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Shadow Resolutions As A No-No In A Sound Banking Union

Shadow Resolutions As A No-No In A Sound Banking Union

Luca Enriques

University of Oxford Faculty of Law; European Corporate Governance Institute (ECGI)

Gerard Hertig

ETH Zurich; European Corporate Governance Institute (ECGI)

2015

E. Faia, A. Hackethal, M. Haliassos and K. Langenbucher (eds.), Financial Regulation. A Transatlantic Perspective, Cambridge University Press, 150-166, 2015

Abstract:

The credit crisis has generated much debate on the bailout or resolution of larger banks. By contrast, little attention has been paid to resolution procedures being generally circumvented when it comes to smaller banks. We describe how supervisory leniency and political considerations often result in public officials nudging viable banks into acquiring smaller, failing banks and show how this weakens supervision, distorts competition, and gives resolution a bad name. Recent reforms have provided EU authorities with significant incentives to follow formal resolution procedures rather than to operate in their shadow, but this is much less the case at the member state level. We propose a step-by-step approach to get national authorities to subject smaller banks to timely resolution, especially in ‘good’ non-financial crisis times.

Shadow Resolutions As A No-No In A Sound Banking Union – Introduction

The credit crisis has generated much debate on the bailout or resolution of larger banks. By contrast, little attention has been paid to resolution procedures being generally circumvented when it comes to smaller banks. In fact, supervisory leniency and political considerations often result in public officials incentivizing viable banks to acquire smaller, failing banks, which weakens supervision, distorts competition, and gives resolution a bad name. Fortunately, recent reforms have provided EU authorities with significant incentives to follow formal resolution procedures rather than to operate in their shadow.

The 2014 Regulation on a Single Resolution Mechanism (SRM) and Single Bank Resolution Fund (SBRF)1 empowers a Single Resolution Board (SRB) to closely monitor the situation of all banks and their compliance with so-called early intervention measures – i.e. measures taken by supervisory authorities in the presence of financial or other difficulties that may lead to insolvency. More importantly, the SRB is competent for adopting a resolution scheme when a bank is likely to fail and resolution action is in the public interest.2 However, before doing so, the SRB must establish the lack of reasonable prospect that any alternative private sector measures would prevent a failure within a reasonable timeframe.

In other words, private sector solutions are favored over resolution schemes, an approach that reflects two basic assumptions: whenever possible, bank reorganizations should be market-driven, and have no cost implications for taxpayers. It logically follows that a private sector solution should neither be motivated by state interests nor be based on the exercise of state powers. In the real world, however, what is called a “private” sector solution often goes hand-in-hand with state involvement. When that is the case, such a scheme, a private solution only in form, is better termed a “shadow” resolution.

Shadow resolutions can be defined as mergers and other acquisition transactions that are coerced or informally subsidized via threat of supervisory action or promise of a benevolent supervisory stance at some future time. Prototypical examples of threats include capital adequacy reassessments, regulatory investigations, and limitations in the scope of authorized activities. Prototypical examples of informal subsidies include merger assistance, facilitated market access, and compliance leniency.

While reliable data is not publicly available, shadow resolutions are a common phenomenon. Cases are regularly reported in the media and the practice is widely acknowledged in the literature. It has been documented that shadow resolutions were systematically practiced throughout Italy’s banking history and for decades post-World War II in Japan. There is also turn of the millennium evidence of restructuring mergers being frequently induced by public officials in Germany and occasionally in Switzerland. More recently, the credit crisis has prompted regulators across the world to impose mergers and acquisitions to avoid insolvency filings by larger banks.

Shadow Resolutions

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