Editors' note: This column is part of the Vox debate on "Lessons from Recent Stress in the Financial System"
The events of the last two months have demonstrated the importance of a banking regulation ecosystem which combines (i) flexibility to deal efficiently with a bank in crisis in order to avoid financial instability, and (ii) enough preventive measures to lower the probability of crises while also limiting moral hazard.
Recently, several banks have been under stress and, so far, four in the US and one in Switzerland have needed public intervention. Each time, money from deposit insurance funds and/or the treasury has been used, and the problem bank has ‘disappeared’. Moreover, even in the case of a globally systemically important bank (GSIB) like Crédit Suisse, authorities went for absorption of the entire bank by an even larger one.
Evaluations of the events differ. Some are rather positive, stressing that financial instability was avoided (Löyttyniemi 2023). Others, however, are outright negative, stressing in particular the ‘unsustainability’ of megabanks overlapping multiple jurisdictions (Brunetti 2023, Admati et al. 2023). Both sides make valid points in our view.
More generally, there is the question of the ‘political sustainability’ of repeatedly relying on public money for ‘bank bailouts’; the failure of supervisory authorities to prevent these crises can easily lead to ‘bailout fatigue’. This is one reason Lehman happened in 2008, after the Long-Term Capital Management (LTCM) and Bear Stearns interventions. It also explains the US savings and loans crisis in the 1980s, when the Federal Savings and Loans Insurance Corporation (FSLIC) fund was exhausted and the US Congress refused to replenish it.
The current banking situation is already leading to soul-searching in the US (and also the UK), with the Federal Deposit Insurance Corporation (FDIC) suggesting a ‘targeted extension’ of deposit insurance for companies’ working capital. Some go even further, advocating a general extension of deposit insurance (e.g. Heider et al. 2023).
In this column, we focus on the specific situation in the EU, where so far in the recent turmoil there has not been a ‘bank in crisis’. This happy situation is partly the result of the fact that Basel III requirements apply to all EU banks, in contrast with the situation in the US, where many banks (including Silicon Valley Bank) are exempted of such requirements, which apply only to the biggest ones. By contrast, the example of Crédit Suisse is more worrisome, since it is a GSIB headquartered in a fully Basel III-compliant country, Switzerland – which is not the case for the EU.
More worrisome for the EU is the fact that, under its Banking Recovery and Resolution Directive (BRRD), public money is harder to access than in the US or Switzerland until 8% of the balance sheet of the troubled bank has been bailed-in. As stressed, for example, by Dewatripont (2014 a, 2014b) and Dewatripont et al. (2021, 2023), it can be very dangerous for financial stability if one cannot reach this 8% without bailing-in depositors.
The result has been that the BRRD, in force since January 2016, has been very largely ignored – especially in the Banking Union – when dealing with troubled banks, with national authorities preferring to use other options, in particular national bankruptcy laws. This loophole has allowed troubled banks to be declared bankrupt, and therefore not ‘banks’ any more, which means that the BRRD is no longer relevant, thereby allowing national authorities to sell (part of) such ‘non-banks’ to … a bank (as Italy has shown with two Venetian banks)! Given the potential cost in terms of financial instability from failing banks, avoiding bailing-in depositors by using this loophole was probably useful, but such an unharmonised approach – and thus an unlevel playing field – is clearly not first-best. Reforming the system is therefore needed.
Evaluation of the Crisis Management and Deposit Insurance proposal
In our view, the Crisis Management and Deposit Insurance (CMDI) proposal by the European Commission
is an important step in the right direction because it comes to terms with the reality that the EU framework (the BRRD) has not been used in resolution since it could be hitting depositors and destabilise the entire banking sector. The CMDI rightly proposes to ease, under certain conditions, the use of deposit guarantee scheme (DGS) money in order to protect deposits while resolving troubled banks. Note that the CMDI refers to national DGS schemes since the Commission (realistically) feels the time is not yet ripe for moving to a European Deposit Insurance System (EDIS) in the euro area, a desirable endpoint to complete the Banking Union.
Evidence presented by the Commission along its CMDI proposal credibly shows that the problem is more acute for mid-sized and smaller banks than for larger ones because the former have a higher share of deposits in their balance sheet. For banks with at least €100 billion of assets, the BRRD obliges them to have a minimum buffer of 8% of own funds and subordinated securities which are bail-inable, giving them access to the EU Resolution Funds.
The innovations in the CMDI proposal are that it (1) recognises that small and medium-sized banks may not have a sufficient amounts of bail-inable own funds and subordinated securities to meet the 8% requirement of the BRRD without hitting deposits; and (2) allows national DGSs to cover the gap between the two in resolution. The CMDI would permit easier access to DGS money and protection of deposits by : (i) eliminating the ‘super seniority’ of the insured deposits (and the DGS) over other deposits; and (ii) introducing generalised depositor protection, which means that senior bonds, and not only junior ones, can be bailed-in without having to touch deposits (a feature which is already in place in some EU countries). Note, however, that the CMDI proposal de facto means that national DGSs would become junior in resolution to deposits since they would intervene to protect them, a big change in comparison to their current super seniority status.
Facilitating access to DGS money in order to resolve a bank in trouble without hitting depositors is an idea we strongly subscribe to. At the same time, we are conscious of the fact that using public money for banks in trouble is never popular, and that safeguards are therefore needed to avoid a political backlash. This leads to the following considerations:
- It is ‘politically astute’ of the Commission to say in the CMDI proposal that deposit-guarantee and resolution funds will be paid for by the banking industry rather than by ‘individual taxpayers’. In reality, as tax-incidence reasoning indicates, this is only partly true: individual depositors/taxpayers will be impacted to some extent since banks will adjust their behaviour, for instance by paying lower interest rates on deposits. Moreover, one should not forget that moral hazard is not reduced by industry-funded bailouts, but only by bail-ins.
- What is needed, therefore, in order to reduce crisis events due to moral hazard (and also to avoid both a political backlash and also opposition by large banks, which fear having to pay for smaller ones) is to continue beefing up long-term subordinated loss-absorbency for all banks, small and large.
Enhanced loss-absorbency is thus a complement to and not a substitute for the crisis-time flexibility introduced by the CMDI. Both flexibility and enhanced loss-absorbency capacity are needed in order to credibly claim, as the Commission does, that CMDI “will improve cost-efficiency, support the real economy and its competitiveness”.
- Another way to increase crisis prevention is enhanced supervision. In this respect, recent evidence of ‘click banking’ leading to higher deposit volatility in times of increasing interest rates suggests more demanding stress tests and higher outflow rates in the computation of the Basel liquidity coverage ratio.
- This being said, since it is impossible to make sure that deposit guarantee and resolution funds will not be used, it is important that those deemed responsible for the problems are seen to be ‘punished’. Next to the bail-in of creditors and shareholders, holding management accountable in front of courts in cases of misbehaviour would be helpful in this respect. (Beyond this, it is surprising that, in a sector plagued by such intense leverage, regulation allows managerial compensation to be tied to stock prices, given that it induces them to take risks regulation then tries to reduce.)
- The CMDI proposal insists on exit of the problem bank from the market as a condition for access to DGS money. This is also a useful disciplinary mechanism. One should, however, avoid ‘unintended consequences’ in terms of unnecessarily ‘tying the hands’ of public authorities in their resolution strategy. Indeed, history is full of examples where taxpayers have benefited from the state temporarily nationalising troubled banks rather than being forced to find a buyer at very short notice, especially in crisis times where multiple banks may be in trouble. Allowing for the option of temporary ownership by a member state is also natural in a setting where DGS money is still national. Asking for the state to exit ‘within X years’ could, however, help protect taxpayer interests too. One could benefit here from the expertise that DG Competition has acquired since the Great Financial Crisis as a watchdog ensuring that state aid is kept to a minimum and unfair advantage is not obtained by the acquiring bank (Dewatripont et al. 2010).
In conclusion, we welcome the new flexibility offered by the CMDI proposal because it will help improving financial stability, which is crucial for the real economy and therefore also for taxpayers. However, in order to avoid worsening moral hazard, such flexibility should be accompanied by additional measures: beefing up the loss-absorbency capacity of all banks; enhancing bank supervision, in particular for new risks to the banking landscape; and making bank managers more accountable. Finally, one should not unnecessarily tie the hands of resolution authorities by forcing excessively rapid sales of troubled banks.
Admati, A, M Hellwig and R Portes (2023), “Credit Suisse: Too Big to Manage, Too Big to Resolve, or Simply Too Big?”, VoxEU.org, 8 May.
Brunetti, A (2023), “Big Banks Must Become Globally Resolvable – or Significantly ‘Smaller’”, VoxEU.org, 1 May.
Dewatripont, M (2014a), “European Banking: Bailout, Bail-In and State Aid Control”, International Journal of Industrial Organization 34: 37-43.
Dewatripont, M (2014b), “Banking Regulation and Lender-of-Last-Resort Intervention”, in ECB Forum on Central Banking Conference Proceedings: Monetary Policy in a Changing Financial Landscape, Sintra.
Dewatripont, M, G Nguyen, P Praet and A Sapir (2010), “The Role of State Aid Control in Improving Bank Resolution in Europe”, Bruegel Policy Brief, 17 May.
Dewatripont, M, P Praet and A Sapir (2023), “The Silicon Valley Bank Collapse: Prudential regulation lessons for Europe and the world”, VoxEU.org, 20 March.
Dewatripont, M, L Reichlin and A Sapir (2021), “Urgent reform of the EU resolution framework is needed”, VoxEU.org, 16 April.
Heider, F, J-P Krahnen, L Pelizzon, J Schlegel and T Tröger (2023), “European lessons from Silicon Valley Bank resolution: A plea for a comprehensive demand deposit protection scheme (CDDPS)”, SAFE Policy Letter No. 98.
Löyttyniemi, T (2023), “Financial instability in 2022-2023: Causes, risks, and responses”, VoxEU.org, 28 April.
Perotti, E. (2023), “Learning from Silicon Valley Bank’s uninsured deposit run”, VoxEU.org, 5 May.