Benoît Coeuré: The Single Resolution Mechanism - why it is needed
Speech by Mr Benoît Coeuré, Member of the Executive Board of the European Central Bank,
at the ICMA Annual General Meeting and Conference 2013, organised by the International
Capital Market Association, Copenhagen, 23 May 2013.
* * *
I wish to thank Barbara Attinger, Cécile Meys, and Pär Torstensson for their contributions to these remarks. I
remain solely responsible for the opinions contained herein.
Ladies and Gentlemen,
The financial crisis has highlighted the weaknesses of the institutional framework of
Economic and Monetary Union. The negative feedback loop between banks and sovereigns
as well as signs of market fragmentation made European leaders take an extraordinary
decision last summer, namely to establish the European Banking Union.
This is a historic step forward, but not unprecedented. As some of you might know, before
the National Banking Act of 1864, banks in the United States were state-chartered
corporations, subject to the oversight and resolution regime in the state in which they
operated. And only the Banking Act of 1933, often referred to as the Glass-Steagall Act,
established a system of federal deposit guarantees and created a new entity, the Federal
Deposit Insurance Corporation (FDIC).1
Of course, one important difference is that in the United States, the banking union came
after, and not before the fiscal union. Establishing a banking union without a fiscal union is
certainly more challenging. Nevertheless, and as I will argue later, it is desirable and
possible, provided the right sequence is in place.
In this respect, today I would like to outline my thoughts on the three pillars of a true
European Banking Union: (i) the Single Supervisory Mechanism (SSM); (ii) the Single
Resolution Mechanism (SRM); and (iii) a common system of deposit protection. I would like
to emphasise that for there to be a genuine banking union, by which I mean a situation where
confidence in deposits is independent of the jurisdiction in which they are located, all three
pillars have to be in place. While good progress is being made on the supervisory
mechanism, therefore, there should be no doubt in anybody's mind that the single resolution
mechanism is its indispensable complement. The two have to proceed in parallel. They can
be complemented at a later stage by a common system of deposit protection, but eventually
all three pillars will need to be in place for the banking system to be truly one.
The Single Supervisory Mechanism
The first pillar of the banking union will be the Single Supervisory Mechanism. A strong and
independent supranational supervisor will contribute significantly to the smooth functioning of
the monetary union and to restoring confidence in the banking sector. This restoration of
confidence in the banking sector is key to restarting a well-functioning interbank market and
to amplifying recent developments towards financial reintegration.
The Single Supervisory Mechanism will comprise national competent authorities from the
euro area as well as the ECB, with the possibility of non-euro area members participating.
The scope of the proposed regulation is very broad, covering all of the more than
6,000 credit institutions in the euro area. However, not all of them will fall under the direct
responsibility of the ECB. The ECB will directly supervise those banks and banking groups
that are considered to be significant. The national authorities will retain their responsibilities
for prudential supervision of the other banks. However, the ECB may at any time, on its own
initiative and after consulting with, or at the request of, a national competent authority, decide
to exercise direct supervision. The banks falling under direct supervision will be identified by
using a methodology based on the criteria mentioned in the Regulation. We expect that it will
cover more than 80%, or more than 25 trillion euro, of the euro area's banking assets. It will
represent the largest single supervisory jurisdiction by assets.
The precise assignment of tasks within the Single Supervisory Mechanism will be specified in
a Framework Regulation that the ECB will publish six months after the publication of the
SSM Regulation. A public consultation will precede this publication - it will be very important
to have input from the industry on this matter.
As you may know, the current position is that a political agreement was reached on 18 April
between the European Council and the European Parliament on a Regulation conferring
supervisory tasks on the European Central Bank. In our view, the Regulation will provide an
effective framework for the ECB to exercise prudential supervision, while also providing for
the necessary separation between the supervisory and monetary policy tasks of the ECB, as
well as setting a high level of democratic control on the SSM.
The Single Resolution Mechanism
The second pillar of the banking union will be a Single Resolution Mechanism (SRM).
Although the framework for the SRM still needs to be defined as part of a collective effort by
the European Commission, the European Council and the European Parliament, I would like
to discuss why the SRM is needed, what its main components should be and how it can be
established.
The crisis has shown the importance of having a framework in place for resolving failing
banks swiftly and impartially. As the ECB stated in its Opinion on the Commission's proposed
Bank Recovery and Resolution Directive (BRRD): "...all financial institutions should be
allowed to fail in an orderly manner, safeguarding the stability of the financial system as a
whole".2 This will provide the right incentives to financial market participants and minimise
public costs and economic disruption.
A timely resolution of a bank should avoid that problems in one bank spill over to other
banks, possibly affecting European financial stability. Moreover, the uncertainty surrounding
ad hoc
the use of solutions in Europe, as we all saw recently in the case of Cyprus, has
shown the importance of establishing a clear and credible legal framework to underpin the
resolution of banks. Without such a framework, decisions are often taken late and in an
improvised way. Any solution which does not imply an outright bailout seems to take
creditors and markets by surprise. This will need to change. I would say that after the events
of Cyprus, markets should be convinced that Europe is serious and committed to bailing in
and thus ending the bailout culture.
While Europe has already demonstrated that it has the resolve, the establishment of a
credible resolution framework will ensure that it will also have the powers and the tools.
Ending bailouts is key not only to enhancing market discipline, but also to ensuring that those
who appropriate the gains are also those who cover the losses. It would, however, be a
mistake to assume that there will be no more troubled banks once the SSM is in force and
supervisory responsibility is transferred to the ECB. So if the Single Supervisory Mechanism
is to be effective, it needs to be complemented by a Single Resolution Mechanism to deal
with non-viable banks. It is thus crucial that the SRM framework is in place once the SSM is
operational. From the ECB's point of view, only if the SSM is complemented by a Single
Resolution Mechanism with a common backstop can the negative feedback loop between
sovereigns and banks be broken, ensuring thereby that monetary policy transmission is fully
restored.
The SRM would need several components to be effective. Although the European
Commission is still defining the framework for the SRM, let me nevertheless mention what,
from my point of view, the main features of such a mechanism should be.
First, the SRM should be based on a strong and independent Single Resolution Authority
(SRA) entrusted with the necessary powers. This would enable prompt and coordinated
resolution action to be taken, specifically where cross-border banks are concerned.
Experience has repeatedly taught us that mere coordination between national authorities
does not suffice in a cross-border bank resolution. Successful resolution needs prompt and
decisive action. Although the organisational aspects of the SRA still need to be decided, in
order to achieve its objectives, the SRA should be strong, independent and preferably a
standalone authority and should collaborate closely with the SSM and the European
Commission.
Second, the SRA should have adequate funds for resolution financing. Indeed, for the
resolution framework to work well and be credible, the SRA must have access to a
privatelyfunded European Resolution Fund. This Fund should be pre-funded by levies from the
private sector. This would ensure that the SRA has access to the necessary financing to take
resolution action and achieve least-cost solutions, as the Federal Deposit Insurance
Corporation (FDIC) does in the US.
Third, in order to ensure the credibility of the Fund, it should have access to a temporary and
fiscally neutral fiscal backstop at euro area level, to be used only as a last resort.
Indeed, in order for the SRM to be effective, it will require a common resolution framework,
containing comprehensive powers and tools. A harmonised toolbox of resolution powers is
foreseen in the Bank Recovery and Resolution Directive, so it is crucial that this Directive is
adopted as an immediate priority and passed into law before the SSM is operational.
A key resolution tool included in the Directive, one that all authorities should have, is the
possibility of bailing in by creditors. Bailing-in is conducive to achieving a specific policy goal,
namely that the burden of bank failures should be borne first and foremost by the private
sector, rather than the taxpayer.
In accordance with the Financial Stability Board's Key Attributes of Efficient Resolution
Regimes for Financial Institutions, which have been incorporated in the BRRD, resolution
authorities should be able to write down or convert into equity liabilities in a manner that
respects the hierarchy of claims in a liquidation. Thus, when a bail-in by creditors takes
place, legal certainty and predictability are essential. Despite the limited spillovers, the
idiosyncratic aspects of the bail-in by uninsured depositors in Cyprus may remain a cause for
concern among investors. Creditors need to have a clear picture of what could happen in the
event of a bank failure. This is key to avoiding excessive market volatility, bank runs,
underprovision of capital and liquidity and/or overpricing of risk. This can be done by
respecting the hierarchy of creditors in the event of insolvency, i.e. the order in which
creditors will suffer losses in a bail-in.
In order to enhance legal certainty and predictability, a clear pecking order has to be
established regarding the financing of resolution measures. Losses and resolution costs
should first and foremost be borne by the shareholders and subsequently by the creditors of
the failing institution. Only at that point should the private sector be called in to finance
resolution via the resolution fund. Then and only as a last resort in case the accumulated
funds in the resolution fund are insufficient, should there be a temporary public backstop
providing credit to the resolution fund. But any such support should be fiscally neutral and
recouped through ex-post levies on banks. This will ensure that financial sector repair is
ultimately financed by the private sector itself.
As regards the use of bail-in, let me stress that it should not create wrong incentives to the
original entity by just continuing with "business as usual". Following the resolution process,
only the critical functions and "good parts" of the original entity should survive, either
because they are sold to a private sector purchaser - as commonly done by the FDIC with
the Purchase & Assumption approach used in the US - or because they are transferred to a
bridge bank. It needs to be clear that the aim of resolution is not to preserve the failing
institution as such, but to ensure the continuity of the functions that are critical for the
financial system as a whole.
Another important way of providing legal certainty and predictability in resolution would be to
introduce harmonised depositor preference for eligible deposits in the EU. Currently, deposits
have a preferential status in the hierarchy of claims in some Member States, while in others
the deposits rank alongside any other senior unsecured creditor of the bank in insolvency.
This may imply different treatment of depositors depending on the location of their deposits
and lead to further market fragmentation.
Introducing harmonised depositor preference for eligible deposits in the EU would lower the
risk of bank runs as it reduces the incentive for uninsured depositors to withdraw deposits. In
addition, it would aid the resolvability of banks, since it avoids the cumbersome task of
splitting the eligible deposits into covered and uncovered parts. It would also enable
uninsured deposits to be transferred or sold along with the insured deposits and thus
increase the franchise value of the bank under resolution and its essential parts.
Nevertheless, it should be acknowledged that depositor preference may lead to increasing
secured lending and decreasing maturity of the funding of banks. However this can be limited
(i) by introducing a minimum requirement for bail-in-able instruments, calibrated to provide an
adequate buffer of loss absorbency as foreseen in the draft EU framework; as well as (ii) by
the introduction of the Net Stable Funding Ratio that banks will have to fulfil.
Another argument often raised against deposit preference is that it may also raise the cost of
senior unsecured funding for banks. This is a discussion that we need to take seriously.
However I would make here two observations.
First, one has to recognise the change in the liability structure of banks that is brought about
by the deleveraging of the system. With generally lower loan to deposit ratios in the future
relative to the pre-crisis period, and a clearer priority ranking of bank creditors, the role of
senior unsecured wholesale funding for banks has evolved and will likely continue to evolve.
If we accept that a smaller and less leverage banking system is desirable, then this evolution
is not to be feared or resisted.
Second, the overall effect on funding costs of banks is not straightforward, given the potential
offset provided by cheaper deposit funding. Currently, more than half of the G20 countries
already have depositor preference, among them the US, with no appreciable cost difference
to banking systems without depositor preference. Furthermore, deposit preference can in
principle reduce the probability of default of financial institutions. Depositor preference could
further strengthen the incentives of unsecured creditors to exercise more effective discipline
over banks' risk-taking. This implies that while the loss given default for senior unsecured
creditors increases as a result of depositor preference, the probability of default is likely to
decrease. Also, as I argued before, lowering the risk of bank runs also reduces the future
probability of default.
Clearly, when applying the pecking order, the Single Resolution Authority should take into
account all relevant factors. Particularly, it should consider (i) the least-cost principle for the
taxpayer, (ii) financial stability considerations and (iii) the impact on the real economy. These
elements call potentially for some flexibility in the application of the bail-in tool. But despite
the undisputed need for flexibility, consistency should be ensured at the European level and
exemptions should be clearly defined and strictly limited.
Finally, the third pillar of the banking union is an integrated framework for deposit protection.
A first step towards this aim would be the adoption of the pending legislative proposal of the
Commission on a Directive for Deposit Guarantee Schemes (DGS). This framework should
ensure depositor confidence and enable the national guarantee schemes, built on common
EU standards, to interact with the SRM. Bail-in rules, with a clear treatment of depositors in
resolution and insolvency, and with depositor preference making it less likely that the DGS is
drawn upon, will make this interaction much easier in a real crisis, and will facilitate the
implementation of a common DGS at a later stage.
Conclusion
Let me conclude. The decision to establish a genuine banking union is a fundamental step
towards completing the architecture of Economic and Monetary Union, therefore making it
more effective and more resilient. It goes without saying - but it goes perhaps better with
saying it - that it is not the only step. It will have to be complemented itself by the completion
of the Union in the fiscal, economic and political fields, as identified by President van
Rompuy last year. In the area of banking policy as in those other fields, we have to heed the
lessons of the past: we have to make the new architecture comprehensive and internally
consistent. We cannot again leave the project half-completed. It is for that reason that we, at
the ECB, have been insisting that the Single Supervisory Mechanism must be completed
with the other pillars of the banking union, and the banking union must be completed with
action in other areas too. So while we have made considerable progress, there is still much
work to be done.