Can the single resolution mechanism ensure Europe’s financial stability?

The European Union started 2016 with optimism as the Single Resolution Mechanism (SRM) came on stream on January 1, 2016, which will implement a system-wide bank recovery and resolution directive in the euro area.

The new framework was a result of the global financial crisis of 2008, during which individual governments resorted to giving financial support or bail-outs to companies (or countries) financially struggling or facing bankruptcy. The crisis, sparked by the collapse of several investment banks in the United States, resulted in a series of taxpayer-funded financial market bail-outs by governments like Germany, the Netherlands, and the United Kingdom. The European Commission allowed the release 592 billion euros (€) ($640.81 billion) worth of state aid within four years (2008–2012) to shore up weak and failing banks. However, this resulted to higher government debt. As the crisis evolved and turned into the European debt crisis, some weaknesses within the European shared economy were exposed and realised.

Single Resolution Mechanism

The SRM was first proposed by the European Commission in July 2013 and adopted by the European Parliament in 2014 as part of a bigger framework to respond to financial crises and strengthen Europe’s financial system. The SRM is aimed at complementing the Single Supervisory Mechanism (SSM), which designates the European Central Bank (ECB) as the lone supervisor of all banks in the euro area. Both mechanisms are important foundations of the Banking Union, an initiative designed to integrate the banking system of the 19 states in the euro area so that they can better absorb the impact of economic panic and reinforce financial stability within the system.

For the European Commission, the SRM, in rare cases that banks fail despite stronger supervision, will help manage bank resolutions more effectively through a Single Resolution Board (SRB) and a Single Resolution Fund (SRF).

The SRB consists of selected representatives from relevant national authorities, the SSM, and the European Commission who will be in charge of carrying out the preparation for and the implementation of the resolution of a bank that is failing or likely to fail. The SRB will have the power to decide which steps should be taken to ensure a safe resolution especially to prevent the failure from spreading panic across the system.

On the other hand, the SRM provides for the creation of the Single Resolution Fund, which is expected to hold €55 billion ($59.84 billion) to be built up within a period of eight years from ex-ante contributions from banks within the euro area. The new policy prescribes that levies be imposed on banks to contribute funds.

As part of the agreement, Eurozone countries will lend the fund money through national credits lines or national resolution authorities to the SRF. Member states will define some of the rules in intergovernmental agreements, as part of the compromise reached by the member states and the European Parliament on the SRM in March 2014. Such measure, policymakers hope, will prevent expensive government bailouts and market panic resulting from bank failures.

Banks, investors get more responsibility

Compared to how Europe responded to the financial crisis where bail-outs were directly taken from taxpayers’ money, investors today should become more responsible for their own fate. This includes bail-ins, where the institution’s shareholders and investors bear the losses of the failing bank.

When the Italian government bailed in four banks in late 2015, about 130,000 shareholders and bondholders of Cassa di Risparmio di Ferrara, Banca delle Marche and CariChieti, and Banca Etruria lost their investments. One pensioner even hanged himself after his €100,000 ($108,260) investment in Banca Etruria was lost.

Before New Year, Portugal transferred five of Novo Banco's senior bonds to Banco Espirito Santo, which resulted to a direct loss among affected investors. Novo Banco was an offshoot of the break-up of Banco Espirito Santo into a “good bank” (Novo Banco) and a “bad bank” (Banco Espirito Santo). Due to the reassignment of bonds, losses were effectively imposed on the selected holders whose investments were transferred.

These two country cases illustrate how investors should prepare for risks and how the SSM will affect the banking industry.

Under the SRM, banks will have to pay contributions to the SRF. This takes the responsibility away from the national government in saving failing banks and places the costs of resolution squarely on bank stakeholders and creditors.

“Taxpayers will be protected from having to bail out banks if they go bust. No longer will the mistakes of banks have to be borne on the shoulders of the many," Jonathan Hill, commissioner for financial stability, financial services, and capital markets union, said in a statement.

But when and how can the SRF be utilised? The key and golden rule set by the European Commission states that no banks can be bailed out with public money until the creditors have ponied up at least 8% of the lender's liabilities. Banks will have to build up their loss-absorbing capacity in the face of any crisis that might arise in the future. Investors should better prepare to assume the responsibility of saving their own banks.

Looking forward

The SRM sets to standardise national rules into a single European mechanism in the euro area, including the creation of a Banking Union. Unlike most Asian countries that individually remain focused on preventing a crisis from happening, Western-style resolutions give more attention to resolution, bail-out, and bail-in regimes, similar to interventions in the United States.

What makes the euro policy different is that it provides power to a single regulator to place a bank, across any euro area state, under resolution. This is to ensure that the Banking Union will be firmly established, membership in which is mandatory for all euro area states.

European regulators are optimistic that any economic crisis in the future will be effectively held in abeyance without compromising national funds. In 2015, the largest Eurozone banks had set aside €2.8 billion ($3.2 billion) for the bloc's funds, which are expected to merge into the SRF this year.

Countries like those in Southeast Asia are closely watching these developments, particularly the introduction of the SRM. In many respects, Southeast Asia is following Europe’s footsteps through the ASEAN Economic Community, which has created the ASEAN Banking Integration Framework that envisions banking integration, which was first introduced in Europe, by 2020.

Surely, lessons will be learned from Europe’s experiences. But whether banking integration and single resolution can bring economic stability still remains a big question. The biggest challenge is whether the SRM, even if successful in shielding taxpayers from saving banks, can indeed prevent panic from spreading across Europe in an impending financial crisis.