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Euro Area Policies: Selected Issues

Author(s):
International Monetary Fund
Published Date:
July 2009
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II. The Need for Special Resolution Regimes for Financial Institutions—The Case of the European Union1

A. Introduction

1. The global financial crisis has illustrated the limits of ordinary resolution regimes in dealing with failing financial institutions. The absence or limited scope of such regimes has been shown to be lacking globally, including within the EU. For the financial stability framework to be effective, it needs to include a dedicated resolution regime that expands the set of tools available in crisis management beyond the “default options” of ordinary bankruptcy and fiscal support for failing financial institutions. Such a regime can reduce the systemic impact of a potential failure, afford control to the authorities; shift the financial burden away from taxpayers, reduce moral hazard and increase market discipline.

2. It is pressing for countries across the EU to review the effectiveness of their resolution frameworks and to introduce legislation where necessary to prepare to address possible further difficulties in banking systems across the region. To restore confidence in the financial system, EU countries need to be in a position to deal effectively with individual non-viable institutions, and to be able to contain the total fiscal cost of a more comprehensive restructuring of the banking system, should such restructuring be necessary to restore confidence and the normal functioning of the financial system.

3. A revision of the national frameworks for the resolution of financial institutions can be in the interest of each member state of the EU, as well as in the interest of the EU as a whole. The absence of robust resolution frameworks will make it more likely that national authorities resort to propping up failing financial institutions. Such support may conflict with the general principle underlying Articles 92–94 of the Treaty of Rome that State Aid distorts competition and runs counter to a common market.

4. Establishing a dedicated resolution regime for cross-border institutions at the EU-level would have clear benefits. However, even the introduction of special resolution regimes in individual member countries can substantially reduce the overall fiscal burden incurred in resolution, and is likely in and of itself to be conducive to more effective management of cross-border failures.

B. Resolution Regimes: Crisis Lessons

5. The absence or inadequate scope of resolution tools to deal with failing financial institutions has been revealed during the global financial crisis. Authorities were often confined to two alternatives: (i) corporate bankruptcy, as chosen for instance by the U.S. authorities in the case of Lehman Brothers, a global financial-services firm; and (ii) an injection of public funds, as chosen by the U.S authorities in the case of the American International Group (AIG). Events have shown that both these options can be very costly. A disorderly bankruptcy (as in the case of Lehman Brothers) can magnify the systemic impacts of the failure of a financial institution. When the authorities aim to avoid these impacts (as in the case of AIG, or in the German cases of Hypo Real Estate and IKB), and inject capital to support the institution, events have shown that the fiscal outlays incurred in the course of an open-ended injection of capital can be large. A special resolution regime allows authorities to avoid the choice between “disorderly bankruptcy” and “injection of public funds” and results in an efficiency improvement, by containing both fiscal costs and sytemic impact (Figure 1).

Figure 1.Fiscal Cost and Systemic Impact in Resolution Regimes

Source: IMF staff

6. Both ordinary bankruptcy and capital injections may afford little control to the authorities charged with overseeing financial stability. In ordinary bankruptcy proceedings, authorities have limited control over actions taken by the courts, and may struggle to uphold wider financial stability considerations. When the authorities seek to avoid ordinary bankruptcy, by providing public support, they may have little formal powers to replace the management of a failing institution. They may also have limited control over the actions taken by the firm’s owners or managers, creating moral hazard.

7. The efficient solution from the viewpoint of financial stability may be different from that achieved by either ordinary bankruptcy or capital injection. For example, the efficient solution may involve a sale of the institution to another financial institution as a going concern. However, existing shareholders—either large blockholders or the majority of small shareholders—may hold out and block the resolution option taken by the authorities. This is likely to happen whenever the resolution option involves a loss of value or a loss of control for existing shareholders. The cases of Fortis and HRE are examples of shareholder control delaying or closing off the resolution path preferred by the authorities.

8. When ordinary bankruptcy is viewed as too costly by the authorities, bankruptcy ceases to be a credible threat, creating moral hazard If in the absence of other options, public infusion of capital becomes the only alternative, this is certain to create moral hazard and reduce the force of market discipline. Empirical research has documented that institutions that expect to receive public support hold smaller amounts of tangible common equity relative to total assets, on average (Nier and Baumann, 2006). This research also shows that expectations of public support reduce the force of market discipline.

9. In many European countries, the general insolvency law applies to financial institutions and is administered by bankruptcy courts. This is a major difference from countries such as Canada and the United States, where the law provides for special rules for bank insolvency, administered by the supervisor or the deposit protection agency. Nonetheless, there is substantial diversity among the EU member countries when it comes to features of their resolution regimes for financial institutions. Also, some EU countries are either in the process of reviewing, or have recently revised, the relevant legislation.

C. Principles and Design of the Framework

10. A consensus is beginning to emerge as to the features that a special resolution framework should comprise. In particular, sound practice is for the framework to (i) allow the authorities to take control of the financial institution at an early stage of its financial difficulties, through “official administration”; (ii) empower the authorities to use a wide range of tools to deal with a failing financial institution, without the consent of shareholders or creditors; (iii) establish an effective and specialized framework for liquidation of the institution that assigns a central role to the authorities; (iv) ensure clarity as to the objectives of the regime and the scope of judicial review; and (v) promote information sharing and coordination among all authorities involved in supervision and resolution.

11. The resolution regime needs to specify a regulatory threshold, such that when the threshold is crossed, the resolution authority is entitled to take control of the firm and to commence the restructuring process. The regulatory threshold reflects the very essence of special resolution proceedings—to permit the authorities to intervene in a financial institution at an early stage of financial difficulty when the institution may still have positive net worth. This contrasts with the “balance sheet threshold” often applied in ordinary bankruptcy proceedings, which permits proceedings to be initiated only after net worth is virtually exhausted. Taking control at an early stage permits the authorities to explore the most appropriate resolution option prior to a full deterioration of capital, while seeking to prevent further weakening of the institution’s condition.

12. Actions in the resolution stage should be complemented by supervisory “early remedial action”. Early remedial action is a phase of heightened supervisory involvement, aiming to reduce the chance of entering the resolution stage. This may involve supervisory “assistance” in the design of a plan to address incipient financial weakness and the monitoring of the plan’s execution by the supervisory authority.

13. Effective resolution needs to expand the set of tools available to authorities in the resolution phase beyond the “default options” of liquidation and capital support. The following tools have been found particularly useful:

  • Acquisition by a private sector purchaser. This solution can provide continuity of services, protects the public purse and protects the interests of counterparties, whose exposures to the failing institution are replaced by claims on a stronger institution. Importantly, the resolution authority needs to have the power to effect a private sector sale on terms that do not require the consent of existing shareholders. In cases where some of the assets are difficult to value, an alternative is for the authorities to sell the institution as a whole, but to provide some form of financing or a guarantee to the acquirer.

  • Bridge bank. A bridge bank is a temporary institution created by the resolution authority to take over the operation of the failing institution, and preserve its going concern value. It is attractive particularly in cases of failure of large and complex organizations, where due diligence examinations by potential purchasers can take time, and where it is important to keep up critical services.

  • Partial transfer of deposits and assets to a “good bank”. When some of the institution’s assets are nonperforming or difficult to value, it may not be possible to find an acquirer for the whole institution. In these cases, the resolution authority needs to have the powers to effect a partial sale of assets and liabilities. In a “good bank” solution, only easy-to-value or “clean” assets are transferred in addition to deposits and (a fraction of) the bank’s other liabilities. The residual institution (a “bad bank”) continues to be owned by existing shareholders, whose capital therefore continues to be at risk from a loss in value of the toxic assets.

  • Temporary public control. As a last resort, the government needs to be able to take temporary ownership of the failing institution. This may be appropriate where a significant injection of public funds is needed. It may be particularly useful if the system is highly concentrated and options for a sale to private bidders are limited.

14. Given that control over the resolution proceedings rests with the banking authorities rather than with the courts, judicial review needs to be provided for ex post. The review mechanism should only seek to determine whether the banking authorities have acted legally and should not allow the court to reassess their exercise of discretion. The onus is instead on the legal framework to clearly set out the objectives that the resolution framework seeks to achieve, such as the preservation of financial stability, and to define clearly the extent of discretion afforded to the banking authorities in pursuit of these objectives. This is important since the authorities’ actions will typically have a bearing on property rights, e.g. of existing shareholders.

15. The resolution framework needs to be consistent with the general considerations that govern the conditions under which personal property rights can be constrained by the authorities. This includes national constitutional law as well as the European Convention on Human Rights. Where the relevant actions of the banking authorities inflict damage on a bank’s owners without proper justification, the remedy can be in the form of monetary compensation. However, the legal framework should establish clear limits on the circumstances in which such damages may be awarded, and it should grant immunity for banking authority officials from liability for actions they have taken in good faith.

16. Introduction of special resolution regimes requires careful reflection of the appropriate scope of the regime. At a minimum, all deposit-taking institutions (banks) need to be within the scope of the regime. It may be desirable for the scope of the regime to be robust to a potential trend away from business models that involve funding through retail deposits and to apply more broadly to those financial institutions that can pose a systemic risk, as per suitably defined criteria.2

D. Cross-Border Issues

17. The introduction of special resolution regimes at the national level could be a useful element to help achieve a more effective resolution of financial institutions operating across European borders. By virtue of the Winding-Up Directive, resolution actions taken by authorities in accordance with their national (special) resolution framework have full legal force across the EU, in cases where the failing institutions has branches in other member states. When the failing institution has subsidiaries, this does not hold necessarily, by law. Nonetheless, even in these cases, special resolution regimes are likely to have a positive effect on the cross-border resolution, in the following three ways:

  • An effective regime will tend to reduce the fiscal burden involved in resolution. When the overall burden is reduced, an agreement among national authorities on sharing the burden, and on the appropriate resolution path, is likely to be easier.

  • Special resolution regimes are likely to reduce difficulties associated with situations where the subsidiary is systemic in a host country, but the parent is not considered systemic in the home country. In the absence of a special resolution regime in the home country, the host authorities may be concerned that the home authorities let the institution fail. If a special resolution regime were in place that would provide the home authority with the power to effect a forced sale of the institution, the home country authorities could well judge that the cost of using this option is small relative to the cost of letting the institution fail, with obvious benefits to the host economy.

  • The “bridge bank” is likely to be particularly helpful as an interim solution in complicated cross-border cases, when negotiating a permanent solution may be time consuming. Where a special resolution regime is in place in the home country of a complex cross-border group, the authorities can initially transfer the group to a bridge bank institution. This leaves intact the rights of the host authority with respect to potential action relative to the subsidiary, and creates some time for negotiation.

18. National special resolution regimes may not be sufficient to fully address all cross-border issues. They may need to be complemented by a EU-level special resolution regime for cross-border institutions. A resolution regime that applies at the fully consolidated level may come to be an element in a dedicated European regime for cross-border financial institutions, such as the one discussed in Čihák and Decressin (2007). In addition to the resolution framework, the regime might include a European banking license, a European deposit insurance scheme, covering deposits issued by branches and subsidiaries, and strong supervision and information sharing among relevant authorities. While this is a useful medium-term goal, a more realistic approach at the current stage is for the European authorities to encourage individual EU countries to introduce or strengthen their national frameworks, which are needed in any case.

E. Conclusion

19. There is a strong case for financial institutions to be subject to a special insolvency regime. Standard judicial insolvency regimes do not necessarily take into account financial stability considerations and are typically cumbersome and slow, while in financial crises speedy and decisive action is necessary.

20. Special resolution regimes can contribute to overall financial stability, and improve the trade-off between the need to stabilize the banking system and to minimize fiscal costs and longer run-costs of moral hazard. By expanding the toolset at the disposal of authorities, a special regime may come to facilitate a decisive restructuring of weakened financial institutions, should such an effort be needed as part of an overall strategy to restore confidence in the financial system.

References

    ČihákMartin andJörgDecressin2007The Case for a European Banking Charter” Working Paper No. 07/173 (Washington: International Monetary Fund).

    ČihákMartin andErlendNier2009The Need for Special Resolution Regimes for Financial Institutions—The Case of the European Union” IMF Working Paper forthcoming (Washington: International Monetary Fund).

    NierErlend andUrselBaumann2006Market Discipline, Disclosure and Moral Hazard in BankingJournal of Financial Intermediation Vol. 15 pp. 33362.

This is a summary of Čihák and Nier (2009, forthcoming).

G-20 Leaders have asked the IMF to prepare (with the FSB and BIS) guidelines on how national authorities can assess the systemic importance of the components of the financial system. The guidelines are to be prepared by the next meeting of G 20 Finance Ministers and Central Bank Governors, scheduled for November 2009.

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