How to Save Bank Resolution in the European Banking Union

The Single Resolution Mechanism (SRM) just enacted by the European Parliament will fail in its essential mission of managing the failure of a systemically important bank in a way that overcomes the fatal link between sovereigns and their banks. The SRM simply provides no strategy to avoid contagion from a bank failure because depositors and short-term creditors are not adequately protected, due to an insufficient resolution fund and the absence of a credible, centralized deposit insurance scheme.  If bank resolution is not a credible threat, then the Single Supervisory Mechanism of the European Banking Union will be a paper tiger.

In a recent article, we argue for an organizational and capital structure substitute for the SRM’s flaws that can minimize the systemic distress costs of large bank failure. Our proposal is that banks should effectively be made to “self-insure” against failure, instead of being state-insured.  We borrow from the approach the US Federal Deposit Insurance Corporation (FDIC) has devised to deal with large bank failure pursuant to the “Orderly Liquidation Authority” granted by the Dodd-Frank Act.

The FDIC’s implementation strategy has three important lessons: First, systemically important financial institutions need to have in their liability structure sufficient unsecured (or otherwise subordinated) term debt so that in the event of bank failure, the conversion of debt into equity will be sufficient to absorb asset losses without impairing deposits and other short term credit.  Second, the organizational structure of the financial institution needs to permit such a debt conversion without putting core financial constituents through a bankruptcy.  Third, a federal funding mechanism deployable at the discretion of the resolution authority must be available to supply liquidity to a reorganizing bank.  These elements are critical to avoiding debilitating bank runs and other sorts of financial system breakdowns.

The European SRM currently on the table does not even come close to this model. European institutions have been negotiating over the size of a resolution fund, which will reach a maximum size of 55 billion Euros over eight years. This is a far cry from what is required for a credible resolution framework.

Our approach, inspired by the FDIC model, suggests a way forward. Essentially, we would require European banks to “self-insure” against failure by holding sufficient term debt at the holding company level. This would shield deposits and other short term credit provision at operating subsidiaries and also avoid disruptive bankruptcy proceedings in the operating subsidiaries. To this end, we would propose changes to the forthcoming implementation of the Liikanen report and the Recovery and Resolution Directive to accommodate incentives for banks’ structural changes and to require them to hold a sufficient layer of bail-in debt.

Liquidity provision for the resolution procedure should come from the ECB as the only financially credible player in the EU. Here the Fund created by the SRM framework could play a useful role: as providing first loss protection to the ECM in its role of liquidity provider to a reorganizing financial institution.  This is much like the way that the US TARP program provided first loss protection to the Federal Reserve in support of some of its crisis-era liquidity facilities. Together, these measures would facilitate a “single point of entry” approach to resolution at the holding company level. As a by-product, prescribing such a holding company structure for banks would make cross-border resolution much easier, both for EU-wide and also for transatlantic and global situations.

A critical realization is this: without agreement among the Member States to a federal deposit insurance scheme to mutualize losses, the only effective approach is our self-insurance scheme. Moreover, given the foreseeable deposit insurance caps, self-insurance and a protective organizational structure will still be necessary to avoid debilitating runs by wholesale short term credit providers.

Taken together, our proposals would strengthen the current Banking Union project, overcome political difficulties, and ensure a consistent approach to bank resolution across the Western world. This would enable large and complex cross-border firms to be resolved without threatening financial stability and without putting public funds at risk.

The full paper, Resolution in the European Banking Union: A Transatlantic Perspective on What It Would Take, is available here.

Jeffrey N. Gordon is Richard Paul Richman Professor of Law at Columbia Law School and Co-Director of the Millstein Center for Global Markets and Corporate Ownership. W. Georg Ringe is Professor of International Commercial Law at Copenhagen Business School & University of Oxford.