Andreas Dombret: Europe's solution for too-big-to-fail
Speech by Dr Andreas Dombret, Member of the Executive Board of the Deutsche
Bundesbank, at the Institute for Law and Finance, Goethe University, Frankfurt am Main,
3 May 2012.
* * *
1. A special insolvency law for financial institutions - context and objectives
Ladies and gentlemen
It is always a pleasure to visit the House of Finance on the beautiful campus of Goethe
University to discuss current economic policy issues with representatives from academia,
economics and politics. And when such an important topic as "Effective Crisis Management
in the Financial Sector" is on the agenda, I am especially happy to be here. So I thank you
sincerely for your invitation and wish to present my thoughts on a legal topic, using an
economic point of view.
What is it about? In the light of the financial crisis the G20 leaders agreed at the London summit
in April 2009 that, in future, they will supervise and regulate "all systemically important financial
institutions, financial instruments and financial markets". Since then, a bulk of measures has
been adopted at subsequent summits in Pittsburgh, Seoul and most recently in Cannes. One
focal point were the SIFI rules designed to contain the "Too-Big-To-Fail" problem. 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% of the EU GDP.1
However, the economic implications of the crisis go far beyond the fiscal burdens. They
affect the real economy and therefore, for instance, every entrepreneur who relies on a bank
loan to finance his investment decision. Thus, 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,2 the IMF estimates that 58 major banks in the
EU could reduce their aggregate balance sheet total by €2 trillion, or around 7%, 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.
2. A new international standard for resolution regimes
2.1 Basics of the FSB Key Attributes of Effective Resolution Regimes for
Financial Institutions
For this purpose, the Financial Stability Board, FSB for short, has developed, and the G20
have adopted, a new international standard for resolution regimes: the "Key Attributes of
Effective Resolution Regimes for Financial Institutions" - which I will refer to as the "Key
Attributes" from now on. This is the first time that the main features that national resolution
regimes should include have been stipulated at the global level. For example, in future each
of the G20 jurisdictions will have to set up a designated resolution authority for financial
institutions. Moreover, specific requirements fostering cooperation between national
authorities will promote crisis prevention and crisis management. Finally, institutions and
supervisors alike will have to become very concrete in their planning of possible responses to
an upcoming crisis. I will discuss these points in more detail later.
These Key Attributes were urgently needed, even if some financial sector commentators
would have preferred a globally uniform insolvency law. It goes without saying that I, too,
prefer optimal solutions, but - to put it bluntly - regulators and central banks do not live in the
"land of Make-A-Wish". The scope and complexity of the individual and mutually dependent
issues which have had to be, or remain to be, solved in an overall package are sometimes
like a Gordian knot. Unlike Alexander the Great in the legend, however, the G20 states have
no magic sword to cut through the knot, and a reasonably timely approach that can be
implemented at the global level is perhaps only a first step that may be followed by others at
a later point in time.
2.2 Establishment of a designated resolution authority for financial institutions
One end of the rope forming the Gordian knot involves the institutional set-up for national
resolution regimes. 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. This new authority will be given a strong mandate. In particular, its tasks will
be to

promote financial stability,

ensure continuity of systemically important financial services,

protect depositors, although this could be done - as in Germany - in coordination
with the deposit guarantee schemes,

seek to minimise the overall costs of resolution in home and host jurisdictions and
 duly consider the potential impact of resolution actions on financial stability in other
countries.
To fulfil its role, the resolution authority will be equipped with far-reaching instruments. For
example, it will be able to

remove senior management and replace it with an administrator to take control of
the firm,

transfer or sell assets and liabilities to a third party or a bridge bank and

impose a moratorium with a suspension of payments to unsecured creditors.
Implementing the Key Attributes will lead to a gradual alignment of the national legal
frameworks for resolution regimes. I am convinced that this will most certainly have a positive
impact on financial stability.
2.3 Strengthening international cooperation between national supervisory and
resolution authorities
A further cluster of problems - the other end of the rope forming the Gordian knot - concerns
the handling of crisis situations at large complex financial institutions. I don't need to explain
to you that insolvency proceedings are currently carried out on a national and territorial level.
However, the 30 largest systemically important banks hold on average 53% of their total
assets abroad, according to data from a study carried out in 2010.3 68% of their subsidiaries
are located abroad, and they generate 56% of their pre-tax earnings from cross-border
operations. In the past, if institutions like these became distressed, national supervisors
regularly ring-fenced their assets. The banking groups were broken up according to national
boundaries or were rescued by the respective home states as separate national entities. This
meant systemic distortions and considerable cost for the taxpayer. Mervyn King once
summed this up succinctly with the words: "Global banking institutions are global in life but
national in death".4
We may not have Alexander the Great's sword, but there are two magic words which will
help deal with these challenges. These words are "cooperation" and "planning". In order to
systematically 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. First, the competent authorities of the home jurisdictions of a SIFI are
required to conclude institution-specific cooperation agreements with their counterparts in the
respective key host countries. Second, Crisis Management Groups are to be set up for each
SIFI; within these groups, all responsible national bodies5 will come together at regular
intervals to discuss crisis planning and crisis management. Third, in order to lay the
necessary foundations for this, all impediments to sharing confidential information must be
removed. I consider this last point to be especially important!
We have known for years now that the exchange of information between supervisory
authorities is hampered by the lack of or an inadequate legal basis. Incidentally, this
particular impediment not only obstructs resolution regimes but also affects many different
areas of the G20 financial sector reform agenda. The necessary legislative changes will have
to be made when the requirements resulting from the Key Attributes are transposed into
European and, later, German law such as the German Banking Act. The European
Commission is already aware of this problem.
2.4 Recovery and resolution planning
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. Any impediments to
resolution should be identified and removed. In November of last year, the G20 committed
themselves to carry out such assessments for all global systemically important banks by
October 2012. As the second component, the institutions themselves must submit plans
describing how they envisage a potential restructuring and discuss them with supervisors.
Ideally, the supervisory authority would be able to take these plans out of the drawer in the
early stages of a crisis and restructure the institution in cooperation with the resolution
authority. This planning process is useful for the institutions as well. According to a recently
published survey involving 19 big financial institutions, 40% of those questioned claimed to
have drawn up complete recovery plans. Despite the costs involved, the majority of the
surveyed institutions see the advantages in this planning process, for example in that they
provide a better operational understanding of the business structures.6
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. The purpose of this is to
prepare for the effective use of the resolution tools. The resolution of an institution has to be
planned in such a way that

systemically important functions performed by the institution are continued,

the stability of the financial system is not jeopardised, and
 the use of taxpayers' money is avoided.
3. From standard-setting to the application of the new rules
3.1 The European Commission's proposal for a directive
Ladies and gentlemen, 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. Just how difficult this is may
be seen from the fact that the publication of an EU legislative proposal originally planned for
the summer of 20117 has since been postponed several times, and has yet to be presented. I
do appreciate the fact that, before making a publication, the European Commission wants to
clarify difficult technical and political issues, such as the design of the bail-in instrument or
implications for the deposit protection schemes in Europe. However, further delay in
publication entails the risk that the European states each implement the Key Attributes on
their own; this could create unnecessary inconsistencies and, consequently, new problems in
the event of an institution becoming distressed. Moreover, it would be extremely inefficient if
all EU states had to transpose standards on resolution regimes into national legal systems
twice within a short space of time - first to comply with the G20 commitment and again
shortly afterwards to implement the EU directive.
3.2 Germany: the Bank Restructuring Act
Notwithstanding international initiatives, German legislators responded to the financial crisis
early on. On 1 January 2011, the Bank Restructuring Act8 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. This is why, when drawing up the
Act, care was taken to ensure that the new instruments, such as stronger powers of
intervention for BaFin, fitted into the already recognisable contours of the expected EU
legislative proposal.9 In addition, with all banks contributing to a Restructuring Fund by
paying a bank levy introduced in 2011, the banking industry is for the first time being made to
participate in the costs of overcoming future crises - even though the amount accumulated in
the fund is still far too small. The basic idea is that the money paid into the Restructuring
Fund will be saved over many years until the target amount of €70 billion has been reached.
Admittedly, this leaves us with a problem in the interim. However, the act in itself is a step in
the right direction since it heightens what the IMF, in its last Article IV Consultation,10 called
the "level of preparedness". The fact that legislative change is also still needed in Germany
before the Key Attributes and the EU directive can be fully and consistently implemented
does not contradict my - in principle - positive assessment of the Restructuring Act.
3.3 Rigorous monitoring of the implementation of the new international standard
Experience over the past few years has shown that international standards can sometimes
be futile if they are not implemented and applied in a consistent and timely manner. For this
reason, the FSB wants to rigorously monitor the progress made in implementing the Key
Attributes in its member states. What makes this all the more important is the fact that the
Key Attributes take us into unchartered waters. Moreover, implementation will require
legislative and institutional changes - some of them extensive - in all G20 jurisdictions. Last
but not least, monitoring of consistent implementation is crucial for overcoming obstacles to
cross-border cooperation which will play such an outstanding role. To facilitate the monitoring
process, work is currently underway, as a matter of urgency, on an assessment methodology
that will make it easier to objectively assess the level of implementation in individual
countries. This instrument is to be used by various bodies: a) countries will be able to
perform a self-assessment in order to identify any gaps in implementation; b) the IMF/the
World Bank will use this methodology when carrying out their FSAP assessments; c) the
FSB is already planning a first review for 2012 as part of its peer review process, and d) the
FSB Peer Review Council, which has not yet been set up, will apply this instrument to global
systemically important financial institutions. Countries with a below-average performance in
these assessments will be required to provide an explanation, and can expect the results to
be published. I believe implementation must be monitored rigorously because the new
standard closes a serious gap in the regulatory framework.
4. Conclusion
This gap illustrates perfectly that the regulatory framework before the financial crisis was not
geared to the stability of the financial system as a whole. This failure to take sufficient
account of the systemic stability perspective must and will be remedied. For this reason, let
me draw your attention to the German Government's draft of the Financial Stability Act,
which the German Cabinet passed yesterday. This act will assign central tasks of
macroprudential oversight to the Bundesbank. Among other things, the Bundesbank will be
responsible for identifying risks to German financial stability as well as for proposing
warnings and recommendations. The Bundesbank will present its analyses and proposals to
a Financial Stability Committee, a new body that is to be established. However, it cannot be
made to subscribe to analyses or proposals it does not agree with. To this end, the draft act
provides that the Financial Stability Committee cannot override the Bundesbank's
representatives on key decisions. I welcome this legislative initiative, it respects the
Bundesbank's independence.
Difficult and complex legislative proposals can sometimes pose a problem comparable to
unravelling the Gordian knot. Did you know that, according to ancient Greek mythology, the
gods tied this intricate knot to the chariot of King Gordius to secure the drawbar of the chariot
to the yoke? There was actually no need to cut the knot. If the peg had been pulled from the
drawbar, the knot would have fallen apart on its own. To tell the truth, ladies and gentlemen,
when I compare that image with the Gordian knot as represented by the resolution regime, I
see neither a brute force solution nor a brilliantly simple one. 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.