Other measures are needed to make the Banking Union credible:
- reduction of regulatory incentives that favour sovereign debt, and
- structural reform of bank activities to make bail-in and bank resolution credible.
Thierry Philipponnat, Secretary General of Finance Watch, said:
“The SRM has the right objectives: namely to enable the orderly resolution of banks in participating member states, and to weaken the interdependencies between financial institutions and their sovereigns.
“However, we do not see how these objectives can be met without reducing the regulatory incentives that favour sovereign debt, and without a structural reform of bank activities to make bail-in and bank resolution credible.”
More detailed comments follow:
The compromise agreement will accelerate the mutualisation of contributions to the Single Resolution Fund (SRF) to 60% of the planned fund within two years. We welcome this positive outcome from the negotiations, which will bring the SRF into use more quickly.
We note the agreement to let the SRF borrow from the markets. This development raises important questions about who will lend and under what conditions. For example, could market borrowing be relied on in a systemic financial crisis? We look forward to learning further details.
The SRM will harmonise different national resolution approaches, which should strengthen supervision (Single Supervisory Mechanism) and the Single Rulebook.
The governance and decision-making arrangements under the SRM have been streamlined and improved to reduce the possibility of political interference, although they will not eliminate it entirely. For example, member states will be able to object to “material modifications” in the amount of funding deployed from the SRF, introducing an extra degree of uncertainty that could be unwelcome in a systemic crisis.
The need to reform bank structures to make resolution credible
According to the Council and Commission statements (links below), the SRF will be pre-funded by banks and its borrowings must be repaid by banks; its funds should not be deployed until bail-in has been applied and any private solutions attempted. In theory, this means public money would only be at risk when the SRF and its credit lines have been exhausted.
In practice, the presence of too-big, too-complex and too-interconnected banks in the EU’s banking system fatally damages the credibility of this mechanism.
A large share of banks’ debt instruments including senior debt is held by other financial institutions. While CRD IV/CRR may help to reduce this (i), a decision to write down capital and to bail in other liabilities equivalent to 8% of the total assets of a large, systemically important institution will inevitably multiply financial stresses throughout the system.
Given the interconnectedness of the EU’s banks, this could increase the number of institutions needing assistance or lead to bail-in not being properly applied. In either case, the EUR 55bn SRF and its credit lines would then be exposed to significantly higher losses, potentially overwhelming the fund.
The total assets of Eurozone banks are more than 500 times larger than the SRF (ii). In our view, bail-in will only be credible if the current level of complexity and interconnectedness in the EU banking sector is significantly reduced.
A strong separation of EU banking activities would achieve this. It would make resolution easier, improve the effectiveness and credibility of bail-in, reduce interconnectedness and systemic risk, and reduce the likelihood of the SRM having to deal with systemic failures in the first place. The 29 January 2014 proposal by the Commission on banking structural reform, which sets the right ambition, should thus be at the top of the agenda of the next Parliament.
The need to reduce regulatory incentives that favour sovereign debt
The SRM agreement does not address the mechanism by which sovereign stress can flow back to the banks that hold their sovereign debt. Eurozone banks today hold around EUR 1.75 trillion in government debt,(iii) encouraged by a number of regulatory incentives.
These regulatory incentives need revisiting if the goals of Banking Union are to be met. They include the zero risk weighting of sovereign debt for capital adequacy purposes, the definition of High Quality Liquid Assets in the Liquidity Coverage Ratio, and the treatment of sovereign debt in the large exposures regime.
Mr Philipponnat said:
“The current regulatory preference for sovereign debt gives rise to “moral suasion”, a situation in which large banks hold undue influence over their governments through the purchase of their governments’ debt. When this is combined with doubts about the behaviour of the SRM in a systemic crisis, it is clear that important flaws remain in the design of Banking Union, not least the presence of banking structures that are incompatible with a credible bail-in and resolution mechanism.
“To make Banking Union work for the EU’s citizens, policymakers must address these flaws in the next Parliament.”
For a detailed explanation of why structural reform of the banking sector is necessary to make bank resolution credible, see Finance Watch’s September 2013 report “Europe’s Banking Trilemma”.
Press releases on SRM from the Commission and Parliament – 20 March 2014
Press release on SRM from the Council – 27 March 2014
Commission proposal on banking structural reform – 29 January 2014
(i) For example, by deducting holdings of Tier 2 instruments of financial sector entities from bank’s own funds.
(ii) Eurozone bank assets were EUR 29,613 billion at the end of 2013, according to ECB data.
(iii) ECB data cited by Reuters – 10 March 2014