16 October 2012

Charles Goodhart: Funding arrangements and burden sharing in banking resolution

This column argues that if banking supervision is to be shifted to the European level, so too should resolution and recapitalisation. It outlines how the costs of resolving and recapitalising failing banks might best be handled.

One of the problems that a banking union might help to remedy is a tendency for national regulatory authorities to be too soft on or to be partially captured by their own national champion banks – institutions that often have strong political links and lobbying capacities. Another problem has been that such national champions, especially when cross-border, have become too large relative to the size of their domestic exchequer. If such banks should become insolvent, the cost of rescue can become so large as to endanger the fiscal solvency of the state (as in the cases of Iceland, Ireland, and Spain).

One of the main purposes of a banking union is to loosen the links between national banks and nation states whereby weakness in the one can imperil the other. A third problem is that – as the experiences of Dexia, Fortis, and the Icelandic banks have shown us – sharing the loss burden of a cross-border international bank through ex-post negotiation has been fraught with difficulties.

If a banking union is to help in resolving such problems, the ECB must have the ability to close down the operations of a failing bank expeditiously. It must do so in a manner that does not place an excessive fiscal burden on the home state, while allocating any residual burden of loss arising from the failure of a cross-border bank in an agreed distribution amongst the participating countries. Banks do fail from time to time; even ‘narrow banks’, which are supposed to be perfectly safe, can fail (as a consequence of fraud for instance, or a loss from ‘safe’ assets). Good supervision should make failure less common, but cannot prevent it altogether. Since the supervisor is responsible to the polity, which has delegated its powers, the supervisor also has responsibility for trying to minimise, or at least to reduce, the externalities and costs of bank resolution in the event of failure. Thus if responsibility for bank supervision is to be shifted to the federal eurozone level, by the same token the management (and financing) of failing bank resolution should also pass to the same federal, eurozone level.

Of course, the hope is to shift the costs of bank failures from the taxpayer onto other shoulders, to the banks themselves, or to their creditors. But attempts to shift the burden, particularly in the midst of a general financial crisis, can lead to severe and unhappy consequences. The remaining banks will be too weak to support an additional impost, and placing the burden on a failing bank’s creditors may have contagious consequences for other banks’ funding costs and financing abilities.

So, at least in the short run, and in the middle of a crisis, there may be little or no alternative except to resort to the taxpayer to recapitalise, or otherwise to bear the burden, of resolving a failing bank (or indeed of a failing banking system).

Whatever the mechanism for resolving a bank, the sooner that is done, the less the likely burden that will have to be subsequently met.

Full article (from p 103)

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