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Peterson Institute
04 April 2012

Jacob Funk Kirkegaard: New hope on banking regulation in Europe


Despite the press focus on the firewall's size, this step was not the most important item on the EU finance ministers' agenda to achieve the longer-term stability of the euro area. Far more important was the ministers' discussion of a pan-European banking resolution framework.

While nothing concrete was adopted on the issue in Copenhagen, and the EU Commission plans to produce legislative proposals before June, several important messages crystallised. First, a pan-European banking resolution scheme is the strong desire of EU finance ministers (although this lofty goal has been stated before). More important, this goal was framed in a discussion of bail-ins, resolution funds, and concerns over moral hazard and taxpayer money.

As discussed also in the EU Commission’s recent communication on bank crisis resolution, the intent of an investor bail-in is to stabilise a failing financial institution without the need to commit public funds. The bank would be recapitalised through the writing down of the claims of private creditors, enabling the institution to continue essential retail customer services, while regulators reorganise it, sell it off or wind down parts of its business. Bail-ins here would be calibrated to impose losses first on shareholders but also on bank bondholders, while aiming to protect deposits, client assets, and other claims.

The ability to bail-in some types of euro area bank bond holders in the future seems on the table, and the principal discussion seems to be about whether or not it is to be mandatory. It was comforting to hear from European Central Bank (ECB) vice president, Vitor Constancio, at the press conference that the ECB is not opposed to such bail-ins provided that “objective triggers” are stipulated in the legislation and that the use of bail-ins not be left to the discretion of national regulators. The ECB seems to favour a more mandatory approach. Considering how the ECB blocked the bail-in of most of the bond holders in Irish banks 2010 (with large costs for Irish taxpayers), this stance suggests increasing ECB flexibility on this important issue.

The discussion of bank resolution funds was similarly encouraging. Constancio stated that the ECB favours a European level solution, which was also supported by ECB Executive Member (and until recently, German State Secretary for Finance) Jörg Asmussen. In separate comments, Asmussen called for “the setting up of a special fund for bank resolution at the euro area level, accompanied by the establishment of a joint supervisory and resolution regime”. The euro area thus seems intent on addressing a deficiency in its institutional structure—namely, the lack of an integrated banking sector resolution authority and supervision. The precise demarcation of “European level solution” remains somewhat unclear. Lots of banking regulations are covered by internal market regulation and therefore these cover all 27 Member States and notably the United Kingdom. On banking regulation, what is possible at the EU-27 level and what is possible at the euro area level will prove a tough political nut to crack. The new European Systemic Risk Board (ESRB) headed by the ECB president, Mario Draghi, also favours a relatively flexible macro-prudential framework for EU capital requirement legislation. In other words, Member States should (in coordination with the rest of the euro area/EU) be free to choose higher national capital requirements. Hopefully the EU Commission’s upcoming proposals will incorporate these ideas.

It is clear that in the longer run, at least, the European banks will be expected to pay for any resolution funds, whether at the national or European level. What we heard in Copenhagen suggests additional future costs for the European financial sector. Assuming that more types of European bank bondholders may have to accept haircuts in the future, this will add to the funding costs for the sector. In total, European governments seem increasingly intent on meting out pain to their banking sectors.

The political dynamics are driven by the realisation that no agreement will be found on a European or even euro area Financial Transaction Tax (FTT). EU politicians therefore feel they have a need to reassure their restless electorates that they are being tough on the banks in other ways. Increased capital requirements, the prospects for more write-downs for bank bond holders, and the need to finance resolution funds all amount to a more productive pain for European banks than a non-globally implemented FTT. The apparent acceptance of sacrifice by the European banking sector of at least the bail-in issue... might indicate an acceptance in the European financial industry of this lesser evil.

Lastly, were the European Union to adopt a new banking resolution framework, the Irish government’s case to renegotiate its expensive banking sector bailout would improve. For the euro area and the ECB to insist that Irish taxpayers bear the full cost of paying off the majority of its private bank bondholders would be untenable, especially if they are changing the EU regulatory framework to prevent such outcomes in the future. As a result, any solution for Ireland in the form of an EFSF refinancing of the country’s National Asset Management Agency (NAMA) promissory notes will be politically timed with the announcement of a new European banking resolution framework. But whether this can be achieved before the Irish referendum on May 31 is questionable.

It is early. But after so many bungled interventions, regulatory failures, and taxpayer funds wasted, Europe seems more intent than ever on finally doing something right and constructive about its banking sector.

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© Peter G Peterson Institute for International Economics


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