no significant changes to the national insolvency regimes. These regimes are in many cases long-standing, rooted in national property and contract law, and reflect different national policy choices that result in material divergences. As a consequence, these unharmonised regimes now exist in parallel with the harmonised administrative resolution regimes adopted in accordance with the BRRD.

The effectiveness of the European framework ultimately hinges on how those distinct regimes are aligned and operate in conjunction. Two concepts are important for determining under which regime a bank failure is managed and whether the primary responsibility lies at EU or at national level. The first is that of "significant institutions" and the second is the "public interest".

"Significant institutions" are those subject to consolidated supervision by the European Central Bank (ECB). Together with institutions that are "less significant" but established in more than one Member State in the banking union, they fall within the remit of the Single Resolution Board (SRB). That is, resolution planning and decision-making for those banks is centralised at the European level under the Single Resolution Mechanism (SRM), which comprises the SRB, an autonomous EU agency, and the national resolution authorities designated under the BRRD by each Member State. The SRB leads the resolution planning for those banks; decides whether to take resolution action if such a bank is declared failing or likely to fail; and, if resolution action is undertaken, adopts a resolution scheme that specifies the resolution tools that will be used and any use of the Single Resolution Fund (SRF). The scheme is executed by the relevant national resolution authority or authorities using their powers under the national resolution frameworks. Non-viable banks within the banking union that are not considered significant do not fall under the remit of the SRB. Decisions about such banks fall to the responsible national resolution authority (NRA), including whether the bank is resolved under the BRRD or wound up under the national insolvency regime.

The concept of the "public interest" is the most important determinant as to whether a failing bank is dealt with under the (harmonised) resolution regime or (potentially divergent) national insolvency procedures. This requires a public interest assessment (PIA), framed as a decision by the resolution authority as to whether taking "resolution action is necessary in the public interest". For banks that fall within the SRM, the PIA is made by the SRB.3 For banks outside the SRM's remit, the assessment is made by the NRA. Where the PIA is negative, the failing bank is subject to proceedings under the applicable

2 Directive 2014/59/EU of the European Parliament and of the Council of 15 May 2014; text quoted from recital 5, BRRD. The BRRD goes beyond the Key Attributes in that it includes broader requirements for recovery and resolution planning, restrictions on the use of the "asset management tool", governance arrangements for intra-union cross-border cooperation, and minimum loss-sharing conditions that must be met before the resolution funding arrangements can be used. For the policy debate at that time, see V?ron and Wolff (2013).

3 That is, the SRB in its Extended Executive Session, involving five SRB Board Members and the Member from the relevant NRA.

Bank failure management in the European banking union: What's wrong and how to fix it

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national insolvency regime, provided that the grounds for insolvency are established. As a result, the "normal" insolvency procedures are the default wherever a positive public interest in resolution is not established, whether or not the institution is "significant".

In this paper, we discuss how the current framework falls short of ensuring effective bank failure management. We focus on three problems. First, national insolvency regimes are often poorly suited to dealing with the specificities of banks' failures. They tend to destroy value and may create sectoral distress unless accompanied by substantial liquidation aid. Second, the lack of alignment between certain elements of resolution and insolvency can hinder the resolution framework from achieving its objectives. Third, there is a broad category of banks that may perform functions for which continuity may be desirable but whose business models may not be compatible with the conditions necessary for the use of certain resolution tools. These shortcomings may prevent the current bank failure management framework from fulfilling the aims of the banking union.

The paper proposes possible reforms to address these shortcomings. Although less ambitious approaches could be beneficial in the short term, the ultimate objective should be to develop an integrated bank failure management framework within the banking union. This would imply expanding the functions currently performed by the SRB in order to ensure the orderly exit or restructuring of all types of failing or non-viable bank.

The paper is structured as follows. Section 2 summarises the main elements of the current European bank failure management framework. Section 3 discusses the problems in more detail. Section 4 outlines the features of a basic reform to address the main challenges posed by the status quo. Section 5 proposes a more ambitious reform and Section 6 concludes.

Section 2. The status quo: Two discrete regimes for failing banks

The resolution framework under the BRRD

Conditions for resolution

In principle, the scope of the EU resolution framework under the BRRD is broad. Any EU credit institution may be put into resolution if: (i) it is found to be failing or likely to fail (FOLTF); (ii) there is no reasonable prospect that other private sector or supervisory measures (including writedown or conversion of capital instruments) could prevent its failure within a reasonable time frame; and (iii) resolution action is necessary in the public interest. Of these conditions, the third ? the PIA ? is the most susceptible to interpretation.

The BRRD provides only a brief and high-level explanation of what is meant by "necessary in the public interest". Resolution is deemed to be in the public interest if it is a necessary and proportionate means of achieving the specified resolution objectives, which include continuity of critical functions, avoiding adverse effects on the financial system, or protecting public funds, depositors, and client funds and assets; and winding up the bank through normal insolvency proceedings would not achieve those objectives to the same extent.4 The BRRD elaborates this latter idea: "A failing institution should in principle be liquidated under normal insolvency proceedings. However, liquidation under normal insolvency proceedings might jeopardise financial stability, interrupt the provision of critical functions, and affect the protection of depositors. In such a case it is highly likely that there would be a public interest in placing the institution under resolution and applying resolution tools rather than resorting to normal insolvency proceedings."5

4 Article 32(5) BRRD. 5 Recital 45 BRRD.

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Bank failure management in the European banking union: What's wrong and how to fix it

Table 1 takes stock of the outcome of the public interest assessments in a number of cases since the BRRD came into force.

Table 1: Bank failures since enactment of BRRD

Table 1

Name of bank

Date

Assets at failure SI*

PIA

PIA Authority**

Procedure***

Jadranska Banka

10/2015 HRK1.9bn

no

positive

NRA

Resolution

CariChieti

11/2015 EUR 4.7bn

no

positive

NRA

Resolution

Banca Popolare dell'Etruria

11/2015 EUR 12.3bn

no

positive

NRA

Resolution

Cassa di Risparmio di Ferrara 11/2015 EUR 6.9bn

no

positive

NRA

Resolution

Banca delle Marche

11/2015 EUR 22.7bn

no

positive

NRA

Resolution

Coop Peloponnese

12/2015 EUR (200m)

no

positive

NRA

Resolution

BANIF

12/2015 EUR 12.8bn

no

positive

NRA

Resolution

Andelskassen JAK

1/2016 DKK 250m

no

positive

NRA

Resolution

Maple Bank

2/2016 EUR 5bn

no

negative

NRA

Insolvency

Trasta Komercbanka

3/2016 EUR 430m

no

positive

NRA

Insolvency

Banco Popular Espa?ol

6/2017 EUR 148bn

yes

positive

SRB

Resolution

Banca Popolare di Vicenza

6/2017 EUR 34bn

yes

negative

SRB

Insolvency

Veneto Banca

6/2017 EUR 28bn

yes

negative

SRB

Insolvency

ABVL

2/2018 EUR 183m

yes

negative

SRB

Insolvency

Tesla Stedna Banka

2/2018 HRK 4m

no

negative

NRA

Insolvency

Dero Bank

3/2018 EUR 27m

no

negative

NRA

Insolvency

Banca Base

4/2018 EUR 38m

no

negative

NRA

Insolvency

Kobenhavns Andelskassen

9/2018 DKK 411m

no

positive

NRA

Resolution

PNB Banka

8/2019 EUR 550m

no

negative

SRB

Insolvency

* "Significant Institution" subject to consolidated supervision by the ECB.

** Authority that carried out the public interest assessment: the national resolution authority (NRA) of the home Member State or the SRB.

*** "Insolvency" includes any collective procedure other than resolution under the BRRD.

Sources: SP Global, public domain.

As the table shows, the SRB has made only one positive PIA, in the case of Banco Popular Espa?ol, with assets of close to EUR 150 billion at the time of its failure.6 By contrast, it made a negative PIA in the cases of ABLV, PNB and the two "Veneto Banks", the latter each with EUR 30 billion in assets.7 The SRB's negative PIA for the Veneto banks was made on the grounds that their deposit and lending functions were

likely to be substituted given the large number of other banks active in the region. The SRB explains its

interpretation of the PIA in its paper on its "Approach to the Public Interest Assessment", published in July 2019.8 This draws on the definition of "critical functions" in the BRRD, indicating that the SRB ultimately

considers significant adverse effects on financial stability only if such consequences materialise at the level

6 SRB (2017a).

7 The decisions on Banca Popolare de Vicenza and Veneto Banca are set out, respectively, in SRB (2017b,c). See also the briefing by Mesnard et al (2017).

8 See SRB (2019).

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