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The interplay btw. sovereign and banking risks: is EBU a right answer?
Angelo Baglioni
Bologna – 26 October 2017
Contents
• Three reasons for the European Banking Union
• Single Supervisory Mechanism (SSM) • Single Resolution Mechanism (SRM) • European Deposit Insurance System (EDIS)
(missing)
Baglioni - European Banking Union 2
Three reasons for the European Banking Union
• Reduce the fiscal cost of bank bailouts • Break-up the two-way link between sovereign
and bank risks at national level • Achieve a higher level of supervisory
convergence
Baglioni - European Banking Union 3
Reduce the fiscal cost of bank bailouts
• Fiscal cost of banking crisis: – direct support measures: recapitalization,
impaired assets relief, guarantee – indirect negative impact on primary balance
through business cycle and automatic stabilizers, and possibly on interest outlays
Baglioni - European Banking Union 4
Break the two-way link between sovereign and bank risks
• Risk goes from banks to governments: support
measures and implicit bail-out guarantee
• Risk goes from governments to banks: home bias in banks’ government bond portfolio
Baglioni - European Banking Union 7
Two way link?
• Cross-country differences in risk transmission • Italy: from government to banks
• Ireland (and Germany): from banks to
government
• Spain and Greece: both ways Baglioni - European Banking Union 10
Achieve a higher and uniform level of supervision
• EU: common rules (Basel III) but implemented at national level – National discretion in implementation (e.g. validation
of internal models) – Cross-country divergences (e.g. definition of non-
performing loans)
• Competitive distortions • Possibility of loose supervision in some countries • Improvisation in crisis management (ex. Cyprus)
Baglioni - European Banking Union 11
SSM: organization • Separation between supervision and
monetary policy • Significant banks: direct supervision by ECB
– cooperation between ECB and NCAs (JST) • Less significant banks: supervised by NCAs
– under guidelines by ECB, which can take-up direct supervision
• Supervisory Review and Examination Process • Macro-prudential supervision: left to NCAs (?)
Baglioni - European Banking Union 12
SREP • Annual examination of: capital, liquidity, governance, risk
management • Following the SREP assessment:
– each bank is assigned a score (1-4-F) – supervisory actions can be taken (ex. additional capital,
loan-loss provisions) • Problems:
– Discretion: ad-hoc requirements (Pillar II) instead of uniform rules (Pillar I)
– Opacity: SREP decisions are communicated to banks, which can make some disclosures
– Uncertainty (ex. rumors of additional requirements) and instability
Baglioni - European Banking Union 14
Macro-prudential supervision
• Micro- and Macro- have different objectives: – Micro: stability of single banks and compliance
with prudential regulation – Macro: limit pro-cyclicality and contagion across
the financial system • However they share the same tools:
– Capital requirements, liquidity ratios, leverage limits, etc.
Need to coordinate the two policies
Baglioni - European Banking Union 15
Who is in charge of macro-prudential supervision? (EU)
• National authorities (CRD IV): – set counter-cyclical capital buffer rates – identify Sistemically Important Institutions – decide which banks should be applied a systemic
risk capital buffer
• National law: may introduce L-t-V and L-t-I • ESRB: monitors systemic risk, issues warnings
and recommendations to national authorities Baglioni - European Banking Union 16
Macro-prudential supervision in the euro area (SSM Regulation - art. 5 )
• National authorities notify ECB before taking
action, and they have to take into account an objection (if any)
• ECB can take only restrictive actions (raise capital buffers), with the same (symmetrical) procedure as above
Baglioni - European Banking Union 17
Critical issues:
• Externalities: systemic risk has a strong cross-country dimension, that national authorities might understate
• Heterogeneity: lack of cross-country coordination may introduce segmentation, jeopardizing the levelling-the-playing-field target of EU regulation
• Coordination between national authorities and ECB • Conflicts bwt. policies: micro vs. macro, prudential
vs. monetary policies
Baglioni - European Banking Union 18
Policy implications:
• Need for a simplification and centralization (at the supra-national level) of macro-prudential supervision
• In the euro-area, the ECB (within SSM) should be given full responsibility for macro-prudential policy
Baglioni - European Banking Union 19
Resolution and bail-in • Two building blocks:
– Bank Recovery and Resolution Directive (BRRD) introduces in all EU countries some new legal tools to manage bank crises; effective as of 1/1/2015 (bail-in: 1/1/2016)
– Single Resolution Mechanism introduces in euro-area some new institutions, applying the BRRD:
• Single Resolution Board (SRB) – National Resolution Authorities (NRA)
• Single Resolution Fund (SRF) – National resolution funds (transitory)
Baglioni - European Banking Union 20
BRRD: motivation • Bank liquidations have disruptive effects on
financial/economic system, creating contagion (trough interbank transactions and reputation); see Lehman Brothers
• Bank bail-outs imply costs for taxpayers and moral hazard (“I take profits, you take losses”)
• Need to introduce a third way to manage bank crises: let a bank survive, but make some stakeholders bear losses (imposed by resolution authority), minimizing state aid
Baglioni - European Banking Union 21
Resolution objectives
• Ensure continuity of critical bank functions • Avoid contagion • Minimize resort to public funds • Protect small depositors
Baglioni - European Banking Union 23
Resolution conditions (all to be met)
• Bank is failing or likely to fail: – assets less then liabilities, unable to repay obligations,
losses have depleted own funds, bank has received public support (except as a follow-up of AQR – stress test)
• Last resort procedure: no alternative private sector solution or supervisory action is able to avoid liquidation
• Public interest: resolution necessary to reach objectives (better than insolvency procedures)
Baglioni - European Banking Union 24
Resolution tools
• Sale of business: some assets/liabilities are transferred to another existing bank
• Bridge institution (good bank): profitable lines of business are transferred to a new (temporary) solvent bank controlled by the resolution authority
• Asset separation (bad bank): loss-generating lines of business are transferred to a vehicle, with the purpose of orderly liquidation
Baglioni - European Banking Union 25
Resolution tool: bail-in • Resolution authority makes an assessment of the funds needed to
restore viability of the (bridge) bank, and imposes losses to: – Shares/capital instruments (CET1 – Tier1 – Tier2) are
written down – Subordinated bonds are either written down or converted
into equity – Senior bonds are either written down or converted into
equity – Corporate deposits are either written down or converted
into equity – Individual and SMEs’ deposits are either written down or
converted into equity – Deposit Insurance Fund is called to contribute
Baglioni - European Banking Union 26
Exemptions from bail-in
• Deposits up to 100,000 euros • Interbank loans and liabilities to
payment/settlement systems up to 7 days maturity
• Accrued salaries and pension benefits • Commercial debt to service providers • Tax and social security liabilities
Baglioni - European Banking Union 27
Discretionary exemptions:
• Additional exemptions can be decided by the resolution authority, to avoid contagion or instability
• The burden is either allocated to other stakeholders or to the resolution fund, under two conditions: – the contribution of stakeholders is at least 8% of total
liabilities (own funds included) – the contribution of the resolution fund is capped by
5% of total liabilities
Baglioni - European Banking Union 28
State aid • EU Commission Communication (August 2013):
state aids to banks can be authorized only if member states show that all measures able to minimize the extent of public support have been taken, including: – capital raising – burden-sharing
• BRRD: any public support (by government or resolution funds) triggers a bail-in of 8% of total liabilities within the resolution procedure
Baglioni - European Banking Union 29
Exception: financial stability
• Public support (guarantee, capital injection) does not trigger resolution if it is needed to preserve the financial stability of a country (art. 32.4 BRRD), within the State aid framework
• State aid framework: burden-sharing can be waived if it would endanger financial stability or lead to disproportionate results (art. 45 EU Commission Communication)
Baglioni - European Banking Union 30
Problems with bail-in
• Retail customers should be exempted, since they lack information to assess bank risk. Their inclusion creates – social issues – transparency / communication problems – instability
• Bail-in should apply only to new contracts, not to outstanding instruments
Baglioni - European Banking Union 31
A possible solution • BRRD introduces MREL: resolution authorities
have to set a minimum level for MREL = (own funds + eligible liabilities) /
(own funds + total liabilities) • Proposed requirement:
(own funds + junior and senior un-preferred bonds) / (own funds + total liabilities) ≥ 8%
• Junior bonds (hit by bail-in and burden-sharing) and Senior un-preferred bonds (hit by bail-in, not by burden-sharing) should be sold to institutional investors only
Baglioni - European Banking Union 32
SRM organization
• SRB: responsible for resolution of significant and cross-border groups, and for using the SRF
• NRA: responsible for resolution of other banks (not using SRF) – Both apply rules introduced by BRRD
• ECB decides if a bank is “failing or likely to fail” (triggering resolution)
• A resolution scheme adopted by the SRB can be objected by the EU Commission and Council
Baglioni - European Banking Union 33
Governance issues
• Governance of SRM is too complex and prone to political interference
• EU Council involvement should be limited to general rules and overall amount of available resources, not to single resolution decisions
• EU Commission involvement should be limited to the application of State aid rules
Baglioni - European Banking Union 34
SRF
• It can provide resources within a resolution procedure
• Target size: 1% of covered deposits (55 billion), by 1.1.2024
• Funded by contributions from banks: – ex ante (flat and risk-adjusted) – possible ex post additional contributions – national compartments gradually merged during
transitional period (2016 - 2023)
Baglioni - European Banking Union 35
Baglioni - European Banking Union 36
0
20
40
60
80
100
120
2016 2017 2018 2019 2020 2021 2022 2023 2024
% p
oint
s Figure 5.1 - SRF: gradual mutualisation
Concerned national compartment
All compartments (mutualisation)
Problems with SRF
• Limited size (8-year transition period) – somewhat balanced by possibility of raising ex-
post contributions and borrowing from banks and governments
• Need to introduce a common fiscal backstop: SRF should be enabled to borrow from ESM
• SRF interventions should not qualify as State aid: they should not trigger bail-in (?)
Baglioni - European Banking Union 37
ESM - DRI • Direct Refinancing Instrument: introduced in 2013 as an
additional tool of ESM (never used so far) • ESM is endowed with 60 billions, that can be used to
provide capital injections into troubled banks • Problems:
– Reserved to systemic banks, under the condition that the member State is unable to provide support and private resources are unavailable (last resort tool)
– Precondition: 8% bail-in – Member State has to contribute (burden-sharing) – Political decision-making: decisions taken by Finance Ministers
(ESM Board), MoU imposes conditions on overall economic policy of member State
Baglioni - European Banking Union 38
The missing pillar: EDIS
• 2014 Directive: only harmonization of national DIS, supervised at national level – Coverage: confirmed at 100,000 euros (interbank
excluded) – Funding:
• ex-ante risk-based contributions (target level: 0.8% of covered deposits in 2024) (cash + commitments)
• ex-post extraordinary contributions (capped at 0.5% of covered deposits yearly)
• loans from governments
Baglioni - European Banking Union 39
…2014 Directive
• Scope of intervention: • Repayment of depositors • Contribution in resolution (bail-in) • Early intervention: financial assistance outside resolution
• Payout time: 7 days (in 2024) • Transparency: banks should provide information to
customers
Baglioni - European Banking Union 41
The way forward • Need to introduce an EDIS, in order to:
– make deposit insurance stronger, by pooling resources across member States
– reduce likelihood of public support • How? By expanding the scope of SRF – SRB,
rather than introducing a new institution – The role of DIS is contribute to resolution, rather
than repay depositors of liquidated banks – Avoid duplication of administrative bodies (see FDIC) – BRRD allows the same institution to administer both
resolution fund and DIS
Baglioni - European Banking Union 42
EU Commission proposal (November 2015)
• Up to July 2020: European re-insurance system, providing financial assistance to national insurance schemes
• 2020 – 2024: co-insurance. EDIS contribution in direct repayment of depositors , together with national schemes, increases through time
• 2024: EDIS fully in place, replacing national schemes
• EDIS managed by SRB
Baglioni - European Banking Union 43
EU Commission proposal (October 2017)
• Re-insurance: EDIS loans to national DIS • Co-insurance: conditional on AQR positive
outcome (by 2022)
• Full EDIS replacing national DIS: never!
Baglioni - European Banking Union 44
Has the Banking Union achieved its goals? • Reduce the fiscal cost of bank bailouts:
– Yes (direct link through bail-outs reduced), but at the cost of increasing instability due to application of bail-in
• Break-up the two-way link between sovereign and bank risks at national level: No – Bail-in makes the cost of bank crises be paid by local
stakeholders, with negative impact on national economies and public budgets (indirect link)
– Lack of common fiscal backstop for SRF (and EDIS) makes national governments implicitly be the last resort
– Home bias in bank securities portfolio is still strong
Baglioni - European Banking Union 45
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