Andreas Dombret: Failing or likely to fail? Putting the European
banking union to the test
Speech by Dr Andreas Dombret, Member of the Executive Board of the Deutsche Bundesbank,
at the Deutsche Bundesbank's University of Applied Sciences, Hachenburg, 21 August 2017.
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1. Introduction
Professor Keller
Professors
Students at the Bundesbank's University of Applied Sciences here in Hachenburg
Ladies and gentlemen
I would like you to join me today as I take a look at the state of the European banking union. The
students among you can breathe a sigh of relief: I'm not here to discuss committee structures or
test your knowledge of EU institutions, and there will be no quiz after I've finished talking. The
question that I would like to explore is one that is of interest to us and the general public alike:
does the European banking union - that "big new thing" in the history of banking supervision -
actually work?
Truth be told, such a fundamental question shouldn't really need any prompting. Nevertheless, I
will address the question by examining four recent examples of institutions running into difficulties
in the European banking sector - and, to my mind, what better place to illustrate such a topic
than at the Bundesbank's University of Applied Sciences?
To start, which cases am I referring to? First, Banco Popular Español, which was wound up in
June 2017 under the new European resolution rules. Second, Banca Monte dei Paschi di Siena.
It received EU approval for precautionary recapitalisation, a procedure under exceptional
circumstances in which an injection of state capital does not result in an institution being deemed
"failing or likely to fail" or in it bearing the repercussions of such an assessment. My third and
fourth examples are very recent - just two months ago, two Venetian banks were liquidated
under Italy's national insolvency regime. So, within a short space of time, we have seen three
different approaches to dealing with struggling banks in the euro area.
In exploring these cases today, I would like to take the opportunity to delve deeper into the
functioning of the banking union and to draw a handful of initial conclusions. I want to focus on
three topics in this regard:
first, the work of the Single Supervisory Mechanism (SSM);
second, the role of the Single Resolution Mechanism (SRM) and the national insolvency
regimes;
third, the current state of affairs in the European banking sector, which is not to be
overlooked in the context of the banking union.
2. Crisis situations - uncharted territory for the SSM
It isn't for nothing that ailing banks attract so much public attention. This is because, by their
nature, a great deal of money is at stake. That's precisely why declaring that an institution's
failure is imminent or inevitable - known in technical terms as "failing or likely to fail" - is the most
powerful weapon in the banking supervisors' arsenal. It equates to forcefully bringing an end to an
institution as we know it. The all but inescapable consequence is either resolution under the new
European resolution rules or insolvency proceedings under national law. In economic terms, the
decision draws a line - at least temporarily - under the institution's accounts. Losses arising
from business activities now need to be realised. And the value of assets in a gone concern -
that is to say, an institution that needs to be wound up - is almost always lower than that of those
in a going concern. It's not least for this reason that banking supervisors should not be overly
hasty in classifying an institution as "failing or likely to fail".
But there's also an old saying that applies here: it may be far better for all parties concerned to
make a painful break rather than prolong the agony. Needlessly perpetuating the situation could
very well push up costs and losses. What's more, "gambling for resurrection" - by which I mean
focusing on a failing institution's unlikely prospects of recovery, which could leave creditors and
taxpayers footing an enormous bill if things come to a head - is not a viable option. There is no
room for wishful thinking here - and that applies to both financial institutions and their
supervisors.
All in all, one thing is clear: when it comes to the timing of "failing or likely to fail" verdicts, banking
supervisors cannot simply arrange these around the premier league schedule. A lack of
confidence and liquidity can force the supervisors' hand at extremely short notice. In each
individual case, every single detail needs to be scrutinised so that a well-thought-out decision can
be made. In this regard, cooperation within the SSM and with the SRM has worked well in the
cases I have mentioned.
The use of precautionary recapitalisation, which I touched upon at the start of my speech, also
marks a step into uncharted territory for European supervisors. This is enshrined in the new
European Bank Recovery and Resolution Directive (BRRD) as an exceptional measure that
enables an institution to receive an injection of public funds without - as is generally envisaged
being deemed "failing or likely to fail".
Precautionary recapitalisation is only approved under certain conditions. In particular, the
institution must be deemed solvent, and the public funds may not be used to offset existing or
anticipated losses. Supervisors need to carefully examine whether these requirements are met.
Additionally, the European Commission has to decide whether the granting of public funds is
compatible with EU state aid rules.
It's a particularly sensitive issue because one of the fundamental objectives of the new resolution
rules is to shield taxpayers: it should be a bank's shareholders and creditors who are on the hook
for unsatisfactory bank management and any losses that arise as a result, not taxpayers. Then
again, European legislators have accepted a serious disturbance in the economy of a member
state and risks to financial stability as grounds for government intervention to prop up solvent
institutions. The stringent criteria outlined in the legislation do actually need to be fulfilled,
however.
In other words, these conflicting aims make it clear that precautionary recapitalisation cannot be
a blueprint for averting bank crises. Consequently, precautionary recapitalisation is defined in
the BRRD as a purely exceptional measure. This is also my clear understanding of the term.
What is also clear is that, in each and every instance, shareholders and subordinated creditors
need to be bailed in before the government coffers are opened. With regard to Italy's Monte dei
Paschi di Siena, what this means in concrete terms is that the institution's capital base was first
bolstered by €4.5 billion by converting subordinated debt instruments into equity, with the Italian
government then injecting an additional €3.9 billion. However, the government will offer
compensation to retail investors, thereby increasing its stake in the bank. The ownership
structure will change as a result of the aid provided: legacy shareholders will lose out as their
stakes are diluted. By contrast, the Italian government will own up to 70 % of the institution. To
sum up, the state is providing assistance to an ailing bank and, as an investor, will be exposed to
any potential future losses.
Looking beyond this particular case, one thing is clear: while the use of public funds will be made
more difficult under the new resolution rules and will only be permitted subject to compliance with
certain criteria, it has not been taken off the table completely. Yet the fact that government aid
was provided to as many as three of the first four banks to run into difficulties cannot be in the
interest of European legislators. Our resolution regime should be measured against how
effectively it shields national taxpayers - and I firmly believe that this should also be the goal of
national insolvency law as well.
Before I go on to talk about the actual resolution cases in greater depth, let me take this
opportunity to draw three conclusions from the crises as viewed from a banking supervisor's
perspective.
First, it will not be possible to draw up a straightforward supervisory blueprint for dealing with
future crises. As a general rule, every crisis tends to be different and there is no "one size fits all"
approach to resolving them. We observed this recently in Italy and Spain. The institutions there
differ in terms of the reasons why they ran into difficulties, their positions in the banking market
and their standing in their respective economies. However, we must nevertheless learn specific
lessons from each individual case.
Second, as this issue concerns appropriate, tailored solutions - and therefore discretionary
scope as well - efficient decision-making processes are required. In this context, coordination
between all of the institutional stakeholders plays a very important role. As crisis situations will
always be unique, we need to ensure that all decision-making factors are incorporated sensibly
and objectively.
Third, we need to grasp that banking supervision certainly can, and must, deliver far more than
dealing with acute difficulties in the banking sector. As a general rule, it kicks in far earlier by
ensuring compliance with the rules, thereby tackling unwelcome developments in good time.
European supervisors have set new standards as far as the last point is concerned. Capital
addons, for instance, which are set following the annual supervisory review process, have become
far more important than they once were. And that is as it should be.
Having learned from the crisis years, banking supervisors have strengthened their early warning
systems and early intervention capabilities. Supervisors now go beyond the scope of an
institution's solvency and liquidity - these days, they normally also examine business models and
governance, as unwelcome developments in these areas could have an impact on earnings and
resilience in the medium term. One SSM project I could mention here explores the structural
reasons for a disproportionately large risk appetite, which some institutions were shown to have
in the past. This certainly does not mean that we are looking to intervene in an institution's
business activities; instead, it is our aim to identify at an early stage and mitigate to the greatest
extent possible any developments that could pose a serious threat to a bank's livelihood.
Imbalances in the banking sector, then, are an important testing ground for European banking
supervisors - yet everyday supervisory measures are equally as important, even if their success
cannot always be put into numbers as easily.
You can see this, for example, in the case of home country bias, a phenomenon which occurs
when national supervisors unintentionally allow their national interests to influence their work. And
it is precisely this trend that the SSM is designed to counter. It is not so much a case of
supervisors breaking the rules, but more a question of how they interpret them, yet it is not
always possible to identify a home country bias in each individual case. The new supervisory
architecture is designed to counter this home country bias trend that national supervisors exhibit.
Supervisory teams consisting of staff members from several different countries and, of course,
the key role of the ECB have forged a more neutral approach and a more level supervisory
playing field. I consider this a very welcome development.
Dear students, I hope that my remarks, which touched on only a small part of the work of banking
supervisors in the new European era, have also managed to drum up some interest in our field of
work. The tasks of national and European banking supervisors not only entail a high level of
responsibility, but are also very varied and challenging. I do have my own particular reasons for
saying this, however, not least as it is the specialists from the individual member states who
keep the European supervisory mechanism up and running. Germany and, in particular,
the Bundesbank contribute over 28 % of the total headcount of supervisors in the SSM. We
therefore rate well qualified young professionals like yourselves very highly.
3. Resolution - what we have learned so far
Let us now take a look at the topic of resolution in the narrower sense. We all have unpleasant
memories of institutions which unfortunately only appeared to obey the laws of a market
economy and our regulatory framework when times were good. The new European Single
Resolution Mechanism, or SRM, which consists of new rules, a new institution and a new
resolution fund, was therefore established in 2015. How well is it functioning? What have we
learned in the first few years?
There is one thing that I would like to stress from the outset which is all too easily forgotten when
assessing the recent crises: neither in the case of the Spanish bank nor the Italian banks have
we seen lasting spillover effects or negative repercussions in the markets. Branches opened
their doors again on the next working day following the resolution - admittedly under a new name
but otherwise it was business as usual. The fact that it all went largely unnoticed is the most
remarkable thing about it, and that should by no means be taken for granted.
I would like to look a little closer at the resolution of Banco Popular Español in particular, which
was the first financial institution to be resolved under the SRM. This was a concrete case in
which the SRM achieved what some experts had even considered unimaginable up until then:
that a decision could be reached within just a matter of hours on the fate of a multi-billion-euro
financial institution with a countless number of branches - and that without any negative
repercussions for the European or the Spanish financial system. Given the rapid pace at which
the liquidity situation deteriorated, the institution even had to be resolved during the week between
two normal working days. In this specific case, the fact that a purchase offer had already been
made meant that it was possible to find a solution to the crisis with comparatively little
intervention. The management board and supervisory board of Banco Popular also acted in a
responsible manner.
The case of the two Venetian banks was at least just as challenging. I am pleased that the
market exit of these two banks ultimately turned out to be a success. The precarious banks that
were causing us concern in the past no longer exist in their previous form. Unlike in the case of
Banco Popular, these banks were not resolved in accordance with European rules, but were
liquidated under Italy's national insolvency regime.
Here, it was possible to wind up the institutions using government funds as the European
resolution rules apply only to banks that are classed as being systemically important. The switch
from a European regime in crisis cases to a national regulatory framework consequently created
a whole new ball game.
One requirement, nonetheless, was that the European state aid rules be adhered to.
Consequently, the banks' owners and their subordinated creditors, too, had to be bailed in. The
fact that substantial amounts of taxpayers' money were drawn on at the same time was, of
course, justified from a legal perspective. However, the declared objective of the European
resolution rules was to keep the taxpayers' contribution in bankruptcy cases to a minimum. In
order to ensure that national taxpayers are adequately protected, it is therefore essential that
national insolvency rules be aligned with the European resolution rules as a matter of urgency.
4. The current banking union environment - the most important details
Ladies and gentlemen, the cited examples show that many things are working well in the banking
union, but there is still a lot to be done. In particular, right-sizing the bail-in of investors and other
creditors under national insolvency proceedings is a process which has by no means been
stretched to its limits. This, however, is important if banks are to live up to their claim of being
fully-fledged members of our market economy. What this also means is that losses should not
be socialised, but rather that investors and creditors should personally be held responsible for
the risks arising from their decisions. I am convinced that we must press ahead along the path
that we are now on.
A debate on the banking union needs to address many details. This also includes taking a look at
the bigger picture. If we are concerned with the resilience and credibility of the new regime as a
whole, we must always be aware that the banking union was designed for a banking system
scarred by the crisis. We committed the European banking sector to "self-healing" from the very
outset. To this end, the balance sheets of the large euro-area institutions were thoroughly
examined prior to the launch of the new oversight body. I recall valuation adjustments of
€48 billion and mandatory capital increases totalling €25 billion in the period from November 2014
to June 2015.
However, we were, of course, unable to foresee new burdens resulting from factors such as
persistently weak economic activity and knock-on effects of the crisis further down the line.
Nonperforming loans are still saddling banks in a number of member states. The level of
nonperforming loans for EU banks currently stands at around €900 billion. These burdens were a
notable feature of the four most recent crises. Ultimately, self-healing does not happen overnight,
but is often a long and arduous process.
This is also true of the resolvability of credit institutions. Although the new rules were quickly
reflected in price effects for subordinated bonds following their entry into force - which is an
indication that they had the desired steering effect from the very outset -, the transition into the
new world is by no means completed. The Single Resolution Fund, for example, is still in the
development phase. And Europe's credit institutions are still building up their MREL
and TLAC holdings - in other words capital that is to be made available for bail-ins. The
corresponding MREL requirements are expected to be determined by the resolution authorities
by the end of this year.
5. Conclusion
Let me come back to my initial question: is the European banking union working?
The takeaway from the recent crises is ambivalent. For sure, we can breathe a sigh of relief that
we were able to overcome four bank failures without any far-reaching consequences and that
ailing banks exited the market successfully. At the same time, we have to draw conclusions from
the recent crises in order to further strengthen the banking union.
In my opinion, closing the gap between national insolvency rules and European resolution rules is
a major issue that should be addressed as a matter of urgency. As sensible as it may seem to
deal with crises differently depending on the specific circumstances, certain basic principles do
need to be adhered to in a consistent manner. These include, for example, bailing in investors
and creditors as envisaged in the European resolution framework.
In the discussion about the functional viability of the banking union, I would, however, like to warn
against making overly one-sided and generalised judgments. We can only strengthen the large-
scale "banking union" project if we are willing to devote ourselves to the specific problems and
not let up until they have been fixed for good. This means taking account of the individual
circumstances - both for the four cases discussed earlier and the over 3,000 other credit
institutions in the euro area. It also means accepting that the banking union cannot pull simple
solutions out of a hat when the going gets tough. The high level of non-performing loans in
Europe bears witness to the major challenges that still need to be overcome.
Thank you for your attention. I now look forward to our discussion on this topic.