Four Reasons the Bank Resolution Fund Is a Big Step Forward for European Financial Stability

Late last night — or early this morning, depending on your time zone — European finance ministers agreed on a structure to set up a Europe-wide Single Resolution Mechanism (SRM). This would establish a fund that can be used to rescue any EU member bank that is being supervised by the Europe-wide Single Supervisory Mechanism (SSM). In this sense, Europe has solidified the two pillars of a new banking union.

In general, a banking union has been among the highest priority reforms requested by economists — including those in the Baker Institute Report on the Eurocrisis — to plug a major gap in the institutional architecture of the Eurozone. The Eurozone needs channels to share fiscal burdens across borders to create a more cohesive currency union. The two-year-old Fiscal Compact works for normal times, but doesn’t help in a crisis. A banking union provides a cushion against one of the most catastrophic fiscal crises a country can face: systemic bank failures.

First, some background on the issue. As we saw in many peripheral European economies, banks tend to hold lots of government debt and governments tend to feel obligated to bail out their important banks when they get in trouble. This creates what some economists have called a “doom loop” in the event of a big national economic crisis. A blow to the banks causes the government’s liabilities to rise because of the higher likelihood of an expensive bailout. Higher government liabilities make government debt riskier, so bond prices typically fall. This lowers the value of bank assets, since they hold large amounts of government debt.

It doesn’t matter whether the cycle begins in the banking system, as in Spain and Ireland, or with the government, as in Greece. Problems in one exacerbate problems in the other; a downward spiral ensues. In a country with its own currency, the central bank can be the lender of last resort and cut this link. The European Central Bank (ECB) does not have that mandate, so currently the entire burden of bank bailouts falls on national authorities.

If banks can be bailed out by funds from outside the county, however, the link can be severed. So the banking union provides a critical backstop to prevent financial problems from becoming disasters.

A banking union generally improves the stability of the Eurozone, and it needed to happen at some point in the future. But there are several reasons worth highlighting why this specific measure — the way it is designed and its timing – are critical at this juncture of the eurocrisis.

1. The SSM requires a backstop. The ECB will lead the new EU-wide supervisory body, and it plans to start with a survey of the landscape to understand the task ahead. In health insurance, that means identifying pre-existing conditions. In banking, it means the ECB has begun an Asset Quality Review (AQR) to identify the extent of problem assets in the banks for which it will soon be responsible.

Because European leadership has been relatively slow to force banks to recognize losses, most experts expect the AQR could potentially uncover some very unhealthy banks. Conversations at the Baker Institute conference on the eurocrisis last fall indicated that honest assessments of bank losses could easily exceed national resources available to cover them. In other words, in the absence of an SRM backstop, the AQR could ignite another round of serious sovereign debt crisis. Megan Greene of Maverick Intelligence discusses the AQR balancing act with much more nuance in her chapter of the Baker Institute Report.

2. EU Parliamentary elections in May could have killed the SRM. By reaching a deal now, the European Commission can give the plan to the European Parliament before it dissolves for May elections. Polls seem to indicated that euro-skeptic parties will likely make big gains in the elections, and these parties could have made it much more difficult to get a deal passed.

3. The size is about as good as it could be. At €55 billion (US$ 77 billion), the fund is not overwhelming in size. Yet “legacy assets,” those that turned bad prior to creation of the SRM, may not qualify for application of the SRM. Clearly this will require a dance with the necessities uncovered by the AQR, mentioned in the first point, to preserve systemic stability.

Importantly, the deal indicates establishing some sort of EU-level institution (the ECB?) providing a line of credit for the SRM, so it can engage at full strength from the start. The SRM will not possess its full resources at birth, but rather its coffers will be filled over time by a careful combination of national resources and bank fees. Questions remain about whether European banks, as weak as they are, have the resources to provide substantial funds in the near term.

4. The SRM governance structure appears functional. Forecasts of the functioning of new institutions should not be cast in stone. Yet all signs indicate the negotiations over the SRM ended up with an appropriate governance structure. Various groups had debated whether to place the SRM under the European Commission, the EU’s executive body, or the European Council, which is a much less wieldy, more parochial body.

The final governance structure, like the governance of the EU itself, is quite complicated. The new Single Resolution Board (SRB) has representatives from the Commission, the Council, the ECB and national resolution authorities. This provides avenues for support from all major power structures, while paring the number of potential vetoes. For the most important decisions, it will in fact be a small subset of these representatives, so the SRB should be able to act swiftly when markets are spinning out of control.

Overall, this appears to be the right deal at the right time. Well, American observers have been howling for measures like this for years, but at least European leaders have not missed a critical window to get this done. They deserve praise for taking decisive, meaningful action, and the Eurozone will be stronger for it.

Russell A. Green, Ph.D., is the Will Clayton Fellow in International Economics at Rice University’s Baker Institute. Green spent four years in India, where he served as the U.S. Treasury Department’s first financial attaché to that country. His engagement in India primarily focused on financial market development, India’s macroeconomy and illicit finance, but included diverse topics such as cross-border tax evasion and financing global climate change activities.

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