Policy contribution Financial Stability Conference 2017
16 November 2017
Source: Financial Risk and Stability Network
Lukas Köhler, Bucerius Law School, Hamburg
Marcello Tumino, University of Warwick, Coventry
This policy paper has been prepared as an accompanying and follow-up contribution of the Financial Stability Conference 2017 which was held October 18 in Berlin. Early-stage and PhD researchers have been invited to write policy-oriented papers on selected topical issues of the conference to be published, circulated and enclosed in the conference report.
EU banking regulation has gone through a massive set of changes in the past decade, but, even if substantial improvements have been made, the realization of a fully-fledged Banking Union is still an unfinished business under many aspects. Recent case studies suggest that any pledge to avoid bailouts in the future is strictly linked to two main aspects: the fine-tuning of bail-in rules on one side and, on the other, the enhancement of the legal certainty about the limits imposed on publicly funded recapitalisations.
After the Global Financial Crisis (GFC), policymakers and financial regulators at the international level recognised that addressing the ‘too-big-to-fail’ issue posed by many financial institutions was an essential prerequisite for economic recovery. In particular, it is almost uncontested that banks play a pivotal role within a financial system since they provide key economic functions and represent an essential source of funding for the real economy. The policy of bail out credit institutions in financial troubles has a long history and it has usually been vindicated with the claim that letting them fail would imply higher costs, both in terms of overall public expenditures and economic slowdown. However, many analyses highlighted how this policy choice actually poses a serious threat to public finances, hinders competition and favours a risk-taking culture that magnifies the issue of moral hazard [e.g. Huertas, 2015]. These problems were severely felt in Europe, where they have been aggravated by the Sovereign Debt Crisis that exposed a perverse link between sovereign debts and the banking sector.
Indeed, in the European context, the new awareness on these issues led to a gradual but determined shift towards a policy based on burden sharing and investors’ involvement in bank crisis management. On one hand, there was the need of improving the banking regulation and supervision (from both a micro and macro perspective), mainly with the introduction of a more forward-looking approach and adequate supervisory tools such as periodical stress tests or asset quality reviews. Within this domain, the aim is to prevent bank crises or to halt them at their onset. On the other hand, one of the greatest challenges was making even systemically important banks resolvable or ‘safe to fail’, curbing the bail-out practice. Here, the main objectives are re-stabilising ailing banks or minimising the effects their failure may have on financial stability. Firstly, to address the latter issue, a wide set of reforms has been mandated at the G20 level since 2009. Then, the work on this field has been conducted by the Financial Stability Board (FSB), which since 2011 develops and refines the principles and key attributes a sound resolution regime should possess to be effective. Substantial contributions in this field have been made also by another international standard setter, the Basel Committee on Banking Supervision (BCBS) hosted by the Bank of International Settlements (BIS).
Along these lines – and in the light of the de Larosière Report which exposed the criticalities of the EU system of financial supervision in 2009 – the EU co-legislators launched the ambitious project of the Banking Union (BU) in June 2012. It should be noted, however, that avoiding bailouts as a strategy option in bank crisis management was already a priority under the State Aid framework enforced by the EU Commission. Its 2013 Banking Communication (the latest iteration of the so-called ‘crisis communications’) tries precisely to strike a balance between avoid distortions of competition in the single market and preserving financial stability.
Radically reshaping the former architecture of bank regulation and supervision, the BU was supposed to rest on three pillars: a Single Supervisory Mechanism (SSM) under the aegis of the European Central Bank, a Single Resolution Mechanism (SRM) led by an independent resolution authority (the Single Resolution Board – SRB) and a European Deposit Insurance Scheme (EDIS). The overall aim was to break the vicious circle between banks and sovereigns (the so-called ‘doom loop’), put an end to the practice of bailing out financial institutions using taxpayers’ money, curb moral hazard and ensure financial stability. Steps ahead towards these objectives have been made, but progress seem to advance on a bumpy road. This is even more apparent with regard to a common deposit guarantee scheme to ensure depositors in the euro-area.
Feedback and comments are welcomed.