03 May 2012

Bundesbank/Dombret: Europe’s solution for too-big-to-fail

"Like it or not, it looks as though we will have to get on with the painstaking work of untangling the knot and work out the details of the legal contribution to solving the economic problem of too-big-to-fail", remarked Dombret in his speech at Goethe University on 3rd May.

The public sector often had to rescue institutions using taxpayers’ money. This implicit guarantee for SIFIs gives rise to misguided incentives, thus encouraging SIFIs to take excessive risk. Economists call this phenomenon “moral hazard”. The scale of this problem is vast!

This is borne out by the fact that, faced with the financial crisis, the governments within the European Union provided banks with assistance equivalent to 30 per cent of the EU GDP. The process of adjustment within the euro area banking sector is not over yet, particularly as the sovereign debt crisis has presented new challenges. Essentially, banks have got to remove problematic assets from their balance sheets, devise sustainable balance sheet structures and develop resilient business models. In its recent Global Financial Stability Report, the IMF estimates that 58 major banks in the EU could reduce their aggregate balance sheet total by €2 trillion, or around 7 per cent, by the end of 2013. The IMF fears that this deleveraging process could have a negative impact on the credit supply within the euro area, and pose a potential danger to economic development throughout Europe and beyond.

The IMF’s estimate needs to be evaluated in finer detail. Nevertheless, it does illustrate the sheer scale of the problem. The point is, not least, that it must be possible in a market economy for financial institutions to withdraw from competition for economic reasons without casting the financial system into turmoil. This underlines how important it is to find a sound preventive solution for dealing with big banks.

What does the G20’s solution proposal entail? The new SIFI rules are built on two pillars. First, the likelihood of a SIFI failing has to be reduced, meaning that SIFIs are to be more resilient, mainly through specific capital surcharges that go beyond the requirements of Basel III. Second, the restructuring or resolution of a SIFI is to be made possible in future without jeopardising financial stability and without having to resort to taxpayers’ money.

A new international standard for resolution regimes

The Financial Stability Board (FSB) has developed a new international standard for resolution regimes: the “Key Attributes of Effective Resolution Regimes for Financial Institutions.” These Key Attributes were urgently needed, even if some financial sector commentators would have preferred a globally uniform insolvency law. In adopting the Key Attributes, the G20 states committed to establish a designated resolution authority for financial institutions so that the particularities of crisis situations in the financial sector, such as the danger of runs on banks, can be taken into consideration. In order systematically to enhance cooperation between home and host countries, thereby improving crisis prevention, the Key Attributes contain a wide range of requirements which seek to promote cooperation.

Recovery and resolution planning will facilitate cooperation between the authorities. This planning process consists of three mutually dependent components. First, the responsible authorities agree on an assessment on the banking group’s resolvability, the aim being to examine the practicability and credibility of a resolution strategy. As the second component, the institutions themselves must submit plans describing how they envisage a potential restructuring and discuss them with supervisors. If restructuring is not possible or fails, the third component comes into play, namely that of resolution planning, which is to be developed by the authorities.

From standard-setting to the application of the new rules

These and other standards from the Key Attributes are a milestone on the road to containing the too-big-to-fail problem. On the one hand, the fact that international consensus has been reached with the backing of top G20 policymakers can be considered a success. On the other hand, a great deal of detailed work remains to be done since the FSB Key Attributes still have to be transposed into legal texts which, by necessity, have to be much more concrete than the international standard.

Notwithstanding international initiatives, German legislators responded to the financial crisis early on. On 1 January 2011, the Bank Restructuring Act entered into force, aiming to facilitate dealing with a distressed systemically important bank without jeopardising financial stability and, as far as possible, without using taxpayers’ money. Moreover, the Act is intended to enable coordinated action with other responsible authorities at the European level if a cross-border banking group becomes distressed.

Full speech

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