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E.Barucci, M.Messori, "Is the Single Resolution Fund an effective back stop?"

image-09/24/2014 - 12:361. Introduction

As we have shown in the previous chapter, the Single Resolution Mechanism (SRM) requires 
the setting up of a Resolution fund to complete the restructuring or the controlled bankruptcy 
of a bank in difficulties, since the bail-in process towards shareholders and debt claimants can 
be insufficient to meet all the bank obligations and – in particular - to protect the holders of 
covered deposits and other covered bonds. The European Commission addressed these 
problems even before the starting of the Banking Union (BU) process (Fall 2012) by 
proposing a Directive aimed at harmonizing the national systems of deposits guarantee (the 
Deposit Guarantee Schemes Directive – DGSD, 2010), and a Directive aimed at building new 
recovery and resolution mechanisms in each Member State and at coordinating these national 
mechanisms at the European level (the RMs Directive, 2012). The launch of the BU induced 
the European Commission to immediately commit itself to design a possible SRM after the 
approval of these two old Directives, and then (end of June 2013) led the European Union 
(EU) Council to the actual approval of the Banking Recovery and Resolution Directive 
(BRRD) and to the transposition of the older DGSD inside the BRRD.

In December 11th, 2013 the EU Council involved the European Parliament and the Commission in a trilogue to implement the legislation of BRRD. According to the Council’s main proposals, each national resolution fund (NRF) would have to be funded – that is, to have an ex ante coverage – by means of the yearly transfers, compulsory made by all thebanks belonging to the EU’s Member States which apply to the BU. The amount of these transfers should be based on the level of asset risks of each specific bank. At the standard, every NRF should have a size at least equal to 0.8% of the total amount of the guaranteed deposits in the national banking sector. However, the NRFs could enjoy a long transition period (ten years) to reach this relative size. Moreover, the mutual aid between NRFs in termsof reciprocal lending activity would have to be set on a voluntary basis; and the access of these funds either to market loans or to the European aid mechanisms (typically, the ESM) would have to be treated as an exceptional case. Finally, each NRF could be supported bynational public backstops ill-designed. ***This chapter is not devoted to analyze the drawbacks of the BRRD. Nevertheless the latter are important since they influenced the European initiatives on the SRM and the SRF. In fact, one week after the starting of the implementation of the BRRD (that is December 18th, 2013), the European Commission set its regulation on both the SRM and the SRF. And finally the functioning of the SRF has been established by the Directive 2014/59 and by the Regulation 806/2014 approved by the European Parliament.In the remaining of this chapter, we examine three main topics. In section 2 we analyze the working of the SRF. In section 3 we point out the most important weaknesses of this European fund and the related need of a public backstop. This first conclusion leads us to emphasize that the role and the specific features of the possible public backstop are insufficiently specified by the European rules, and that this institutional deficiency could have a negative impact on the whole construction of the SRM.2. The functioning of the SRFThe SRF is managed by the Single Resolution Board (SRB), which operates in a plenary session as well as in an executive session. The SRB calculates the individual contributionsrequired to each of the credit institutions which are subject to the SRM, that is which belong to a EU’s Member States involved in the BU. The single Member State remains competent to levy the contributions from the entities located in its territory, and to transfer these national contributions to the SRF. However, in the short term, there will just be the NRFs set up under the above mentioned banking resolution directive; hence each national flow of contributionswill be allocated to its NRF. Starting from 2016, the NRFs will be replaced by the SRF;during a long transition period (eight years), the NRFs will act as sections of the SRF. In this period, the national sections will progressively merge in the sense that they will transfer increasing shares of the collected contributions to the SRF. At the end of the eighth year, this process of mutualization will be completed so that all the contributions will be acquired by the SRF and the national sections will cease to exist.The SRF as well as the provisional national sections will be ready to provide temporary support to banks under resolution. Support includes loans, guarantees, asset purchases, andcapital for the creation of bridge banks. As specified in the previous chapter, losses, direct costs or other expenses incurred with the resolution tools (that is, the resolution costs) should be borne by the fund or by its national sections, only if the claimants of the bank (shraheoldes and debtholders) participating to the bail-in process have at least covered the 8% of bank total liabilities including its own funds. During the transition period, these residual resolution costs must be primarily sustained by the section(s) of the Member State(s) where the institution under resolution is established. To be precise, in the first year of the transition period, the resources should be fully taken from the section(s) just specified; in the second year the latter should contribute for the 60% and in the third year for the 40%; in the subsequent years, this fraction should continue to gradually decrease to go to 0 at the end of the eighth year. If the financial resources of the section(s) involved were not sufficient to cover the residual resolution costs, there might be the support of the other national sections. The SRB can activate temporary (remunerated) transfers between the national sections. Decisions by the SRB on temporary transfers are taken by simple majority; however these decisions can be objected by any Member State, whose section had to contribute to one of these transfers. In any case, the disbursement of the SRF or of its national sections cannot exceed either the 5% of the total liabilities of the bank under resolution including its own funds or the means available and attainable in the next future by the SRF (see below).Contributions to the SRF are divided in two components. The first one is determined by the ex ante contributions that each of the specified credit institutions has to make every year. These contributions are formed by two parts. The formeris determined by a flat portion of bank’s total liabilities net of its own funds and of the amount of its covered deposits; the latter depends on the fact that the flat part has to be adjusted by the risk profile of bank’s net total liabilities. Thus the ex ante contributions yearly paid by individual banks depend on their size and on their risk profile. However, the technicalities for the calculation of these contributions are still to be defined. The European Commission has to specify the indicators for assessing the risk profile of banks in order to adjust contributions in proportion to bank’s risk profile. In any case, at the standard, the total amount of the ex antecontributions will have to reach at least 1% of the total amount of the covered deposits, held by the whole set of the credit institutions within the Banking Union (approximately 55 billion of euro). This standard has to be met in eight years at the latest; hence, in normal times, the yearly amount of contributions by all the European banks involved will not exceed 12.5% of the final target.The second component is fed by the ex post contributions that credit institutions have to transfer to the SRF or to its national sections in extraordinary cases. These extraordinary contributions will become necessary, if the SRF (or its national sections during the transitionperiod) will not have a sufficient amount of resources to cover the costs not absorbed by the bail-in process. The ex post contributions of every bank should not exceed three times itsyearly ex ante contributions; and the expected amount of these ex post contributions in the following three years set the limit of the SRF’s disbursement in the case in which the meanscurrently available are below 5% of the total liabilities of the banks under resolution including their own funds.This case opens the possibility that the ex ante and ex post contributions to the SRF areinsufficient to cover the actual resolution costs. In this event, the SRF should either borrow from European aid institutions (such as the ESM), financial intermediaries and other third parties or ask for different forms of support from some of these institutions. In any case, in order to break any potential vicious circle between the European banking system and the management of sovereign debts, the working of the SRF should not have to impinge on the public budget or on the fiscal responsibilities of the EU’s Member States.3. The main weaknesses of the SRFThe utilization of the SRF is subject to a number of constraints. First, once other Europeaninstitutions act and/or decide to open a specific resolution procedure, they have to assess the existence of a public interest for this resolution action and for the utilization of the SRF. The evaluation cocnerns two main issues: the actual existence of a public interest, and the amount of the SRF resources to be utilized by the SRB. In this last respect, any material change in the exploitation of the SRF must be specifically assessed. Moreover, the access of everybeneficiary to the SRF can be subordinated to a series of conditions, commitments and undertakings. Finally, the utilization of the SRF can be hindered more easily than the implementation of a resolution plan. The latter is decided by the SRB in its executive session; at the opposite, every single member of the SRB can subordinate the approval of the SRF’s utilization above the threshold of 5 billion of euro to the decision of the plenary board. A decision by the SRB plenary session is needed once the net accumulated utilization of the SRF resources in the previous consecutive twelve months reaches the threshold of 5 billion of euro. In this case, the SRB plenary session should evaluate the actual implementation of the resolution action and the related utilization of the SRF, and should provide a guidance to the SRB executive session aimed at ensuring the non-discriminatory application of resolution tools in the future, and at avoiding a depletion of the SRF.It is important to note that this third constraint has to be combined with the other two quantitative limits in the utilization of the SRF mentioned above (that is: the bail-in process has to cover at least the 8% of the total liabilities of the bank under resolution, including its own funds; the SRF’s utilized resources cannot exceed the 5% of these net total liabilities or –if more binding - the sum between the means available to the fund and its expected ex-post contributions within three years). The combination of these three constraints limits significantly the role played by the SRF in a large part of the resolution processes.Let us add that the full operativeness of the SRF still requires the definition of a number of issues. First, the European Commission should assess whether the appropriate target level of the SRF was represented by covered deposits or total liabilities, and whether the introduction of a minimum size of the fund in absolute terms was necessary. Second, it should be specified a proportionality principle handling small credit institutions in a different way (smaller contributions) with respect to the large ones, due to the fact that the risks of the former have a minor impact on the macrofinancial stability. Third it should be decided, in the case of banking groups, whether the contributions should be based on the sum total of the single components or on the consolidated data. Finally, it would be necessary to better specify the relative weight of the two criteria (size and risk profile) which determine banks’ ex antecontributions, as well as the risk indicators characterizing banks’ risk profile. This indeterminacy is strengthened by the uncertainty which is typical of the actual working of the SFR. For instance, the fund could have to face an unexpected disbursement in the case in which the hair cut provided by the bail-in process towards shareholders and bondholders of the bank under resolution would lead to a loss higher than the one suffered under normal insolvency proceedings. This possible negative gap has to be filled by the SRF. There is also uncertainty about the borrowing capacity of the SRF. The agreement on the access of the SRF to the ESM lending, which was reached after the entry into force of the new regulation, is unclear on the existence of a binding upper limit.4. SRF as a backstopThe previous analysis shows that the SRF cannot play the role of an effective backstop in the case of a (systemic) financial crisis. In the European institutional design the SRF must be just a complement of the bail-in process. In fact the expectations of the regulators are that the large majority of the resolution actions can be managed through the bail-in, and that the remaining part of these actions asks for a marginal involvement of the fund. Moreover the SRF introduces a principle of mutualization across Member States, which contrasts with the desiderata of a number of European governments and citizen. These factors explain why the utilization of the SRF is subject to a number of ambiguous but binding constraints. On the other hand, the size of the SRF is too small and its governance is too weak but – in the meantime – too complex; and these features preclude significant and flexible transfers from the fund to a single credit institution. These limits are not overcome by the above mentioned possibility that, in extraordinary circumstances, the SRB seeks funding from the ESM, other European institutions, or market financial intermediaries. This possibility is, in fact, too constrained and ill-based to strengthen the role of the SRF.Our conclusion is that the SRF is a useful but temporary bridge to reach a new equilibrium, in the sense that it can manage (together with the bail-in) idiosyncratic shocks but not widespread or systemic shocks. It follows that a complete and satisfying working of the SRM asks for the presence of a common backstop, sufficiently strong to face systemic shocks. The regulation of the BU has not yet implemented or even conceived this kind of mechanism. On the other hand, no one of the European institutions which are currently operative, appears to be able to play this role. Hence, it seems unavoidable to have recourse to public funds: the architecture of the SRM requires a common and public backstop. In a sense, this is a contradiction since the BU was conceived to break the vicious circle between the banking crisis and the sovereign debt crisis, whereas a public backstop directly involves the public balance sheets. To avoid this contradiction, the solution could be the building of a common backstop financed by European funds.