«There is in my opinion a urgent need to address the shortcomings of an unstable European Banking Union,» writes Jean Dermine, Professor of Banking and Finance at Insead, Singapore, in an exclusive essay.

The euro-zone banking market met recently two episodes of great instability. In September 2016, Deutsche Bank (DB) was threatened by the U.S. Department of Justice with a $14 billion penalty. Financial markets had a brutal reaction with several hedge funds reducing their counterparty limits with DB. In December 2016, instability rose in Italy when the authorities had to deal with their third largest bank, Montei di Paschi.

Is there something unique in the euro-zone that is causing instability? Yes, the new single resolution mechanism which, in our opinion, should be revised urgently. Since 1 January 2016, the European Union has set up for the 19 members of the euro-zone a banking union and a single resolution mechanism (SRM). A single resolution board has the right to intervene early to impose losses on shareholders, bondholders and depositors.

Objectives in Handling a Failing Bank

The single resolution mechanism works as follows. Once a bank has been identified by the European Central Bank (ECB), the supervisory authority, as failing or likely to fail, the single resolution board decides whether a private solution is possible or if a resolution is in the public interest.

Three main objectives in handling a failing bank are:

  • swiftness of decisions to minimize the impact on the economy,
  • privatization of losses to stop the linkage between public bail-out, budget deficit and sovereign risk,
  • elimination of moral hazard with bail-in debt held by private creditors who bear losses.

The Bank Recovery and Resolution Directive (BRRD) defines the scope of the bail-in tools which may be applied to all liabilities of an institution that are not excluded. The resolution authorities shall not exercise a write-down or conversion powers to the following liabilities:

  • deposits covered by deposit insuranc
  • secured liabilities, including covered bonds
  • liabilities with a remaining maturity of less than seven days...

Avoiding Widespread Contagion

In exceptional circumstances, such as trying to avoid widespread contagion, the resolution authority may exclude or partially exclude certain liabilities from the application of the write-down or conversion powers.

A privately funded single resolution fund may make a contribution to cover the losses but only after a minimum contribution of 8 percent of total liabilities, including own funds, has been made by shareholders and other liabilities.

There can be no doubt that the creation of the single resolution mechanism is a fundamental change in the way banking markets function. The authorities have finally succeeded in privatizing risk and losses. Economic welfare would be ensured with all costs and risks being priced by the market, avoiding an unjustified public subsidy for bailed-out banks. In addition, the link between bank losses, state aid, budget deficits and sovereign risk would be severed.

Run on Fragile Banks

However, the current single resolution mechanism is a potential contributor to future panic and disruption of the banking system for two reasons. These concern the ability of the private market to bear losses and a much increased likelihood of a run on fragile banks.

If creditors who bear losses happen to be retail investors, pension funds or insurance companies, one can imagine the political uproar that would arise. A recent example occurred in Italy in November 2015. Pre-empting the bail-in rules, the Bank of Italy imposed losses on bond holders of four small local banks.

Losing All Life Savings

A customer of Banca Etruria committed suicide after losing his life savings: He had invested all his wealth in bonds, a ‘safe investment’ distributed by his bank. It would seem imperative to know who are the investors – individual or institutional – holding bail-in securities to ensure that they can bear the losses.

Second, the fact that unsecured deposits with more than seven days maturity are potentially exposed creates the risk of a bank run. Any treasurer with the slightest fear of a resolution will not renew deposits and banks will face major increase in liquidity risk and probability of bank run.

Urgent Need

Note that the directive states explicitly that in special circumstances some deposits might be excluded but, given the ambiguity, any prudent treasurer will run to withdraw deposits. In such cases, the European Central Bank could act as a lender-of-last-resort to solvent banks, but, again, in the presence of ambiguity, there is a significant increase in the likelihood of a run by short-term depositors.

An unstable European banking union has been created. There is in my opinion a urgent need to address its shortcomings.

Jean Dermine is Professor of Banking and Finance at Insead, Singapore. He directs two senior executive programs Strategic Management in Banking and Risk Management in Banking. This exclusive essay is based on a study to be published by the Swiss National Bank in ‹Monetary Economics Today› – «Festschrift in Honour of Ernst Baltensperger».