How to improve funding of bank resolution in the banking union: the role of deposit insurance
Speech by Mr Fernando Restoy, Chairman, Financial Stability Institute, Bank for International Settlements, at the 2021 Biennial International Association of Deposit Insurers Research Conference "Navigating the New Normal for Financial Stability, Deposit Insurance and Bank Resolution", Basel.
Introduction
It is a pleasure to participate in this event organised by IADI.*
This research conference provides a great opportunity to scholars in the field to share, among other contributions, analytical work on the interaction of crisis management frameworks with deposit insurance. This is a key issue within the ongoing reflection in the European Union on how to improve the current arrangements for bank failure management1 and, in particular, on how to best adjust the existing funding mechanisms.
It is unlikely that authorities will be able to achieve consensus quickly on what to change and how to do it. But the ongoing discussions already show that an agreement may be emerging on the diagnosis of a few relevant flaws of the current framework
First, at present the banking union lacks an efficient and sufficiently harmonised framework to deal with bank insolvency. Second, the combination of a common resolution framework with a constellation of heterogeneous insolvency regimes generates inconsistencies that can severely damage authorities' ability to deal with the failure of systemic banks without relying on taxpayers' support. And third, some banks are too large for their failure and market exit to be managed through conventional insolvency regimes, but still do not qualify, or cannot meet requirements for, resolution under the Bank Recovery and Resolution Directive (BRRD). These banks are what I have referred to elsewhere as the "middle-class".2
Some of us have long been suggesting that the above deficiencies could be largely corrected by putting in place harmonised mechanisms to facilitate transfer transactions – such as the sale of a suitable combination of deposits and assets from the failing entity to an acquirer – for small and medium-sized banks under both resolution and insolvency. Under the EU resolution framework, such transactions are labelled "sale of business" (SoB). In that regard, a helpful reference – although not a full solution – can be found in the US regime administered by the Federal Deposit Insurance Corporation (FDIC).3
Those mechanisms would entail adjustments in the institutional framework at the EU and national levels. However, the most important modifications affect the available funding arrangements for relevant crisis management strategies. Money is, as always, key. In crisis situations, sufficient funds are required to protect the public interest when resolving banks (ie the continuation of critical functions). In addition, they may be needed to preserve banks' net asset value and therefore to protect the interest of the deposit guarantee scheme (DGS) and other creditors under insolvency.
The amount of funding needed crucially depends on the chosen bank failure management strategy. The market exit of a failed bank – even when its critical functions are preserved through an SoB transaction – typically requires fewer resources than its restoration through recapitalisation.
In what follows, I will review the existing funding mechanism and propose a few concrete modifications that could help address the main drawbacks of the current setup.
The existing funding mechanisms
In principle, there are three different sources of funding for the orderly management of bank failures under resolution or insolvency: public funding, a bank's internal loss-absorbing capacity and industry-funded sources such as a deposit guarantee scheme or resolution fund.
The most direct form of funding is government bailout. That has been, in practice, the most relevant funding source for managing the failure of significant banks to date. The new resolution framework, however, is built with the objective of avoiding recourse to government funds to maintain the critical functions of failing banks. Yet, as recent experience shows, taxpayer funds are still available to fund banks' exit from the market under national insolvency regimes.
At the other extreme, a core source of funding is banks' own internal resources. Creditor bail-in – ie the writedown or conversion into equity of debt instruments for loss absorption and recapitalisation – could fund the continuation of critical functions by failing banks. This is the cornerstone of the new resolution framework.4 In order to make this strategy feasible, banks that may be resolved are typically asked to issue a sufficiently large amount of debt instruments that could be bailed-in in resolution. In the EU, that takes the form of a minimum requirement for own funds and eligible liabilities (MREL).
The current SRB approach to setting MREL aims at ensuring that all banks whose failure may have public interest implications should have a credible resolution strategy that entails no need for external support, from either the government or industry-funded sources, such as a resolution fund or a DGS. To meet that objective, banks subject to a preferred resolution strategy based on open bank bail-in must satisfy MREL requirements that are consistent with their estimated needs for loss absorption and recapitalisation in resolution, so that the entity can continue to operate immediately after resolution, pending restructuring.
For banks with a credible SoB transaction as a preferred strategy, MREL needs could, in principle, be lower as the bank will cease operating after resolution. However, given the uncertainty about the availability of a suitable buyer at the point of resolution, the SRB also develops a variant strategy for such banks that is less dependent on third parties and market conditions. In most cases, that is open bank bail-in. The SRB then calibrates MREL at the level needed to implement that variant strategy.5 As a consequence, significant banks in the banking union are generally asked, in practice, to satisfy stringent MREL requirements regardless of their preferred strategy. In other words, MREL is effectively calibrated so as to primarily accommodate a restoration strategy. However, the SRB may need to adjust this approach somewhat as the new Single Resolution Mechanism Regulation (SRMR) explicitly links possible adjustments to MREL requirements to the needs of the preferred resolution strategy.6
A third source of funding is the national DGS. Those funds can contribute to supporting transfer transactions in both resolution and insolvency. However, there is a tight limit on that contribution (a financial cap): funds provided by the DGS cannot exceed the net costs for the DGS of paying out deposits if the bank in question is wound up under the national insolvency procedures. "Net costs" in this context refers to net of the recoveries the DGS would have made in a liquidation following a payout of insured deposits. In the EU, DGS claims rank senior to other deposits and securities issued by banks (they are "super-preferred"), so expected losses for the DGS in liquidation and, therefore, the available support for a SoB transaction are typically small when not negligible. Therefore, while a financial cap is a necessary protection for DGS funds that prevents excessive expenditure in a single bank failure, the way in which the cap currently applies makes DGS support for SoB transactions largely irrelevant in practice.
Finally, another source of possible funding for bank failure management in the banking union is the Single Resolution Fund. The SRF is only available for banks meeting the positive public interest assessment required for resolution. Available SRF support is capped at 5% of total liabilities and, more importantly, requires the prior writedown of at least 8% of total liabilities.
Minimum bail-in requirements ensure that the SRF funds are available only when the liabilities that can realistically absorb losses – ie without undermining the effectiveness of the resolution or the resolution objectives – have done so.7
The 8% minimum bail-in condition for SRF access is imposed across the board regardless of the failing bank's preferred resolution strategy. It does not therefore accommodate the situation of banks with a large amount of deposits relative to other liabilities that can absorb losses without unintended effects. Imposing the same minimum bail-in conditions for SRF access by any bank further reinforces the SRB's approach of imposing stringent MREL requirements on all significant banks irrespective of their preferred resolution strategy.
The current framework is therefore internally consistent: restrictions on the use of DGS and SRF funds to facilitate an SoB transaction justifies requiring all banks to satisfy large MREL requirements. Banks that can meet those conditions may credibly be subject to open bank bail-in (as the preferred or a backup strategy) and may also satisfy the conditions required to obtain SRF support if that is needed. The problem, of course, is that a relatively large subset of banks under the SRB remit run business models that could not easily cope with the conditions imposed (MREL requirements) for their resolution strategies.8
On the basis of the new provisions of the SRMR, the SRB will need to adjust downwards MREL requirements for all banks whose preferred resolution strategy is SoB. However, under current arrangements that adjustment cannot realistically be far reaching.9 Without further reforms that would increase the feasibility of SoB for a failing bank, the lack of sufficient loss-absorbing liabilities could severely jeopardise the orderly resolution of that bank. Absent a suitable buyer, the bank might only be able to continue operating and have access to the SRF if sensitive liabilities – such as deposits – were bailed-in.
Therefore, solving the middle-class issue requires a comprehensive approach that could lead to a new internally consistent setup that would be less disruptive than the current one. That might be achieved by adopting three main reforms: (i) first, make DGS funding less restrictive by replacing the current super-preference of covered deposits by a general depositor preference rule; (ii) second, redefine the methodology for calculating MREL requirements for banks with a resolution plan based on SoB transactions to accommodate a higher likelihood of success of that strategy; and (iii) replace the currently universal 8% minimum bail-in conditions for SRF access by a case by case calibration linked to MREL requirements. Let me review each of those three proposals.
Remove super-preference of deposits
In order to change the status quo, the first step would be to explore sensible ways to facilitate the DGS funding of SoB transactions without altering the core principles of the current framework. The most obvious way to do that is by eliminating the super-preference of DGS claims or, more specifically, to replace the seniority of covered over uncovered deposits by a general depositor preference rule.
Indeed, the super-preference of DGS claims is at odds with the prevailing regime in other jurisdictions (such as the United States) where DGS funds have been successfully used for bank failure management.10 More importantly, it does not have a clear policy rationale. DGS are created to serve a specific public objective: to prevent bank runs that could be destabilising for the system. Making DGS exposures senior to other deposits in case of insolvency in fact provides incentives for runs by uninsured depositors, and thus jeopardises the very objective of the DGS. In addition, from a social point of view, it is not straightforward to justify protecting the interest of banks contributing to the DGS more than deposits held by firms, or by households for amounts that exceed the established threshold for DGS coverage.11
In recent work conducted at the FSI, we show that replacing the existing super-preference of covered deposits by a general depositor preference would have a material impact on available funding. In particular, for banks holding large amounts of non-covered deposits, removing the super-preference would substantially amplify the support that the DGS could provide, thereby making the transfer transactions much more feasible under either resolution or insolvency.
However, even with a less restrictive financial cap linked to a general depositor preference rule, the available DGS support will not always be sufficient to ensure the success of SoB. That strategy crucially requires banks to be able to absorb losses stemming from a shortfall of transferred assets relative to transferred liabilities.
Redefine MREL requirements
In a typical SoB transaction, acquirers assume sensitive liabilities (in particular covered and uncovered deposits) and receive, as a counterpart, a subset of a bank's assets. If the assets are insufficient, the shortfall may be made up by DGS funding, if available. Quite often, though, the accounting value of the assets required by the acquirer would be larger, despite the DGS support, than that of transferred liabilities. As a counterpart to those additional assets, the bank would need to have in its pre-resolution balance sheet a set of subordinated liabilities that would not be transferred and would therefore be liquidated, as part of the residual entity, once the SoB transaction was performed. Those liabilities would need to be able to absorb losses after failure, thereby acting as gone-concern capital.
Therefore, in order to accept a resolution plan based on an SoB strategy, authorities should ensure that the bank has sufficient loss-absorbing liabilities – beyond regulatory capital – to effectively fund, together with the available DGS support, the transfer transaction. In principle, that should be the main criterion used to specify MREL requirements for banks with a sufficiently credible SoB resolution strategy. The current approach, under which MREL for an SoB bank is determined by the need to prepare for a variant open bank bail-in strategy is only warranted when, as happens now, the transfer transaction is highly uncertain due to the lack of proper funding.
Analytical work at the FSI (Restoy et al (2021)) provides some ideas on the calibration of MREL requirements for banks pursuing credible SoB resolution strategies. Assuming that deposits are the only liabilities that need to be transferred to the acquirer, the study shows that the amount of required gone-concern capital for SoB banks can be calculated as a function of the amount of non-covered deposits and the estimated value of the franchise. The latter is expressed as the difference between the value of the assets for the acquirer and the expected recoveries in a piecemeal liquidation.
Note, however, that with super-preference of covered deposits, the sensitivity of required gone-concern capital to non-covered deposits would be greater than it would be with general depositor preference. In the latter case, the net costs for the DGS in liquidation, and, therefore, the available support for the SoB transaction, increases with the proportion of non-covered deposits, Therefore, for the same amount of non-covered deposits, a feasible SoB strategy would require the transfer of more assets (and therefore more MREL) with super-preference than with general depositor preference.
Recalibrate minimum bail-conditions for SRF access
A third ingredient of the new funding strategy would be the revision of the 8% minimum bail-in requirement for banks, with an SoB strategy, that meet the public interest threshold for resolution. Once the funding strategy is substantially improved by combining the relaxation of the financial cap for DGS funding and the establishment of sensible MREL requirements, the feasibility of an SoB transaction for banks with traditional business models would be substantially enhanced. Therefore, it would no longer necessarily be the case that those banks should also be prepared for open bank bail-in when their preferred resolution strategy is a transfer transaction.
In order to preserve the consistency of the framework, minimum bail-in requirements for access to the SRF should be calibrated for each bank on the basis of its specific MREL requirements. The latter would already reflect how many losses should, in principle, be allocated to creditors (other than depositors) to facilitate the transaction. For banks with a preferred open bank bail-in strategy, that approach may not lead to substantially different minimum bail-in requirements as MREL obligations should normally suffice to meet the required 8% threshold. However, for banks subject to an SoB strategy, minimum bail-in would be smaller as MREL requirements would also be smaller as they only need to facilitate orderly market exit.
A final comment
Note, finally, that a scheme in which SoB transactions become more feasible, owing to the availability of internal and external funding, may be, under some conditions, consistent with a more integrated approach to bank failure management. If SoB could often be used in both insolvency and resolution, in both cases with the support of the relevant DGS, the dividing line between the two frameworks is to some extent blurred.
In that context, the natural way forward would be to centralise decision-making for all entities, whether significant or non-significant, within the same body (the SRB) and to make available a single (European) DGS (a European deposit insurance scheme (EDIS)) that could – beyond paying out covered deposits – fund SoB transactions with a sensible financial cap.
Of course, other less ambitious options – which do not require the creation of an EDIS with all the desirable powers and tools – could also be considered. For example, the alleviation of the financial cap for the deployment of national DGS funds, without further reforms, could facilitate by itself SoB transactions for national insolvency procedures. That would help make failure management procedures for smaller banks more efficient. Yet that option would fall short of providing sufficient relief for mid-sized banks which – while meeting the public interest test – could not easily satisfy the current minimum-bail-in conditions for access to the SRF.
An alternative option would be to relax the minimum-bail-in conditions for SRF access for banks with a credible SoB strategy without modifying the financial cap for national DGS. That option would increase the SRF's ability to facilitate – using European funds – transfer transactions and could therefore help reduce MREL requirements for mid-sized banks that satisfy the public interest test. However, that option would not help improve the efficiency of insolvency procedures for all banks that do not satisfy the public interest test and therefore need to be subject to domestic insolvency procedures.
Those options could prove helpful in achieving a complex political compromise. However, any option to improve the crisis management procedures without completing the banking union with an EDIS would intrinsically be subject to the vulnerabilities associated with the remaining links between bank risks and the availability of domestic funds to address them once they materialise
References
European Commission (EC) (2021): Targeted consultation on the review of the crisis management and deposit insurance framework, January.
Federal Deposit Insurance Corporation (FDIC) (2017): Crisis and response: an FDIC history, 2008–2013.
Garicano, L (2020): "Two proposals to resurrect the Banking Union: the Safe Portfolio Approach and SRB", paper prepared for ECB conference on "Fiscal policy and EMU governance", Frankfurt, 19 December.
Gelpern, N and N Véron (2020): "A European FDIC: what it means and how to do it", forthcoming.
König, E (2021): "The crisis management framework for banks in the EU: what can be done with small and medium-sized banks", keynote speech at the Banca d'Italia workshop on the crisis management framework for banks in the EU, 15 January.
Restoy, F (2016): "The challenges of the European resolution framework", closing address at the conference "Corporate governance and credit institutions' crises", organised by the Mercantile Law Department, UCM (Complutense University of Madrid), Madrid 3 November.
--- (2018) "Bail-in in the new bank resolution framework: is there an issue with the middle class?", March, speech at the IADI-ERC International Conference "Resolution and deposit guarantee schemes in Europe: incomplete processes and uncertain outcomes", Naples, 23 March.
--- (2019): "How to improve crisis management in the banking union: a European FDIC?", speech at the CIRSF Annual International Conference 2019 on "Financial supervision and financial stability 10 years after the crisis: achievements and next steps", Lisbon, 4 July.
Restoy, F, R Vrbaski and R Walters (2020): "Bank failure management in the European banking union: what's wrong and how to fix it", FSI Occasional Paper, no 15, July.
--- (2021): "How much MREL for mid-sized banks?", forthcoming.
Single Resolution Board (SRB) (2020): "Minimum requirements for eligible liabilities (MREL). SRB policies under the banking package", December.
Visco, I (2021): "The crisis management framework for banks in the EU. How can we deal with the crisis of small and medium-sized banks?" Welcome address at the Banca d'Italia workshop on the crisis management framework for banks in the EU, 15 January.
* I am grateful to Rastko Vrbaski and Ruth Walters for helpful comments on an earlier draft and to Christina Paavola and Dung Tran for administrative support. The views expressed are my own and do not necessarily reflect those of the BIS or the Basel-based standard-setting bodies.
1 See the public consultation recently issued by the European Commission (EC (2021)).
2 See Restoy (2018).
3 See eg Restoy (2019), Restoy et al (2020), Gelpern and Véron (2020), Garicano (2020), König (2021) and Visco (2021).
4 The BRRD requires use of bail-in powers where that is necessary to give effect to loss absorbency by creditors to the same extent as they would in insolvency (BRRD Articles 34(1)(b) and 37(2)).
5 See SRB (2019).
6 See SRMR, Article 12d (3).
7 Moreover, it ensures that, where such funding is provided through the purchase of shares, all losses, including those that are potentially hidden, have already been absorbed and any conversion of liabilities has taken place, allowing the SRF to purchase undiluted shares (BRRD Article 44 (4) b).
8 This is particularly the case for banks mostly funded by capital and deposits with limited or no experience tapping capital markets to obtain external funding. Within the Single Supervisory Mechanism (SSM), 70% of significant institutions are not listed on the markets, almost 60% have never issued convertible instruments and almost one quarter do not finance themselves with subordinated debt (Restoy (2016, 2018)).
9 The SRB now calibrates the adjustment factor in the interval between 15% and 25% of the recapitalisation amount component of MREL (SRB (2020)).
10 See FDIC (2017).
11 See Restoy et al (2020).
