Bank resolution credibility and economic implications

Abstract

This paper tests the credibility of the bank resolution regime in the European Union in removing the implicit public guarantee that governments will bail-out their troubled banks, and discusses the implications of a resolution regime with limited credibility. It argues that the removal of the implicit guarantee, and thus the perceived credibility of the regime hinge greatly on the adequacy of funds envisaged for bank resolution in any given case, and on the willingness of a government to place a bank into resolution first, before bailing it out. As such, to test whether the implicit guarantee is removed, the paper analyses the adequacy of the envisaged funds by looking at their technicalities and their target-levels, starting from internal and external funding (the bail- in tool and capital markets) to the newly created Single Resolution Fund (SRF), National Resolution Funds (NRFs), Deposit Guarantee Scheme (DGS) and the Direct Recapitalisation Instrument (DRI) of the ESM. This analysis comes to the conclusion that the regime might not provide adequate funding for every given bank resolution, and as such it creates winners and losers under a limitedly-credible regime. This finding can have some important economic implications. Most importantly, it aggravates the inconsistencies of the cost of funding of different banks. Also, where it fails to remove the implicit guarantee, it creates an ever closer link between the cost of funding of the bank and its sovereign's credit rating instead of severing the sovereign-bank default loop. Nevertheless, the paper acknowledges that in order to construct a fully credible regime much higher sources of funding would be needed, which would pose huge opportunity losses and hurt the profitability of banks perhaps to a disproportionate extent. As such, the paper settles that the current regime might be a good compromise in terms of the limited credibility it provides.

The ADEMU Working Paper Series is being supported by the European Commission Horizon 2020 European Union funding for Research & Innovation, grant agreement No 649396.