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Banking Union: not quite a way to Damascus but a good path to Brussels

In a previous edition of this Risk Note (January 2013), we discussed the progress towards the creation of a Banking Union in Europe.1

We observed that the action European regulators were taking – shifting from a domestic-based to a European-centric supervisory approach – was unprecedented. However, when that commentary was written the overall context in Europe was different from today: the severe sovereign debt crisis was still fresh in everyone's minds and there was a real concern that if another Member State was to suffer similar difficulties, this could have a significant cross-border effect on the banking system with catastrophic consequences.

The need to set up a resolution mechanism arose as a result of serious concerns about the capacity of certain individual EU Member States to handle a bank's bankruptcy at the national level. Such inadequacies would reinforce the circular effect of the risks between the sovereigns and their banking system.

Since then anxieties over Member State sovereign debt position have relaxed somewhat, but the political agenda has kept up momentum on the Banking Union project and important decisions have already been taken to progress it.

Most recently, by mid-April 2014 the European Parliament had approved three major legal instruments adding the missing bricks to the Banking Union construction, namely the single resolution mechanism (SRM), the Bank Recovery and Resolution Directive IV (BRRD) and the update of the Directive on Guarantee Deposit Schemes.

Looking at the overall direction of the new regulation (as opposed to the detailed provisions) its evolution is remarkable. Commentators recently noted the Banking Union "was a step so bold even the original architects of the EU's single currency club did not think it realistic: persuading Eurozone countries to give up national control over their banking systems".2

From bail-out to bail-in

As previously mentioned, the Banking Union has been designed as an additional tool to monetary union in the context of the euro sovereign debt crisis resolution. The SRM and BRRD will apply from 2016 (when they enter into force) to the same institutions that are subject to the supervision mechanism, namely, those banks established in a euro area Member State (and possibly any other States deciding to join the Banking Union).

Recent bank failures include Lehman Brothers, Fortis, Icelandic banks, Anglo Irish Bank and Dexia. For these institutions, a variety of measures were adopted, many of which revealed the inadequacy of existing tools to efficiently resolve failures in the banking system.

Resolution principles will try to address issues which are not fundamentally different from those arising as part of any other "ordinary" insolvency: where to find the money and, if there is still a shortage of cash, who should suffer from the haircut? It is, however, recognised that – given the risk of systemic effect and the political and economic pressure to save "too-bigto- fail" institutions – specific principles and measures need to be given in such situations.

The principle promoted by the new resolution mechanism when resolution needs to occur, is to minimise the extent to which the cost of a bank failure is borne by the Member State and its taxpayers: it is for shareholders and then bondholders to suffer the losses.

To this end, the BRRD provides resolution authorities with a set of solutions, including the sale or merger of the business with another bank, setting up a temporary bridge bank in order to separate good assets from bad ones, converting the shares or writing down the debt.

These measures will be considered in circumstances where a bank is failing or likely to fail if no private sector intervention can resolve the situation in the short term and formal insolvency would cause financial instability.

Bank fund to finance the resolution process

The single resolution mechanism will be set out in a Regulation and thus be directly applicable without the need for national implementation in participating Member States. The Regulation will set out in detail the workings of the mechanism. The resolution mechanism will create an EU authority to make resolution decisions about the biggest banks. Banks will also be required to make contributions to fund a single resolution fund, aimed to be a last resort financing tool in the resolution process for when contributions by shareholders and creditors under a traditional bail-in would prove insufficient. It is said that the fund is not designed to absorb directly any losses or recapitalise the failing institution. The fund mechanism will combine certain already existing national funds and a European fund.

This fund mechanism could be a very powerful tool to assist in bank resolution. At least two conditions will be required to achieve a useful outcome. First, the level of funding must be sufficient in situations where it is not about dealing with an isolated impaired institution but rather – as in the recent past – a wider crisis affecting or potentially affecting a number of institutions in Europe. Second, the governance of the system needs to ensure a fast and efficient decision-making process.

Deposit guarantee schemes

The update of the Directive on the Guarantee Deposit Scheme3 is aimed at improving the protection of depositors. Banks will be required to participate in a guarantee deposit scheme, which they will actually fund (not simply commit to fund).

What's next?

As noted previously, the steps being taken are significant and the adoption by euro area countries of a mutual resolution system – along with the wider effects of the Banking Union – marks the conversion of these countries to a uniform system, something that would have been unthinkable just years ago.

But the challenges that lie ahead in making this system work remain tremendous. The combination of national and European regulators will need to be accompanied by a high degree of cooperation, including as to the exchange of information and their working methodologies. This will probably take some time. Such a system could may easily turn into an accumulation of multiple layers, causing the entire system to become highly bureaucratic.

The legislation seeks to impose consistency upon, and order to, emergency procedures. It is only when the system starts to be used, however, that its efficiency will be tested and the objective of applying bail-in in a strict and uniform way will be able to be assessed. In the meantime, other Banking Union measures – such as including stress tests of banks' balance sheets – are aimed at making the entire banking system more solid at the inception of the Banking Union. This, in turn, should make any future large-scale bank resolution a less likely scenario.

Footnotes

1. http://www.allenovery.com/publications/engb/ lrrfs/continental%20europe/Pages/Bankssingle- supervisory mechanism.aspx.
2. "European banking union: Foundations laid but bricks still to fall in place", Alex Baker, Financial Times, 8 May 2014.
3. Directive 94/19/EC.

Legal and Regulatory Risk Note
Europe