From Fragmentation to Financial Integration in Europe

Chapter 12. The Single Resolution Mechanism

Charles Enoch, Luc Everaert, Thierry Tressel, and Jianping Zhou
Published Date:
December 2013
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Thierry Tressel

This chapter draws on the February 2013 IMF Staff Discussion Note “A Banking Union for the Euro Area” (Goyal and others, 2013), and its accompanying technical background note, and on the European Union Financial Sector Assessment Program. The contributions by the authors of the background note are gratefully acknowledged.

Establishing a Single Resolution Mechanism (SRM) is an essential step toward the banking union. The absence of an SRM based on a common resolution authority would hamper the effectiveness of the Single Supervisory Mechanism (SSM) and impede timely decision making by leaving national authorities to deal with the fiscal consequences of supervisory decisions made at the center. It would also create the potential for reputational risks to the European Central Bank (ECB) whenever national authorities had a different perspective from that of the ECB, since it would create potential conflicts (and deadlocks) between national authorities and the ECB.

It is desirable to move quickly beyond the harmonized national regimes and set up an SRM, ideally one with common backstops and safety nets. The SRM should include at least the countries participating in the SSM and should be established by the time the SSM becomes effective. Just as banks nowadays are too interconnected to be effectively supervised at a national level, so national resolution regimes would have difficulty, even under harmonized arrangements, handling the bigger banks of the European Union (EU). There would be limited incentives among national resolution authorities to take rapid and least-cost action to address problems. Coordination difficulties for large cross-border banks, in the absence of common backstops, could undermine effectiveness. Incentives could also be skewed for smaller banks, since authorities could shift losses to the center. The recent European Commission proposal is a step forward in this regard and could ensure that an SRM is in place at the time the SSM is effective. However, crucial issues remain to be resolved and clarified.

To be fully aligned with best practices, the common resolution authority should seek to achieve least-cost resolution of financial institutions without disrupting financial stability.1 It should protect and give preference to insured depositors and ensure that shareholders and unsecured, uninsured creditors absorb losses. The SRM will need a mandate, alongside the SSM, to develop resolution and recovery plans and intervene before insolvency using well-defined quantitative and qualitative triggers. It will need strong powers and a range of tools to take early intervention measures and restructure banks’ assets and liabilities (for example, by the bail-in of subordinated and senior unsecured creditors, the transfer of assets and liabilities with “purchase and assumption,” and the separation of bad assets by setting up asset management vehicles), override shareholder rights, establish bridge banks to maintain essential financial services, and close insolvent banks. The SRM should specify burden-sharing arrangements with access to a common backstop for systemic failures, while the resolution of small and medium-sized banks could be funded by a common resolution fund, ideally one merged with a common deposit guarantee scheme (DGS).

This chapter first presents an overview of the European Union’s approach to bank resolution and restructuring. It then discusses the design of the SRM, before characterizing more specifically the common resolution authority. Following that, it discusses the risks in the transition toward the SRM. The next section is devoted to resolution funding and common backstops.

Bank Resolution and Restructuring in the European Union

Resolution Frameworks in the European Union

Need for Resolution Tools

National Financial Sector Assessment Programs (FSAPs) had found that several EU countries lacked domestic resolution tools.2 In reaction to the financial crisis, the United Kingdom created a special resolution regime under the Banking Act of 2009. This was a major step forward in U.K. legislation and has been in many respects the model for the current proposed resolution framework in the European Union. It applies to commercial banks and other deposit-taking institutions and includes powers to transfer assets and liabilities, establish bridge banks, and take over control of a bank while ensuring that shareholders are appropriately compensated. However, it does not provide the possibility of applying a bail-in tool to wind-down or recapitalize failing banks.

The U.K. Independent Commission on Banking has proposed creating a resolution fund and adding the power to bail-in creditors to the other resolution powers. Germany has adopted a restructuring law, which granted the authorities the power to utilize various resolution tools (see Box 12.1). Now both countries can sell failing businesses, that is, to transfer all or part of a failing business to a private sector purchaser or to create a bridge bank. The German Bank Reorganization Act (January 2011) also provides for an asset separation tool (the power to transfer all or part of a business to an entity, even if not a bank, in which the restructuring fund owns shares) and the possibility to bail-in senior unsecured creditors through a court-led proceeding on the initiative of the bank.

Box 12.1Resolution Framework in Germany

Upgraded framework. A new bank restructuring law came into force in 2011. It introduces broad powers and instruments to facilitate the resolution of systemic banks, including the ability to transfer the banking business to another institution, stronger remedial powers, reorganization procedures involving the courts, the appointment of a special administrator to take over the management of a bank, and measures to improve own funds’ adequacy and liquidity. The law provides the basis for the restructuring fund, administered by the Federal Agency for Financial Market Stabilization (FMSA). While the authorities are engaging with the large banks regarding the preparation of resolution plans, there is no specific requirement in the law for establishing resolution plans (“living wills”). Individual small banks are subject to corporate insolvency proceedings (i.e., bank liquidation).

European progress. The new law reflects many aspects of stronger bank resolution frameworks currently under discussion at the European level. The authorities decided to move forward with legislative reform (the U.K. authorities are taking the lead in Europe with their introduction of an SRR in 2009) and are aware that some adjustments to the law might be needed once agreement has been reached at the European level.

Agencies. BaFin—Bundesanstalt für Finanzdienstleistungsaufsicht (Federal Financial Supervisory Authority)—is granted the lead in formulating resolution strategies. Several other agencies are also involved. The FMSA is tasked with providing resources to facilitate the resolution process and therefore becomes a key player. The Bundesbank will need to assess implications on overall financial stability, especially when granted a stronger role in macroprudential supervision. Finally, the BMF—Bundesministerium der Finanzen (Federal Ministry of Finance)—is understood to have a central role in systemic cases even though no direct responsibility is assigned in bank resolution (the BMF is represented on the FMSA’s steering committee and oversees the operations of BaFin). Crisis management coordination will be a task of the Financial Stability Committee that will be established under the framework for macroprudential oversight.

Resolution fund. The new restructuring fund provides additional resources for bank resolution. The restructuring fund has a target size of €70 billion and is administered by the FMSA under the general oversight of the BMF. The restructuring fund is meant to facilitate the resolution of systemically relevant banks through the establishment of bridge banks, providing guarantees (up to €100 billion or 20 times the size of the restructuring fund), capital injections, and other support measures. The restructuring fund is financed ex ante by a bank levy, but expected receipts in the range of €650 million to €1.3 billion per year are low relative to the target size and the potential costs of the failure of a systemically relevant bank. With limited amounts of resources built up so far, existing contingency funding arrangements remain important.

Levy. The bank levy will be higher for banks that engage in activities creating systemic risk (based on size and interconnectedness). The levy is being collected in addition to contributions to the various deposit insurance schemes to cover the costs of operating the restructuring fund and financing the support measures, and it is calculated according to government regulations. Subject to an overall ceiling linked to a bank’s annual profit (over a multiyear period), the levy has been set at 2 basis points of bank liabilities (excluding deposits and capital) up to €10 billion, 3 basis points from €10 billion up to €100 billion, 4 basis points from €100 billion up to €200 billion, 5 basis points from €200 billion up to €300 billion, and 4–6 basis points in excess of €300 billion. Small banks (for example, cooperative banks) will benefit from this staggered structure of the levy. An additional element of the levy, based on the nominal value of off-balance-sheet derivatives, covers interconnectedness.

In Ireland, a new resolution regime was passed into law in October 2011. It covers all credit institutions and enables the Central Bank of Ireland to seek a court order for a range of measures to facilitate effective and efficient resolution, subject to a set of intervention conditions including financial stability concerns. The central bank would be able to take over management of a firm, transfer assets and liabilities, create a bridge bank, and override shareholders’ rights subject to appropriate compensation. The new regime would also provide for the preparation of recovery and resolution plans, and resources would be provided by a resolution fund administered by the Central Bank of Ireland and financed by a levy on credit institutions.

Resolution Directive to be Adopted

A new European Union resolution directive is soon to be adopted. The European Commission has taken steps to harmonize and strengthen domestic resolution regimes in line with international best practices. This should help avoid regulatory arbitrage and make orderly resolution effective and efficient for cross-border banks. In June 2012, the European Commission issued a draft Bank Recovery and Resolution Directive (BRRD) for a harmonized crisis management and resolution framework in all EU countries. The Irish presidency made the adoption of the resolution framework a top priority and planned to adopt it during the first part of 2013 as a precondition to ensure effectiveness of the SSM. The new national resolution regimes would endow EU countries with strong early intervention powers and resolution tools. The transposition of the BRRD into national laws should be accelerated relative to the current deadlines (January 2015 and January 2018 for bail-ins) as part of the announced roadmap toward a Banking Union. The European Parliament published its position on May 21, 2013, and the European Council reached an agreement on the BRRD on June 27–28, 2013, and called for adoption by the European Parliament by end-2013.

New International Standards

Council agreement on the BRRD marks a big step forward (Box 12.2). The Financial Stability Board has developed new international standards for resolution (Key Attributes) that were endorsed by the G-20 leaders in 2011, and the BRRD is well aligned with the Financial Stability Board standards. These standards specify essential features that should be part of the resolution framework at both the national and international levels for Global Systemically Important Financial Institutions. The key objective is to make resolution feasible without severe systemic disruption and without exposing taxpayers to loss.3 The BRRD offers principles for early intervention and resolution of cross-border banks, such as on liquidity provision within cross-border groups, and establishes resolution colleges to develop nonbinding mechanisms for crisis planning and resolution (with the European Banking Authority in a mediating role).

However, the absence of a binding ex ante agreement on burden sharing would leave the key coordination problem in resolving cross-border banks unsolved (e.g., Fortis, Dexia) and put into question the capacity to achieve least-cost resolution. Fast transposition of the BRRD at the national level is highly desirable. It would set the stage for further legislation, including EU Treaty change, to create an integrated resolution regime in the European Union. Such an integrated regime could result in the creation of a fully centralized and autonomous European Resolution Authority backing the SRM (see below).

Box 12.2Proposed Bank Recovery and Resolution Directive: Risks and Areas for Enhancements

  • The resolution of banks is undermined by the absence of a more effective EU-wide framework to fund resolution. Binding mediation powers for the European Banking Authority and mutual borrowing arrangements between national funds face inherent constraints (in particular, the European Banking Authority cannot impinge on the fiscal responsibilities of EU member states).

  • Adoption of the European Union’s Bank Recovery and Resolution Directive (BRRD) will substantially enhance the range of tools available to resolution agencies in the European Union. But the scope of the directive should be widened to include systemic insurance companies and financial market infrastructures. It is a welcome development that all banks should be subject to the regime, without the possibility of ordinary corporate insolvency proceedings.

  • The breadth and timing of the triggers for resolution should be enhanced by providing the authority with sufficient flexibility to determine the nonviability of the financial institution (including breaches of liquidity requirements and other serious regulatory failings, not just capital/asset shortfalls). There should be provision for mandatory intervention in the event that a specified solvency trigger is crossed.

  • The June 28, 2013, Council agreement sets out a detailed framework for imposing losses in resolution to be introduced by 2018, including a requirement for shareholders and unsecured creditors to absorb losses up to 8 percent of total liabilities (including own funds) before other funding arrangements can be tapped. Some liabilities are excluded from bail-in a priori (for example, insured deposits, trade creditors and short-term interbank loans). Other liabilities can be excluded in “extraordinary circumstances,” after European Commission approval, where conditions are met. These conditions would require further clarification, and the role of the European Commission in approving exclusions must be supported by a rules-based framework to avoid delays and uncertainties in resolution.

  • It is a welcome development that tiered depositor preference has been agreed upon in the Council version of June 28, 2013. The provisions rank the deposits of individuals and SMEs (as well as liabilities owed to the EIB) above those of other uninsured creditors, such as bondholders and large corporate depositors. Insured deposits (with the right of subrogation for the DGS) would rank above uninsured deposits.

  • The BRRD affords less flexibility for using certain resolution powers than the Key Attributes. For instance, it does not permit exercising the mandatory recapitalization power and the asset separation tool on a stand-alone basis. Also, departures from pari passu treatment should not be prevented where necessary on grounds of financial stability or to maximize value for creditors as a whole.

  • The revised state aid rules published on July 10, 2013, which may require bail-ins of unsecured uninsured creditors, should ensure clear and consistent bail-in regimes across countries. The introduction of bail-in powers sooner than 2018 would be necessary to access direct recapitalization by the European Stability Mechanism (ESM), but it should not create uncertainty.

Note: Depositor preference is not drawn from the Key Attributes best practices.

Legal Hurdles to Borrower Restructuring

Legal hurdles to borrower restructuring must be lifted. The legal framework should facilitate the restructuring of nonperforming loans and maximize asset recovery. In several EU countries, including Italy, Greece, and Portugal, the IMF is involved in bankruptcy/insolvency law reform, including by introducing fast-track restructuring tools and out-of-court restructuring process. For instance, repossession of the collateral backing a retail mortgage may take several years in Italy versus a few months in Scandinavia and the United Kingdom. The asset recovery process is also very prolonged in many emerging economies in the European Union.4 Sometimes in those jurisdictions, the issue is implementation, with banks being unable to enforce collateral. This can weigh heavily on the value of the bank, making its collateral worth less and leaving nonperforming loans on their balance sheets. An efficient framework for handling nonperforming loans is key to rehabilitate viable borrowers and provide the exit of nonviable borrowers.

Active Management of Nonperforming Loans

There is a need for active management of nonperforming loans. In principle, nonperforming loans can be (1) retained and managed by banks themselves at appropriately written-down values, while the banks receive financial assistance from the government for recapitalization; (2) relocated or sold to one or more decentralized “bad banks,” loan recovery companies, or asset management companies (AMCs) that specialize in the management of impaired assets; or (3) sold to a centralized AMC set up for public policy purposes (possibly when the size of nonperforming loans reaches systemic proportions).

Government Support and State Aid Rules for Financial Sector Action

The Role of State Aid Policy

Competition and state aid policy has in practice served as the main coordinating mechanism in bank restructuring during the crisis, being the only binding EU framework available for this purpose.5 The European Commission Directorate General for Competition (hereafter, DG Competition) has the exclusive mandate and power to ensure that state aid is compatible with the treaty, and that state aid provision is accepted in exchange for strict conditionality. Member states have provided aid through capital injections, guarantees, and asset purchases. Compensatory measures required by DG Competition have included divestments, penalty interest rates, management removals, dividend suspensions, and burden sharing (shareholder dilutions and bail-in of subordinated debt).6

Unintended Consequences of State Intervention

Interventions by DG Competition have been instrumental in imposing restructuring on banks but have on occasion heightened macro-financial concerns. In particular, there have been concerns about the speed of decision making and insufficient transparency, and the impact of compensatory measures on financial stability and economic growth. State aid decisions have involved relatively long timeframes, and rules not well understood by markets have at times exacerbated uncertainties. Since DG Competition could only act in response to national state aid proposals, decisions were taken case by case even in the presence of system-wide problems. The case-by-case approach has occasionally led to concerns about excessive private sector deleveraging and undesirable macro-financial outcomes.

Evolving Flexibility in Management

State aid management is evolving to respond more flexibly to the crisis, but it faces fundamental challenges. DG Competition has been assigned difficult tasks in mitigating competitive distortions while yet preserving financial stability and limiting the costs to taxpayers while ensuring the long-term viability of the institutions receiving state aid. The design of intervention strategies therefore sometimes involves significant tradeoffs. Procedures have been accelerated, and sectorwide implications have been taken into account.

The ongoing Spanish arrangement, for example, takes a broader approach. The European Commission’s powers regarding the resolution of banks have been strengthened further, since European Stability Mechanism (ESM) support to bank recapitalization is now conditional upon the European Commission’s approval of those banks’ restructuring plans. The new mechanism has given DG Competition greater influence in the restructuring and resolution of banks receiving state aid, and it has led to a significant acceleration in the approval process. For instance, it took less than six months to approve the restructuring plans for eight Spanish banks, consistent with the timelines of the European program of assistance to Spain. Stronger coordination with other institutions is desirable, with a view to achieving the European Commission’s objective of “restoring financial stability, ensuring lending to the real economy, and dealing with systemic risk of possible insolvency.”

Where the Directorate General for Competition Can be Improved

DG Competition’s practices in systemic cases can be further enhanced to ensure consistency with a country’s macro-financial framework.7 The phasing and composition of bank restructuring are critical to mitigate adverse macroeconomic effects. DG Competition seeks to set the right incentives to make the best use of state aid and withdraw from state protection as soon as possible. A pricing policy has been established based on the ECB’s recommendations, which seeks to limit moral hazard by ensuring a sufficient degree of burden sharing at a level that is still below the remuneration that the market would request in the absence of state aid. However, increased transparency in pricing and proposed deleveraging would give added credibility to DG Competition’s efforts, which sometimes appear to be ad hoc. An examination of its policy for determining the remuneration of instruments used for capital support would be appropriate. Similarly, it would be helpful to review the methodology for determining the required degree of bank deleveraging.

The New State Aid Rules

The new state aid rules, which apply as of August 1, 2013, provide a new framework for state aid to the financial sector. The new rules introduce a potentially more effective framework focused on minimizing costs to the state and on ensuring financial stability. The framework is also relatively restrictive, however, as it gives a prominent role to the European Commission and requires burden sharing prior to the granting of state aid. Banks will have to present a viable restructuring plan, including burden-sharing measures to be approved ex ante by the European Commission before being able to receive state aid. Burden sharing will require shareholders and subordinated junior debt-holders to incur losses either through write-downs or conversion into equity before recapitalization with public funds could take place, but is subject to exceptions such as when their implementation could endanger financial stability or lead to disproportionate results. Bail-ins of senior unsecured creditors and uninsured depositors will not be mandatory. Thus, the rules require that a legal framework for statutory bail-ins be in place before aid is granted, and this implicitly brings forward part of the statutory bail-in requirement of the BRRD from 2018. State aid requirements would need to be justified in the restructuring or liquidation plans based on an asset quality review or a stress test.

Issues Raised by the New Regime

The new regime, while appropriately affirming financial stability and least cost as the main objectives, also raises some issues. Giving the European Commission an ex ante veto right on restructuring plans and the provision of aid could introduce delays and uncertainties, and it would grant resolution powers to the European Commission that would interfere with those of the SRM. The advancement of part of the BRRD bail-in provisions could create uncertainty by opening the door to uneven treatments during the transition. Lastly, the requirement to bail-in junior debt prior to state aid would mean that, short of voluntary liabilities management exercises, only banks under resolution could receive state aid, a situation that could destabilize weak banking systems.

The European Commission Proposal for a Single Resolution Mechanism

The Blueprint

The European Commission blueprint for the Banking Union of November 27, 2012, stated that a proposal for a SRM would be put forward in the months following the adoption of the SSM. The EU Council agreements of December 2012, March 2013, and June 2013 reaffirmed that an SRM with adequate powers and tools is required to make the SSM more effective and welcomed a European Commission proposal for an SRM. On July 10, 2013, the European Commission took a welcome step toward a more complete Banking Union by issuing an important proposal for an SRM.8

The draft European Commission regulation for an SRM provides for a central resolution authority backed by a single resolution fund, which are desirable characteristics. When the ECB or national authorities signal the need to trigger the resolution of a bank participating in the SSM, a Single Resolution Board (SRB)—consisting of members appointed by the Council, national authorities, the European Commission, and the ECB—would recommend to the European Commission certain key resolution decisions, such as placing an entity under resolution and determining the framework for the use of the resolution tools and funding arrangements. Such decisions would then be formally taken by the European Commission, which could also act on its own initiative. The SRB and national authorities would then be in charge of the implementation process, with the former being able to override the latter. The SRB would also have control over a single resolution fund financed by industry contributions.

Assessment of the Proposal

The proposal goes in the right direction of establishing a strong central resolution authority and a single resolution fund, essential elements of a Banking Union that would reduce fragmentation and mitigate sovereign—bank links (Box 12.3). It provides for strong centralized powers (at the European Commission and at the new SRB) to achieve swift and least-cost resolution while protecting stability and internalizing cross-border effects.

Box 12.3The European Commission Proposal for a Single Resolution Mechanism: An Early Assessment

The SRM proposal of July 10, 2013, contains important positive elements. Being established under the existing Treaties, the SRM could be established by the time the SSM becomes effective.

  • Strong powers. In principle, the SRM draft regulation would enable the European Commission and the SRB to make swift decisions to achieve least-cost resolution, while ensuring stability at the system level and internalizing cross-border effects. The SRM would have a broad range of powers to plan resolutions, assess resolvability, and prepare and adopt key resolution decisions, including with respect to the use of tools and funding arrangements. The SRB would also have investigatory and sanctioning powers and the powers to oversee and assess implementation by national authorities; it would be able to directly address executive orders to a specific bank to ensure implementation.

Funding. A single resolution fund would pool contributions from all banks participating in the SRM, thus weakening sovereign-bank links. Such pooled contributions would be more effective in funding resolutions than funds levied solely at the national level. A single resolution fund would be able to borrow from the ESM in extraordinary circumstances and under strict conditions, after extensive use of burden-sharing powers. DGS would remain at the national level.

However, crucial aspects of the SRM proposal could raise concerns:

  • Legal risks. The SRM is based on Article 114, Treaty on the Functioning of the European Union, which may not allow a transfer of national powers to the European Union. As the SRM proposal entails the transfer of directly binding resolution powers from member states to the European Commission, there is a legal risk that it might not be considered lawful by the Court of Justice of the European Union.1 The proposal gives substantial discretion to the European Commission in the decision-making process. This could create uncertainties regarding the allocation of responsibilities within the SRM, cause conflicts of interest, and hinder its operational independence:

    • ▪ For legal reasons, the European Commission has the final say, but the proposal also allows it to initiate action on its own initiative and overrule the SRB. This could create uncertainty regarding accountability.

    • ▪ A lack of clarity on the precise scope of the European Commission’s powers and its division of labor with the SRB in the decision-making process may create tensions with national authorities that have to implement its decisions. In this respect, the new European Commission state aid powers could create conflicts with the SRM. To contain such risks, a procedure should be designed to constrain the Commission’s discretion and more decision-making powers should be given to the SRB.

    • ▪ The strong powers given to the European Commission could impede the operational independence of the SRB, given the Commission’s multiple objectives. For example, emphasis on state aid carries the risk that DG Competition would be extensively involved in resolution decisions, which could create conflicts with the SRB. To contain such risks, the SRB should be strongly independent from the European Commission.

    • Lack of ex ante agreements on burden sharing and backstops could affect decision making. The SRB would not be able to specify how fiscal costs would be handled by national authorities. This could create deadlocks in the decision-making process.

    • Governance of the SRB. Executive sessions of the board regarding specific banks would involve only home and host national authorities. It would be important to ensure that spillovers on others and the supranational interests are well internalized.

1 The EU FSAP established that “Certain elements of an effective safety net such as an SRM can be designed through secondary legislation on the basis on the current treaty” while “in the medium term, providing an explicit legal underpinning for financial stability arrangements in the treaties could further enhance the legal robustness and transparency of those arrangements.”

However, there are legal and operational issues to be resolved and clarified, such as the legal risk that the SRM could be found to exceed the scope of the European Commission powers under the existing Treaties by the European Court of Justice; the scope of the European Commission powers and associated risks and conflicts of interest; the division of responsibilities between the European Commission and the SRB; the governance of the SRB; the operational independence of the SRM; and the lack of a common fiscal backstop and of ex ante burden-sharing agreements (apart from the ESM). The legal foundations of the EC proposal for the SRM have been scrutinized by the European Council Legal Service (CLS). In two opinions, the service addressed the questions of whether Article 114 of the Treaty on the Functioning of the European Union (TFEU) is the suitable legal basis for the proposal and whether the delegation of powers to the Single Resolution Board envisaged in the proposal is compatible with the EU Treaties and the general principles of EU law. CLS opinions are not binding, yet they play an important role in policy debates. CLS agreed that Article 114 of the TFEU may be a suitable legal basis for the establishment of the SRM subject to certain conditions. Specifically, the SRM proposal responds to a genuine need of uniform application of the rules on resolution that could not be achieved through other methods of harmonization. The Single Resolution Fund could be established provided that it is deemed to be indispensable for the efficient operations of the SRM and an adequate mechanism to safeguard the budgetary sovereignty of Member States is introduced. However, the SRM proposal encountered legal objections over the envisaged delegation of powers to the Board. CLS argued that the powers delegated to the SRB in the EC proposal need to be further detailed to be compatible with the EU treaties and the Meroni doctrine. The service expressed reservations about a number of competencies such as the drafting of certain aspects of the resolution plan, determining the investment strategy of the Single Resolution Fund, and others. In principle CLS argued that it is necessary to exclude that a wide margin of discretion is entrusted to the Board unless an institution of the Union vested with executive competences is involved in the exercise of SRB powers.

Alternatives Proposed

The European Commission SRM proposal is preferable to alternatives that would merely coordinate resolution mechanisms between national authorities. For example, under the French-German proposal of May 29, 2013, national authorities would lack the right incentives to act timely and in the least costly way, especially on cross-border banks.

Design of the Single Resolution Mechanism


International Standards

The powers of a Single Resolution Mechanism (SRM) based on a central resolution authority for the Banking Union should be in line with the emerging best practices laid out in the Financial Stability Board’s “Key Attributes of Effective Resolution Regimes for Financial Institutions.” Its objective should be to make the resolution of financial institutions feasible without systemic disruption while minimizing costs to taxpayers. Burden-sharing mechanisms should ensure that, wherever possible, shareholders and unsecured and uninsured creditors absorb losses in a manner that respects the hierarchy of claims in liquidation. Furthermore, the single resolution authority should comply with preconditions and prerequisites for effective resolution as set out by the Financial Stability Board.

Specific Considerations

In addition to complying with international best practices, the single resolution authority should be designed to address concerns arising from the euro area’s multicountry setting. Having a single, fully centralized, supranational resolution authority would set the right incentives, correct externalities and resolve coordination issues, provide a mechanism for swift decision making, and avoid duplication at national levels. It would also ensure that individual countries are not forced to internalize all the resolution costs and the spillovers to others at enormous cost to themselves. Moreover issues related to burden-sharing, governance, accountability, and interaction with the SSM need to be addressed. Legal difficulties would also arise (for example, the need for a change to the Treaty on the Functioning of the European Union—hereafter the EU Treaty—to establish a new EU institution and an insolvency regime that supersedes national regimes).9 In contrast to supervision, complete centralization of tasks is easier to achieve in the steady state, as the experience of the United States demonstrates, and there would be no need to design a mechanism delegating some tasks to the national level. However, in the short run, it may remain necessary to delegate some tasks, and this will raise two issues: monitoring the delegated tasks and interacting with the SSM. Addressing the need for a common backstop also becomes essential, since a resolution framework requires adequate backing to be effective, in particular to deal with systemic crises.

Preconditions and Prerequisites


Emerging best practices include a set of preconditions to ensure effective resolution: (1) a well-established framework for financial stability, surveillance, and policy formulation; (2) an effective system for the supervision, regulation, and oversight of financial institutions; (3) effective protection schemes for depositors, insurance policy holders, and other customers; (4) a robust accounting, auditing, and disclosure regime; and (5) a well-developed legal framework and judicial system. In the context of the banking union, these preconditions have implications for EU legal regimes and for the existence of an effective and credible SSM and deposit insurance scheme for all banks in the banking union.


To establish a sound basis for effective resolution, a resolution authority with a common fiscal backstop should be operationally independent, consistent with its statutory responsibilities; have transparent processes, legal protections, sound governance, and adequate resources; and be subject to rigorous evaluation and accountability mechanisms. Some considerations are particularly relevant in the supranational context of the banking union.

  • Objectives and mandate. A common resolution authority for the euro area should seek to maximize recovery value in resolution and minimize the overall cost of resolution and losses to creditors. Establishing a strong and autonomous resolution authority will ensure that home-host concerns are internalized within the euro area, but the cost and stability impact on other jurisdictions (in the European Union or outside) will have to be taken into account. The resolution authority should pursue financial stability and ensure continuity of systemically important financial services and functions while protecting depositors and other claimants protected by insurance schemes and arrangements.

  • Operational independence and legal protection. EU Treaty changes that would establish a strong and autonomous resolution authority should provide for an appropriate level of operational autonomy. Complementary EU Treaty revisions should be considered to ensure legal protection of officials for their actions and decisions in the exercise of resolution powers.

  • Accountability. Independence must be complemented with accountability. Resolution is an intrusive process with fiscal implications; it involves difficult and complex decisions about burden sharing and the distribution of costs between various claimants and taxpayers. In the context of the banking union, it would potentially involve choices about the distribution of losses between taxpayers of different countries, and it may impact ownership and competitive conditions both domestically and for the entire eurozone. These considerations call for particular attention to designing even more rigorous accountability mechanisms and evaluating resolution measures in the context of a banking union. The transparency of the single resolution authority would be essential, as would strong accountability and reporting to eurozone finance ministers (Eurogroup/EU Council) and European citizens (European Parliament). If national authorities retain the prime responsibility for the resolution of a subset of banks (an option not to be favored), an accountability mechanism operating at two levels (with national authorities also accountable to the national parliament and to the ministry of finance) will need to be in place.

  • Sound governance. Sound governance will be crucial to ensure early action and effective resolution decisions in the interest of the banking union as a whole. Specifically, conflicts of interest may arise for cross-border systemically important financial institutions during the preparation of recovery and resolution plans or during early intervention and resolution, since ownership structures remain national while assets and liabilities cross borders. A single resolution authority should provide the mechanism to remove these impediments to effective resolution, but its effectiveness and timeliness will depend on its governance, decision-making structure, and access to fiscal resources. It would have to prevent undue political interference and long negotiations that could hold up its decisions.

    For example, one possible model could be to rely on a two-tier governance structure to balance effective decision making with the need for oversight. An executive board could be tasked with making decisions affecting specific financial institutions in the interest of the banking union. A resolution council, including national representatives from all countries participating in the SRM, could be tasked with the oversight of decisions made by the executive board and with decisions on broader policy matters, such as those related to burden-sharing mechanisms and fiscal backstops. The voting mechanism should ensure that resolution decisions would not be blocked, and it would guarantee the “will to act.” Effective resolution also requires cooperating and exchanging information with the SSM as well as having checks and balances.

  • Resources and competencies. The resources allocated to the central resolution authority should be sufficient to build capacity at the center while protecting it from undue influence by national authorities and the industry. Given the importance of global systemically important banks in the euro area financial system, the central authority will need to hire independent staff with the expertise and capacity to implement preventative, early intervention and resolution measures with respect to large and complex financial institutions. In the interim period, pragmatism would call for relying on national resources and expertise. But to avoid duplication of resources at the national levels, swift centralization of resources and expertise would be essential to ensure that capacity is built for the resolution of these financial institutions.

  • Funding. To be effective, the central resolution authority will require access to common funding and a fiscal backstop (this is discussed in more detail under “Risks to the Single Resolution Mechanism,” below).



Consistent with the scope of the SSM, the common resolution mechanism should include all the banks licensed in the eurozone. No bank should remain under nonbank national insolvency proceedings. Consideration should be given to extending the scope of the resolution authority to other financial institutions such as holding companies, nonregulated operational entities within a financial group or conglomerate, and branches of foreign banks (other EU and non-EU banks). Covering these institutions would be important insofar as they could be systemic and therefore would need to be dealt with using adequate tools when they failed. Extending the coverage of the SSM to these institutions, if that turns out to be possible, would ensure consistency and help contain risks of failure.

Powers and Tools

Preparation and Prevention

The central resolution authority should be able to ensure preparation and prevention, in close cooperation with the SSM, and should have powers to

  • review and validate the recovery plans of systemic banks. This task should be performed in close cooperation with the SSM, which should also be involved in the process.

  • prepare resolution plans for systemic banks. Critically, these plans would include details on the application of resolution tools and ways to ensure the continuity of critical functions; the ECB, as the center of the SSM, should be closely involved.

  • take investigatory actions to ensure preparedness of the resolution authority, including requests for information and on-site inspections.

  • require actions to remove impediments to resolvability to ensure that the available tools can allow resolutions to be performed in a way that does not compromise critical functions, threaten financial stability, or involve undue costs to taxpayers. These could include changes to a firm’s business practices, structure, or organization to reduce complexity and other potential costs.

  • be involved in decisions related to intra-group support agreements, alongside the ECB.

Early intervention

Powers to take early intervention measures should also be provided to the resolution authority, which alongside the SSM should be able to

  • require capital conservation measures;

  • impose restrictions on activities, including implementation of measures set out in the recovery plan; and

  • trigger resolution.

Resolution powers and tools, which consist partly in taking control of the failed institutions, should include the possibility to

  • take over control of a firm, including by nominating a special manager and removing the senior management and directors;

  • transfer assets and liabilities (“Purchase & Assumption” agreement) to a sound acquirer;

  • set up a bridge bank, taking over good assets or services to ensure continuity of essential services;

  • separate bad assets by setting up an asset management vehicle (a “bad bank”), in conjunction with other measures;

  • apply a bail-in tool, involving the SSM, to recapitalize or wind down the bank with shareholders wiped out or diluted and creditors’ claims reduced, wiped out, or converted to shares; and

  • override shareholders’ rights regarding any decision needed in resolution, subject to the condition that shareholders should not be worse off than they would be under liquidation of the firm.

Coordination with Other Institutions

Coordination with the Single Supervisory Mechanism

Decisions to trigger early intervention or resolution will be highly sensitive and have distributional consequences that may bring conflicting interests among member states to the fore. In that respect, providing powers to the resolution authority that overlap with some powers of the SSM may contribute to a strong and robust financial stability framework for the euro area. For example, the resolution authority would also have investigatory powers, be able to trigger early intervention, require prompt corrective actions and be able to initiate resolution (for example, by withdrawing deposit insurance).

Coordination with the Directorate General for Competition

The Directorate General for Competition (DG Comp) will remain the EU agency with approval over state aid and competition policy. Therefore, it will continue to play a central role in the restructuring of banks in the European Union, but its role will change as a dedicated resolution framework for the banking union is developed. The challenge will be to find a balance to foster a more integrated approach between the European Commission as the guardian of competition and the SRM and the SSM and also to establish a permanent coordination between the three institutions. For banks outside the banking union perimeter, DG Comp may also play a coordinating role between the banking union’s resolution authority and those in the remaining EU member states based on the BRRD framework.

Establishing an Effective Central Resolution Authority

Steady-State Considerations

Central Resolution Authority

A fully centralized euro area resolution authority should be able, in the steady state, to handle the resolution of failed euro area banks with possible delegation of some tasks to internal offices located across member states. It should have powers and tools, mandates, independence, governance, and accountability to ensure effective resolution in line with international best practices and the BRRD, but with reinforced mechanisms or rules to ensure its effectiveness in a multicountry setting.

  • Positives. This centralized approach is the best solution to internalize cross-border effects and solve coordination failures, help build solid resolution expertise for systemic institutions, provide flexibility to intervene and allocate resources where needed, and avoid national duplications. It would ensure that the ECB would interact at par with a strong supranational institution that would complement its functions and mandates. A strong resolution authority would contribute to ensuring effective supervision, provided there is clear coordination and information sharing between the two institutions. Conversely, a strong supervisory mechanism would also contribute in establishing the credibility of the resolution authority and in making it robust. In short, the two institutions would reinforce, complement, and balance each other. The central resolution authority would also provide mechanisms for clear ex ante burden-sharing arrangements, provided an adequate fiscal backstop is also in place.

  • Obstacles. For an effective central resolution authority to be credible, agreement is needed on a common resolution and fiscal backstops, and including a loss-sharing mechanism involving taxpayers. Also, any EU Treaty change to create a strong supranational resolution authority would require time. Such authority should also be able to apply a single resolution regime, overriding national insolvency laws.

Burden Sharing

Clear and workable burden-sharing arrangements, including between participating member states and the common backstop, are essential for an effective resolution mechanism. In line with international best practices, the euro area resolution authority would have power to override shareholders’ rights and impose losses according to clear ex ante rankings of claimants that would respect the hierarchy of claims but have some flexibility to depart from the pari passu principle. A “bail-in” mechanism haircutting or converting senior unsecured creditors would provide a tool for burden sharing. Meanwhile, depositor preference should be included in the framework to further protect depositors and the funding provided by the deposit insurance scheme (see “Resolution Funds and Deposit Insurance,” below).

Next, pooled contributions from the euro area industry would be needed to finance the costs of normal resolution. Pooled contributions from euro area taxpayers (which would follow specific ex ante rules) would be needed only insofar as private sector contributions and allocation of losses among uninsured claimants are insufficient to cover the costs of resolution, subject to a systemic exemption. In addition to more standard burden-sharing rules that apply to any resolution authority, the single resolution authority should also be provided with a clear mechanism for decision making (see the discussion on governance under “Design of a Single Resolution Mechanism,” above) and a combination of ex ante burden-sharing rules across member states, which could be based on capital keys similar to the capital contributions at the ECB.


A euro area resolution fund would finance the costs associated with bank resolution. Such a fund would build resources from risk-based contributions levied on all countries. The contribution base would, ideally, not only be total deposits but also include other liabilities, possibly adjusting for risk taking and externalities. A good benchmark would be to build a fund targeted to cover the net fiscal costs of up to a large or a few medium-sized bank failures. Adequate common fiscal backstops, which would be particularly important for systemic events, would also be crucial for the effectiveness of the resolution authority (see section “Common Safety Nets and Backstops”). A transition period would reduce the immediate impact on banks and, meanwhile, other costs could be recouped ex post from banks, although this may create moral hazard.

Institutional considerations

Since resolution involves sensitive decisions over distribution of losses, given the need for checks and balances an independent body should be established that would operate alongside the ECB supervisor. To ensure effectiveness, this resolution authority should be an EU institution established “at par” with the ECB, even if there could be merit in a transitional arrangement, such as the creation of a temporary EU agency. At the same time, governance arrangements would need to ensure close cooperation between the SSM and the resolution authority. These arrangements would be complemented by joint technical committees and working groups.



A possible approach would be to bring all euro area banks under a central resolution authority as they are brought under the supervision of the ECB.

  • Positives. Bringing banks under a single resolution authority in parallel with the transition toward the SSM would ensure a more consistent treatment of resolution in the euro area and would greatly simplify the operational complexity of the supervisory tasks awaiting the ECB. Having a unique resolution authority in charge would be particularly relevant for banks being restructured and in need of, or nearly in need of, public support.

  • Temporary body. To facilitate the process, there may be merit to establishing a temporary body or urgently creating an EU agency tasked with the coordination of bank crisis management and resolution among national authorities and the ECB. Such an agency could be linked to the ESM, with accountability to the Eurogroup. The experience of the Swedish Bank Authority in the 1990s and the U.S. Treasury unit set up to restructure AIG provide examples of the usefulness of temporary bodies.

  • Risks. Time would be needed to build resources and capacity at the center. In the event of a delayed transition, the ECB would become tasked with supervising systemic banks, including complex ones, and would have to interact with multiple competent national authorities, including with respect to early intervention and corrective actions. The need for consistency among preparedness measures and mechanisms to deal with cross-border considerations and systemic banks also suggests that a delayed transition would be inefficient and result in duplication of tasks. A slow and delayed transition toward an SRM would also create the risk of an incomplete framework if political support weakened over time.

  • Speed. There are two main strategies:

    A “big-bang” approach. A “big-bang” approach envisages a rapid move toward the establishment of a central resolution authority and supranational insolvency regime. This is the preferred approach, but it may be constrained by political realities and practical considerations.

    • Pros. This rapid approach would help ensure a smooth transition to the SSM by moving supervision and resolution in tandem. Building resources at the center may take time, but the temporary body mentioned above could be the stepping stone to a permanent framework. This approach would build cross-border expertise in early intervention, supervision, and recovery and resolution planning for systemic institutions.

    • Cons. Securing an EU Treaty change could be daunting in the near term. It would also require establishing pan-euro-area insolvency laws (requiring regulations) and the involvement of courts (the European Court of Justice) to supersede national regimes. The temporary body or EU agency, which may require its own treaty or could possibly be established under Article 352 of the EU Treaty, could remain active during the interim.

    A gradual approach. A gradual approach would consist of three steps. First, national regimes would be harmonized and strengthened, as prescribed in the BRRD. Harmonized national resolution funds would be set up, allowing cross-border borrowing arrangements. Second, an EU body, similar to the European Banking Authority, could be established by an EU regulation and tasked with the coordination of resolution in the euro area. It would play a coordinating role in ensuring a single approach to resolution. In the long term, a supranational central authority could be established.

    • Pros. This approach would ensure that no disruptions in resolution structure would happen during the transition. It would guarantee full compatibility across national regimes between national and federal bodies and between “ins” and “outs.” It would not require changes in national laws beyond those needed to harmonize and ensure robustness of resolution regimes.

    • Cons. Until a federal agency is created, the SSM would have to interact with multiple national authorities, which could be unwieldy and constrain effectiveness. It could create incentive problems within the SSM insofar as national authorities would refrain from sharing with the ECB information that might result in a decision to trigger a resolution (one that might have to be financed by domestic taxpayers). The national approach to resolution funding would achieve little risk diversification and would therefore be inferior to a centralized approach. A long transition toward the most robust solution would increase the risks of a stalled process and an incomplete framework. A harmonization of frameworks could itself take time, since transposition into national law would be required in each EU country.

Risks to the Single Resolution Mechanism

Risks associated with an SRM include stalled reforms, the consequences for cost or risk sharing from the euro area crisis, and dealing with too-big-to-fail institutions.

Stalled Reforms

The main transitional risk in a gradual approach is that of a stalled reform process. This risk should be addressed by having a clear roadmap that would be time-bound and would indicate the main steps and key deliverables, including agreement toward a common safety net. This could occur at an early stage, for example while harmonizing national resolution regimes, or it could occur at an intermediate stage while agreeing on an SRM for the banking union.

Harmonization Stage

A fully harmonized system of rules with resolution authority remaining at the national level and coexisting with a common ESM backstop would create incentives to shift the costs of resolution to the euro area taxpayer. It could create an unwieldy system in which the SSM would have to interact with many national authorities during crisis time, but also during the steady state to be able to supervise the euro area systemic banks. The framework would achieve little to weaken the link between sovereign and bank funding costs. Lastly, the transposition of the BRRD into national laws would still leave the door open to different interpretations and, therefore, to different practices.

Centralization Stage

The banking union could transition to a framework with a resolution authority akin to the European Banking Authority (for example, an EU agency) tasked with the coordination and mediation of resolutions that would remain nationally based. Depending on the actual powers of this body, the framework may have to progress in the direction of centralizing bank resolution and internalizing cross-border externalities arising in the resolution of cross-border banks or in the use of a common backstop. However, there is a risk that the agency would lack adequate binding powers, and also a risk that it could be subjected to fiscal safeguards preventing infringements of member states’ sovereignty, which would impede effectiveness.

Need for Burden Sharing and Adequate Fiscal Backstop

To be fully effective, the single resolution authority must be accompanied with burden-sharing rules and, at a minimum, provide a mechanism for swift decision making. Adequate common fiscal backstops are also required to ensure the effectiveness of a centralized resolution authority.


Divergent interests during the transition may have consequences for the future, since the way legacy is addressed during this crisis will create a precedent for the future. The costs of existing bad bank debt should be left as much as possible to those that have been primarily responsible for them, that is, the creditors and national supervisors. But as government solvency is endangered and systemic risk rises, direct recapitalization by the ESM becomes necessary. Creditors may insist on control but resist enhancing backstops for fear that imperfect control would result in a “transfer union.” Debtors may insist on the need to delink banks from sovereigns as a condition for transferring control to the center. An incomplete solution might result in an unstable Banking Union, in either of two alternative scenarios:

  • ESM direct recapitalization but no central resolution. Some form of a common backstop, albeit imperfect (such as the announced mechanism of direct ESM recapitalization) would give strong incentives to national resolution authorities to shift the costs away from national creditors and onto the euro area taxpayers.

  • Central resolution but no adequate common fiscal backstop. Centralizing resolution decisions without an adequate common fiscal backstop and lasting solution for burden sharing would not help address the sovereign—bank links and would not be conducive to information sharing. The fiscal consequences of decisions made at the center would fall entirely on national taxpayers and could generate political risks while jeopardizing the credibility and effectiveness of a single resolution authority.

Too-Big-to-Fail banks

Global systemically important banks’ complexity, cross-border dimensions, and systemic roles place a high value on quickly establishing a robust supranational resolution authority, with powers and tools aligned with the Financial Stability Board’s Key Attributes and with adequate common fiscal backstops. In contrast, national approaches to resolution and fiscal resources would become inadequate to resolving a systemic institution. The need to ensure preparedness and to remove impediments to resolvability suggests a key benefit to pulling scarce resources together and building shared knowledge and capacity at the center, as well as the benefit of the single resolution authority.

Legal Considerations

In time, a change in the EU Treaty would be necessary to establish a strong and autonomous resolution authority. The accompanying supranational insolvency regime would also have to override national insolvency laws. However, certain elements of an effective safety net such as an SRM could be designed through secondary legislation on the basis of the current EU Treaty.

Common Safety Nets and Backstops


Backstops and common insurance mechanisms form essential elements of the banking union. Absent backstops and safety nets, the banking union would be unable to delink or weaken the link between sovereigns and banks. It would possibly be unstable and risky and could jeopardize the credibility of the ECB; and the SRM would be ineffective and noncredible. Setting up backstops and common insurance mechanisms requires a transfer of control to the center, and must follow only after some preconditions have been met.

Common Fiscal Backstops

Adequate common backstops are essential to dealing with systemic crises, since prefunding by DGS and/or resolution funds would likely not suffice to deal with the gross fiscal costs of a crisis. Common backstops are therefore needed to create a framework that is robust and breaks sovereign—bank links in tail events. During the transition, direct recapitalization by the ESM will make it possible to break the link between banks and sovereigns when solvency concerns about the latter arise. To the extent that DGS and resolution funds will only progressively accumulate contributions from the industry, agreements on fiscal backstops and burden sharing may even be more important during the transitional phase.

Deposit Insurance

As noted, common deposit insurance is needed for stability reasons. A pooled mechanism would be more effective in protecting confidence (subject to an adequate fiscal backstop) and in diversifying risks across large numbers of banks. But the need for a common DGS also follows logically once an SSM and a single resolution authority are in place. To the extent that a resolution authority would require common funding from the industry, postponing the centralization of DGS makes little sense. Additional national DGS could be allowed to complement the euro area DGS.

Resolution Funds and Deposit Insurance

European Commission Proposal

The EU Council aims at a swift adoption of the DGS Directive and the BRRD by the European Parliament and transposition into national laws.

  • Resolution funding. Financing arrangements funded with contributions from banks and investment firms that are in proportion to their liabilities risk profile and systemic importance must be established at the national level. Contributions will be raised from banks (on total liabilities, excluding own funds) at least annually to reach a target funding level of at least 1 percent of covered deposits after 10 years. If the ex ante funds are insufficient to deal with the resolution of an institution, further contributions will be raised (ex post). Mutual borrowing arrangements across schemes are allowed, subject to safeguards designed to protect creditor resolution funds. Funding already available in DGS could be used for resolution, in which case contributions for resolution would be based on total liabilities, excluding own funds and insured deposits. But the DGS would rank pari passu with unsecured creditors in insolvency proceedings for the amount of covered deposits. Finally, alternative funding means, such as borrowing from the central bank, should be enabled.

  • Deposit insurance. The DGS Directive paves the way for harmonizing national DGS in payouts speed, coverage, and funding. In particular, it sets a 75 percent share of ex ante financing and a target coverage ratio of1.5 percent of eligible deposits after 10 years, permitting ex post financing of up to 0.5 percent of covered deposits. Borrowing arrangements across national schemes are permitted, allowing up to 0.5 percent of eligible deposits of the borrower, and must be repaid within five years, with the claim ranking first in liquidation proceedings. After 10 years, the size will be recalibrated on the basis of covered deposits (instead of eligible deposits). Bank contributions to national DGS reflect risk, based on core indicators such as capital adequacy, asset quality, profitability, and liquidity. DGS can also be used for resolution funding, provided that the primary function of the DGS is not impeded.

Alternative Preferred Approach

The following describes an alternative to creating a pan-euro-area DGS and resolution fund:

  • Scope. All euro area banks should be covered by the resolution fund and by the deposit insurance scheme for consistency with the SSM and the single resolution authority. Covering only a subset of banks could be destabilizing by inducing reallocations of deposits between the national segment and the euro area segment, and it could create distortions to competition within the single market, but additional schemes could be allowed to top-up the pan-European scheme. Given different sizes of banking systems across euro area countries, the coverage would be skewed toward the largest financial systems in the core of the euro area.

  • Funding.

    • Resolution fund. The resolution fund should be prefunded through ex ante risk-based premiums (reflecting at least capitalization, profitability, liquidity, and asset quality) and should also be adjusted for the systemic importance of an institution. Use of funds could be complemented by arrangements to recoup losses through ex post levies on the industry. To the extent that ex post levies are procyclical and induce moral hazard, their share in the industry funding should be limited. The resolution fund should also have access to common backstops; this which would be particularly important during the transition when the fund has insufficient reserves and for systemic events. The tax rate should be chosen to smooth the cyclical burdens on the industry while building a target prefunding ratio within 10 years. The tax base should include all liabilities (including wholesale funds) excluding capital.

    • Deposit insurance. To a significant extent, the DGS should be prefunded through ex ante risk-based premiums levied on the industry and should be complemented, if needed, by ex post levies on the industry. The tax base should be the total eligible deposits. The tax rate should be chosen to minimize the cyclical burdens on the industry while ensuring that the deposit insurance fund reaches its target level within 10 years. As above, it should be risk-based and reflect the systemic importance of a bank. The prefunded element of the DGS should, in steady state, maintain a ratio of about 1.5 percent of total eligible deposits (hence, the total fund size would be about €100 billion). This would allow covering deposit payments for two or three medium-sized bank failures, but having a backstop available would be critical.

    • National DGS. Specific national schemes could be allowed to continue to operate in addition to the pan euro area deposit insurance, provided they are aligned with the EU Directives.

Merging Resolution and Deposit Insurance Funds

A single integrated fund for resolution and deposit insurance would have benefits. There are synergies between DGS and resolution funding, as both contribute to stabilizing financial systems. There are economies of scale that derive from jointly administering the funds. Objectives do not conflict when the ranking of claimants is clear and adequate, provided insured depositors are protected. Furthermore, separating funds does not preclude the fungibility of fiscal outlays during banking crises. Nevertheless, DGS and resolution funds have different objectives. The former must ensure that eligible depositors are reimbursed up to the coverage limit, while the latter must ensure that failed banks can be wound up and cover all resolution costs while minimizing losses of value and contagion risks.

Mixed Model

There has also been discussion about creating a common resolution fund, administered by the single resolution authority, while harmonizing deposit insurance schemes but allowing them to remain at the national level. Such a model would go some way toward enhancing the effectiveness of the SSM while providing common financing for resolution, although without common backstops its impact would be limited. Under this model, it would be essential that national deposit insurance funds were available to contribute to resolution, up to the amount available for payout. Even so, the disadvantages would include less efficient risk pooling, which would not effectively decouple sovereigns and banks; complexities in cost allocation and implementation in the case of cross-border failures, requiring close coordination between national DGS and the single resolution authority; and duplication of costs and administrative resources, since both funds would be assessed on the same banks.

Desired Size

While there is no well-established good practice, the typical target size of deposit insurance and resolution funds could range from about 1 to 2 percent of insured deposits in large systems (as in the European Commission proposal or the United States) to 4 to 5 percent in smaller systems, where the aim is to cover two to five midsize bank failures or four to six small bank failures. Part of the gross outlays would be recouped from asset sales during resolution and from ex post contributions from the industry (see Table 12.1, which illustrates the size of financial sector support during the recent crisis).

Table 12.1Financial Sector Support 2008–11(percent of 2011 GPD)
United Kingdom6.8
United States5.3
Source: IMF, Fiscal Monitor; Spain Financial Sector Assessment Program; and staff estimates.

Includes actual use of debt guarantees. Asset purchases and capitial support from the Fund for Orderly Bank Restructuring as of March 2012 and the European Stability Mechanism/European Financial Stability Facility (EFSF) loan announced on June 9th.

Source: IMF, Fiscal Monitor; Spain Financial Sector Assessment Program; and staff estimates.

Includes actual use of debt guarantees. Asset purchases and capitial support from the Fund for Orderly Bank Restructuring as of March 2012 and the European Stability Mechanism/European Financial Stability Facility (EFSF) loan announced on June 9th.

Legal Concerns

A single resolution fund would require having a supranational resolution framework in place. This would require establishing a euro area insolvency regime, which may require an EU Treaty change. Treaty change would be required if a Euro Area Deposit Insurance and Resolution Fund is “joint and several.” The no-bail-out clause of Article 125 prohibits the European Union, euro area, or member states from being liable for or assuming the liabilities of another state or of its public bodies. However, voluntary loans to other member states (as envisaged in the BRRD), or multiple several-guarantees arrangements (as under the ESM) would not appear to be in contradiction with the current EU Treaty.

Fiscal Backstops and Burden-Sharing Arrangements

Decision Making

At a minimum, clear rules for decision making should be put in place to ensure that resolution decisions can be taken promptly. These should include some ex ante agreed burden-sharing rules to ensure an orderly process—a clear hierarchy of claims (including bail-ins of unsecured senior creditors) and some ex ante rules for allocating fiscal costs across member states. To minimize moral hazard and conflicts of interest, rules allocating fiscal burdens across countries would be especially important insofar as some banks would remain under the supervision of national authorities while more systemic ones come under the direct responsibility of the ECB. The governance of the single authority should also leave some room for discretion to allow for swift decision making (“over a weekend”) in emergency situations. Least-cost resolution and the allocation of losses should also weigh in stability concerns.

Pecking Order

The probability and severity of banking crises is minimized by effective supervision and ambitiously high capital requirements. But when crises occur, burden sharing should follow this order (subject to a systemic exemption):

  1. haircutting shareholders

  2. junior creditors

  3. bailing-in senior unsecured creditors

  4. bailing-in resolution and deposit insurance funds, and

  5. taxpayer contributions.

(See the section below on “Layers of Backstops” for a discussion of rules that could govern the allocation of losses between the national sovereign and a common fiscal backstop.)10

Insured depositors should come last in the ordering of losses, and there should be depositor preference (for example, the deposit insurance fund should be senior to other claimants). In most crises, the hierarchy of losses would not conflict with stability concerns and would support market discipline ex ante. However, in systemic crises, taxpayer funding would become inevitable. Since 2008, according to the European Commission, over €4.5 trillion has been used to rescue banks in the European Union (including liquidity provision measures and asset guarantees by governments).

Plan for Tail Events

A common fiscal backstop and agreements on burden sharing would help ensure that banking crises do not endanger the solvency of the sovereign. Historical evidence shows that one-fourth of banking crises had gross fiscal costs in excess of 16 percent of gross domestic product (GDP), although net costs are invariably lower, as values of distressed assets recover. In the steady state, private sector resources will not suffice to cover the gross costs of systemic crises, but fiscal costs cannot be left entirely on national taxpayers.

Layers of Backstops

A series of common backstops, including elements of a fiscal union, must therefore be created at the euro area level to prevent downward spirals between sovereigns and the banks in tail scenarios. The following is one type of scheme that could be considered:

  • Common resolution fund/DGS. A euro area fund of the kind described above would provide a first buffer to weaken the link between sovereigns and bank failures. It would cover a proportion of each banking crisis that would depend on its level of agreed prefunding. Ex post levies on the banking sector may also help reduce fiscal contributions in the medium term, although achieving full fiscal neutrality may be difficult in the case of systemic crises.

  • ESM direct recapitalization. In extreme circumstances, if all ESM resources were used for directly recapitalizing banks and served as a loss-sharing mechanism (i.e., investing in going-concern banks with negative equity), ESM’s eventual size would be able to cover crises requiring up to about 5 percent of euro area GDP in fiscal outlays. Its capital keys would provide an ex ante burden-sharing agreement, while its governance would facilitate swift decision making. In practice, a fraction of the resources would likely be available for bank recapitalization (and the rest for sovereign support).

  • Earmarked contingent euro area taxation. A more ambitious approach would be to grant a eurozone institution (under the Eurogroup) with limited taxing power that could be relied upon to back blanket guarantees during systemic events.

  • ECB line of credit. Temporary ECB lines of credit to the resolution authority, guaranteed by the common fiscal backstop, may be essential to finance a bank resolution in an emergency, contingent on a fiscal backstop being in place to cover the eventual net fiscal costs of the banking crisis.11 A similar set-up is used, for example, in the United States, where the Federal Reserve was involved in financing the asset management company that dealt with AIG’s and Bear Sterns’ toxic assets. In Switzerland, the Swiss National Bank funded the Swiss Stabilization Fund to deal with UBS’s legacy assets.

Cofinancing by the National Sovereign

If there are residual imperfections in the SSM, the presence of a common backstop could create incentive problems, reinforce regulatory forbearance, and unduly shift the costs of bank failures to euro area taxpayers. To mitigate this risk, consideration could be given to involving national taxpayers. For instance, the ex ante burden-sharing arrangements designed by the single resolution authority could specify the share of losses borne by national taxpayers (on top of losssharing rules associated with a common backstop), conditional on sovereign solvency being protected and on strong national fiscal rules. This is not unlike standard insurance with deductibles and copayments. However, the need to delink banks and sovereigns could constrain the usefulness of such arrangements. Allowing cofinancing also raises difficult questions. For example, after a bank is recapitalized by the sovereign, would the sovereign’s shares be diluted should the situation worsen and require additional recapitalization by the common backstop? Several ex ante burden-sharing approaches could be considered:

  • Fixed amount of loss to national taxpayer. Losses would be allocated to national taxpayers up to an ex ante defined maximum that could be expressed in percent of GDP. The threshold would balance the needs to align incentives and to attenuate the sovereign—bank nexus. Above the threshold, losses would be allocated to the common backstop. This approach could suffice in the steady state, but it might also be dynamically inefficient when the threshold limit was about to be breached.

  • Cofinancing starting with the first euro. National taxpayers would contribute a minimum ex ante agreed share of the gross fiscal costs of each bank failure. While cumbersome, this approach would help align incentives, regardless of the size of the banking crisis.

  • Liquidity backstops. Under the current set-up, national authorities would bear the risks of resolution but would be eligible for ESM loans. This approach might only marginally weaken the link from the banks to the sovereign, and may therefore not be desirable.


Harmonized National Resolution Funds and DGS

The European Commission approach could be a stepping stone toward the creation of a single pan-euro-area scheme in the long term. However, since risk sharing would take place at the national level, it would achieve little risk diversification in the interim, in particular in countries with smaller, less diversified banking systems. It also would not delink banks from sovereigns. The degree of harmonization of national funds achieved through a directive may not suffice to merge national resolution funds into a single euro area fund.

  • Transitioning heterogeneous banks into the resolution fund. A slow transition to a single fund by gradually extending coverage to a larger sample of banks, for example in conjunction with the extension of the SSM, could be problematic. In countries with weak sovereigns, such an approach may create liquidity pressures for the banks remaining under the national DGS. A rapid phasing-in of a resolution fund might raise concerns about the cyclical effects of bank levies, if the transitioning period is too short.

  • Euro area “reinsurance scheme”. A reinsurance scheme for national DGS could also be created, funded at the euro area level through levies on the industry (although this too could suffer from the problem of procyclicality) and/or annual contributions from member states. Ex ante agreement on the degree of national funding and supranational funding in depositor payouts would prevent moral hazard. Over time, the reinsurance fund would build administrative capacity and could become a step toward the creation of a permanent euro area DGS and resolution fund.

Fiscal Backing

As noted, resolution funds and DGS require explicit fiscal backing, complemented at times by liquidity lines from the central bank, to cover the gross costs of systemic crises. Thus, agreement on backstops is required to transition to a euro area resolution fund.


Establishing a strong and autonomous resolution authority is key to enhancing the effectiveness of the single supervisory mechanism. To be effective, a centralized resolution authority requires clear rules for burden sharing and adequate common backstops to break sovereign—bank links. A pan-euro-area resolution fund should be built over time from risk-based industry contributions. It should be complemented by a fiscal backstop that could be provided by the ESM or, over the longer term, by earmarked pan-euro-area taxes, as well as a liquidity line from the ECB. Establishing a strong and fully independent single resolution authority at par with the ECB may, however, require an EU Treaty change.

In the near term, a single resolution mechanism, such as proposed by the European Commission, is a welcome step in the right direction and would ensure that an SRM is in place by the time the SSM becomes effective. It would allow for swift decisions on burden-sharing arrangements and ensure least-cost resolution, even if there remain areas of concern. Without a strong SRM complementing the SSM, the credibility and effectiveness of the banking union would be jeopardized. To effectively break bank—sovereign links, the SRM would have to have access to an effective common fiscal backstop, ultimately backed by a combination of ex ante and ex post industry levies from a single resolution fund. A credit line to the ESM could be a bridge to a more permanent solution.

Centralizing DGS would enhance credibility and risk diversification. In the long term, a single deposit insurance and resolution fund could be created by merging the resolution fund and national DGS.

Although it has not been a focus of this chapter, addressing transitional risks will be important. A temporary body or EU agency, which would be an embryonic resolution authority under the European Commission SRM proposal, could be created to help deal with the resolution of failed banks. Designing appropriate cofinancing arrangements, for example clear ex ante burden-sharing arrangements with room for discretion, may be useful to fully align the incentives of national authorities with the common good, although due consideration should be given to how burden-sharing arrangements might impact sovereign—bank links.

It will also be important to avoid a stalled reform process. Lacking a single resolution authority would weaken the effectiveness of the SSM. Centralized resolution without agreement on burden-sharing rules and on adequate fiscal backstops would lead to an ineffective and noncredible resolution authority. To address transitional risks, a clear and time-bound roadmap for the remaining elements of the banking union, demonstrating a shared understanding of the end point by all member states, should be announced, with strict deadlines and key deliverables at each step of the reform process.


    GoyalRishiPetyaKoeva BrooksMahmoodPradhan and others2013A Banking Union for the Euro AreaIMF Staff Discussion Note No. 13/1 (Washington: International Monetary Fund).

The Financial Stability Board Key Attributes of Effective Resolution Regimes for Financial Institutions. Available at the website of the Financial Stability Board, at

See, for example, FSAPs on the Kingdom of the Netherlands, Germany, the United Kingdom, Spain, and Luxembourg, available at

In recognition of the impending legislative proposals, the EBA has been active in developing methods for the recovery and resolution of failing banks, such as in its efforts for recovery plans, including the development of templates.

See the European Banking Coordination “Vienna” Initiative (2012) in a working group focused on nonperforming loan issues in central, eastern, and southeastern Europe. Recommendations, among others, focused on establishing a conducive legal framework for nonperforming loan resolution, removing tax impediments and regulatory obstacles, and enabling out-of-court settlements.

The Treaty on Functioning of the European Union contains strict limitations on state aid to avoid distorting competition and the internal market. According to the Article 107 of the treaty, no state aid should be granted in any form which distorts or threatens competition. However, state aid can be exceptionally allowed under paragraph 3 of Article 107 in cases of serious disturbances to the economy.

The European Commission framework for state aid in the financial sector was described in a set of six communications issued from 2008 onwards. For more details, see:

As announced in the European Council conclusions of June 28, 2013, the European Commission has adopted revised state aid rules for the financial sector in the summer of 2013 to ensure a level playing field in resolution decisions involving public support.

See Chapter 10 for a detailed discussion.

Secured claims should be secured up to the value of the collateral, and the remainder would be unsecured and treated as such.

The possibility of such central bank lines of credit are envisaged in the European Commission draft Directive for bank recovery and resolution.

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