13 November 2024

SUERF's Restoy: Post-turmoil bank failure management: the European challenges

The 2023 banking crises in the United States and Switzerland tested those countries’ post-GFC resolution frameworks. This episode showed that there are strong reasons to extend resolution planning obligations to all banks whose failure could have adverse effects on the financial system.

 Crucially, resolution plans should include well defined requirements for a minimum amount of loss-absorbing liabilities. Those requirements should be calibrated to directly support the feasibility of the envisaged resolution strategy and ideally be composed primarily of debt instruments. The EU now has a great opportunity to address the deficiencies identified in the current bank crisis management framework, particularly with regard to the failure of mid-sized banks. The European Commission’s CMDI legislative proposal is a highly valuable initiative whose main features should be preserved in the ongoing political negotiations.

Introduction

One of the most significant policy reforms that emerged from the Great Financial Crisis (GFC) was the creation of a new bank resolution framework. Under the slogan “avoid the perception of too-big-to-fail banks”, the Financial Stability Board established new standards aimed at reducing the impact of systemic bank failures.

The FSB’s Key Attributes of Effective Resolution Regimes for Financial Institutions contain the main elements of the new framework. The Key Attributes aim to facilitate orderly resolution of systemic entities without exposing public funds to losses. A key component of the new resolution regime is the bail-in tool that would allow resolution authorities to write down liabilities or to convert them into equity in order to absorb losses and, in some cases, recapitalise a firm in resolution.

During the 2023 bank turmoil, crisis management frameworks in both the United States and Switzerland were directly tested. In the US, the failure of two regional banks, Silicon Valley Bank and Signature Bank, required the use of a systemic exception as authorities felt that the preservation of financial stability justified waiving the restrictions on the support that the Federal Deposit Insurance Corporation (FDIC) is allowed to provide, in order to protect all the deposits of those banks. Moreover, a special liquidity facility was established by the Federal Reserve to ease potential system-wide funding pressures.

In Switzerland, the crisis of Credit Suisse, a global systemically important bank (G-SIB), was not managed under the new resolution framework but rather through a series of ad hoc measures taken to facilitate the absorption of Credit Suisse by UBS without the formal declaration of Credit Suisse as a failing institution. Moreover, although the measures adopted outside resolution included a substantial bail-in of some creditors, they also entailed the provision of public guarantees to support the liquidity and solvency of the resulting institution.

Arguably, the actions taken by authorities met the primary objective of preserving financial stability. At the same time, those actions did not follow the usual procedures and, contrary to the objectives of the post-crisis reforms, required different forms of external support.

While not directly affected by last year’s turmoil, the application of the new resolution framework in the European Union had previously shown relevant flows. In particular, the crisis of two significant Venetian banks in 2017 had to be resolved with a large amount of government intervention. That triggered a still ongoing discussion on how to improve the current crisis management framework. In particular, there is now relatively broad consensus that, at present, there is no effective mechanism to deal with crises of mid-sized banks without public support.

This article discusses some of the issues that the recent turmoil and other recent bank failure episodes in Europe have raised in relation to the current policy framework for bank crisis management.¹

Some issues stemming from the recent turmoil

Resolution planning

The speed with which apparently solvent banks became failing banks, particularly in the US, points to the need to strengthen resolution planning (FDIC (2023a)). This should first be achieved by enlarging the scope of application of meaningful resolution planning obligations to all banks that can be systemic in failure – something that is not yet the case in some jurisdictions, notably the US.

In addition, resolution plans for international banks should address practical issues relating to the operationalisation of resolution actions – particularly bail-in – in a cross-border context. Given that debt securities earmarked to be bailed-in in resolution are typically issued in international financial centres, it is important that resolution decisions – such as a conversion of debt securities into equity – be effective in all relevant jurisdictions.

Moreover, resolution plans should contemplate different options and not focus on just a single resolution strategy (FSB (2023a,b)). As the case of Credit Suisse shows, the preparatory work conducted around the development of the entity’s resolution plan proved very useful for managing the failure of the bank, even if the plan was not ultimately implemented. Yet the process would have been smoothed if, in addition to contemplating a massive bail-in, the plan had included provisions for a possible full or partial sale of business (SoB).

Loss absorbency

One of the main ingredients of the new resolution framework – and of the new resolution planning and resolvability requirements – that emerged from the crisis is the availability of sufficient resources within systemic banks’ balance sheets to absorb losses and, if needed, recapitalise the institution after resolution is triggered. In particular, the FSB has issued standards for total loss-absorbing capacity (TLAC) that all G-SIBs should comply with.

In jurisdictions where the new resolution framework is being applied beyond G-SIBs (like the EU), there is a version of the TLAC standard, the minimum requirements for eligible liabilities (MREL), that is also binding for less systemic institutions. In other jurisdictions, such as the US, no TLAC-type requirement is applied for non-G-SIBs. Therefore, most US banks – including those failing in the recent turmoil – had no specific obligation to hold liabilities that could absorb losses in resolution beyond the capital requirements established in prudential regulation.

However, a recent proposal by the FDIC (Gruenberg (2023) and FDIC (2023b)) would require banks with more than $100 billion in assets to satisfy minimum long-term debt requirements. The counterpart of those debt instruments on the asset side could be transferred to the acquirer, but the debt instruments themselves would be left in the residual entity to be liquidated. This would make those debt instruments act as gone-concern capital supporting the transfer transaction (Restoy (2023)).

MREL obligations in the EU are, on average, substantially larger than the long-term debt requirements now considered in the US.² However, while the proposed US requirements can only be met with debt, MREL targets in the EU can be met with a variety of eligible liabilities that include equity, debt and even some non-covered deposits. In reality, many small and mid-sized institutions in the EU cover a large part of their MREL requirements with equity instrument.³ This is probably due to the fact that it is difficult for those banks to tap regulated debt markets, given their lack of experience and their specific business model.

From a conceptual point of view, there is merit in, at least, limiting the eligibility of equity to satisfy gone-concern capital requirements. Experience shows that, unlike long-term debt, equity instruments tend to disappear quite quickly as a bank approaches the point of non-viability and during the resolution process itself as hidden losses emerge in the balance sheets.⁴ Therefore, equity, being the most powerful loss-absorbing instrument in going-concern, might simply not be available in gone-concern....

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