EU framework for Crisis Management in the Banking Sector - briefing

20 October 2009
by eub2 -- last modified 20 October 2009

The European Commission has adopted a Communication on an EU framework for crisis management in the banking sector. The purpose of the Communication is to consult as widely as possible on a broad range of issues aimed at safeguarding financial stability and the continuity of banking services in a cross border banking crisis. The Communication sets out questions on the tools that the Commission considers would be necessary for an EU crisis management framework. These tools range from “early intervention” action by banking supervisors aimed at correcting irregularities at banks, to bank resolution measures which involve the reorganisation of ailing banks, , to insolvency frameworks under which failed banks are wound up. The Commission’s consultation will last for three months, and will be followed by a public hearing to present the results and set out the Commission’s intentions.

Why is a new crisis management framework needed for the EU?

The recent crisis has exposed a clear gap in the EU regulatory framework covering the banking sector. Although much has been accomplished in recent years to ensure adequate capitalisation and prudential supervision of EU banks and to strengthen protection of depositors, far less has been achieved in the area of crisis management. In 2008, Member State authorities and Central Banks signed a Memorandum of Understanding on cross-border financial stability, setting out detailed arrangements for more effective cooperation in the event of a cross-border crisis. However the arrangements are voluntary, and do not provide an adequate legal framework to support reorganisation at a cross-border level. The Commission considers that in light of recent experiences, a more binding framework is necessary. The consultative Communication sets out the range of issues that will need to be considered to provide realistic alternatives to bailing out banks with public funds. The overriding aim is to put in place a framework that will allow a bank to fail – whatever its size - while ensuring the continuity of essential banking services, and minimising the impact of that failure on the financial system. This is essential to avoid the 'moral hazard' that arises from the perception that some banks are too big to fail.

Why didn't the EU have the necessary framework in place before the crisis?

Until recently, many felt that arrangements should only be national, especially if there was a risk that there would be budgetary implications and in view of the close connection of crisis resolution measures with national insolvency regimes in many Member States. However, the experiences of the recent crisis have strengthened the case for action at EU level since they demonstrated clearly that the absence of adequate arrangements can result in ad hoc national solutions which might ultimately prove more costly for national taxpayers.

What issues does the crisis management Communication cover?

The Communication reviews the measures that might be needed at all stages of the failure of a bank.

* Early intervention covers actions by banking supervisors aimed at restoring the stability and financial soundness of an institution when problems are developing, together with intra-group asset transfer between solvent entities for the purposes of financial support. These actions would be taken before the threshold conditions for resolution are met, and before the institution is or likely to become insolvent.
* Resolution covers measures that should be available to national resolution authorities to manage a crisis in a banking institution, to contain its impact on financial stability and, where appropriate, to facilitate an orderly winding up of the whole or parts of the institution. The Communication does not prescribe what authorities should be responsible for deciding on and applying resolution measures in Member States, but discusses what measures are needed and how national actions can be coordinated or integrated when applied to a cross-border group. One option considered is coordination by an EU resolution authority.
* Insolvency covers reorganisation and winding up that takes place under the applicable insolvency regime. The Communication asks what changes are necessary to insolvency law to support resolution measures, and whether greater coordination or integration of insolvency regimes is needed to deal with the reorganisation or winding up of cross-border groups.

Is this work intended to solve the current crisis?

The current crisis has called for extraordinary measures to be taken in order to avert a potential meltdown of the European banking industry. The decisive actions taken by Member States, in cooperation with the European Commission, have succeeded in stabilising financial markets. The measures considered in the Communication are aimed at the management of future crises. Early supervisory intervention should assist in averting preventable bank failures, while an EU resolution framework would equip national authorities with adequate tools to manage the consequences of failures that could not otherwise be avoided.

Resolution measures may interfere with the rights of shareholders and creditors. How does the Communication propose to deal with this?

Bank resolution tools that involve transfer of assets may interfere with the rights of stakeholders (creditors and shareholders), and any EU resolution framework would need to incorporate adequate safeguards to protect those interests.

For example, EU law contains a number of mandatory requirements that confer rights on shareholders. These include pre-emption rights, and the requirements that any increase or reduction of issued share capital is approved by the shareholders' general meeting. In addition to this, any transfer of ownership or assets of an ailing bank must comply with shareholders' right to property under the European Convention on Human Rights. A balance needs to be struck between protecting the legitimate interests of shareholders and enabling resolution authorities to intervene quickly and decisively to restructure a failing institution or group to minimise contagion and ensure the stability of the banking system in affected Member States. Where rights granted by EU law are affected, an EU resolution framework would also have to contain appropriate mechanisms for redress and compensation.

EU law does not currently specify the rights of creditors in the context of bank insolvency. Appropriate safeguards under a bank resolution framework might include compensation mechanisms to ensure that no creditor is left worse off than it would have been had the bank under resolution been wound up under the applicable insolvency law.

Who will pay the costs of a cross-border crisis?

The Communication addresses the issue of financing resolution measures. The emphasis is on avoidance of public sector bail-outs and on facilitating private sector solutions, such as the purchase of the whole or parts of a failing bank by another institution. Various possibilities are considered, such as putting in place a framework for intra-group financial support, or the possible involvement of deposit guarantee schemes in the financing of resolution measures. However, there is also recognition that use of public funds may be unavoidable at some stage of a resolution, and that progress is needed in clarifying how the potential costs of managing a crisis in a cross-border bank would be shared between affected Member States. Work is currently underway on burden sharing in a working group of the Economic and Financial Committee.

What resolution tools will be needed, and how will that affect national systems?

As the Communication is consultative, the question of what tools will be needed as part of a cross-border crisis management framework remains open at this stage. There are significant differences between the existing tools and systems for crisis management across Member States. A recent study by the IMF has suggested that authorities should at least have powers to facilitate or effect private sector acquisitions, transfer business to a temporary structure (such as a "bridge bank") or to separate clean and toxic assets between "good" and "bad" banks through a partial transfer of assets and liabilities. However, the Communication also notes that some Member States currently deal with failing banks using other measures, such as the appointment of a 'special administrator' under adapted national insolvency regime. It seeks views on the suitability of these, or other measures, for an EU bank resolution framework.

The Communication focuses on crisis management for cross-border banking groups, and on the need for systems which allow measures to be applied in a consistent and timely manner.

What kinds of financial institution would be covered by an EU regime?

The Communication focuses principally on crisis management in the banking sector. This focus is justified by the special nature of banks - their unique role as providers of credit, deposit-takers and payment intermediaries – which give rise to particular problems and public policy objectives in the event of a bank failure. However, it also asks whether the scope of a resolution framework should be wider and cover other kinds of financial institution, such as investment firms. Banking groups often include such institutions, and their failure may pose systemic risks to the financial system, as the collapse of Lehman Brothers clearly demonstrated. The Communication recognises that different kinds of crisis management measures may be necessary to address the specific risks to market stability represented by other types of financial institution.

How does this relate to discussions at international level?

Discussions have taken place on crisis management in a number of international fora (G20, Financial Stability Board, Basel Committee). There is broad recognition that the problems of cross-border banking groups extend beyond the EU, and many significant financial groups are global in their organisation. While certain of the problems which need to be addressed are the same - for example, the difficulties of cooperation and coordination, information sharing, the lack of effective tools, the need for better advance planning, the territorial scope of national insolvency regimes when applied to a group - there are nevertheless significant distinctions between the progress that can be reasonably expected at international level and what can be achieved within the EU. The depth of integration of both banking business and the legal framework at European level both allows and requires greater cooperation and convergence in order to develop a more robust framework to underpin the Internal Market.

Would a requirement for cross-border groups to prepare "living wills" help authorities to manage a cross-border banking crisis?

There are currently no harmonised powers for supervisors to require banking groups to prepare contingency and resolution plans, often referred to as "living wills". The idea is that systemically important cross-border financial institutions could be required to produce detailed plans to facilitate, in a period of severe financial stress or instability, the preservation of the firm as a going concern, the continuity of its financial infrastructure services, and the rapid resolution or winding down where necessary of the institution (or part of the institution). Work by national and international regulatory bodies on this subject is still at an early stage, and further analysis will be needed to assess whether a requirement for institutions to maintain detailed and up-to-date plans would be realistic, the implications of such plans for group structures and their usefulness for authorities as tool both for ongoing supervision and for crisis management.

Text of the Communication COM(2009) 561/4

Source: European Commission