European regulators have been trying to create resolution and recovery frameworks that will enable them to wind down failed banks without using taxpayers’ money. So far, they have not succeeded. But few bankers are quibbling with the progress made. 

The fall of Lehman Brothers in September 2008 still haunts bank regulators. Throughout Europe, officials are working to put in place plans that would enable big banks to go broke without causing the chaos that ensued after Lehman’s demise.

Producing credible recovery and resolution frameworks is proving tough. The process involves not only trying to coordinate among national regulators, who often barely disguise their distrust for one another, but shaking up the very structure of banks.

European progress

In Europe, two major commissions have proposed radical changes to banks’ business models in an attempt to make the financial system safer, by both bolstering the strength of individual institutions and making sure there is little contagion if they do happen to collapse. The Liikanen Report, headed by Finnish central bank governor Erkki Liikanen to cover the EU, proposed several measures in October 2012, including separating banks’ trading and deposit-taking operations and using bail-in debt instruments as a resolution tool. The Liikanen Commission was set up shortly after the UK’s equivalent, the Independent Commission on Banking (ICB), suggested that banks ring-fence their retail arms from their investment banking divisions.

As yet, regulators cannot claim to have resolution frameworks that would work if put to the test. “Do I think the problem has been solved yet? No, it hasn’t,” says John Liver, head of global regulatory reform at EY. “There’s a lot of detail to be worked through before we can say that we’ve got close to solving the issue of too big to fail. I wouldn’t belittle the progress that’s been made on the principles. It’s just that if a big bank were to fail today, you couldn’t say that taxpayers would definitely be off the hook. The building blocks are yet to be put in place.”

Like Mr Liver, however, many senior bankers are sanguine about the progress made by European officials so far. “What has been achieved in Europe in the past 18 to 24 months is unprecedented,” says Julius Baer’s Marco Mazzucchelli, who used to be the deputy head of Royal Bank of Scotland’s investment bank and was a member of the Liikanen Commission. “The individual measures might not be perfect. But taking them altogether, we are very close to having a new regulatory and supervisory framework for the European banking system that is fit for purpose.”

Conflicting strategies

Bankers still fear, however, that countries could implement conflicting recovery and resolution directives. Their concerns are fuelled by the fact that regulators, both globally and within Europe, have shown far less coordination regarding how banks should structure or resolve themselves than they have regarding new capital and liquidity requirements. “Even within the EU, there are understood to be disagreements between some neighbouring regulators on how to deal with the resolution of cross-border banks,” says Emil Petrov, head of capital solutions at Nomura.

There are some principles that seem to have been universally agreed upon. One of those is that bail-in debt – debt that can be written down or converted to equity at the point a bank runs into trouble or is deemed non-viable – will be a significant part of the answer to the resolution problem. Plenty of uncertainty surrounds the exact form of bail-in debt European regulators will eventually require their lenders to have. But analysts see little reason for policy-makers not to emerge in favour of such debt instruments, which will have the effect of making it easier for them to take over failed banks without putting their taxpayers’ money at risk.

“With bail-in, the concept is that a government would be in a position to take over a failed bank and work it down while imposing losses on creditors,” says Bill Winters, the chief executive of asset manager Renshaw Bay, former joint head of investment banking at JPMorgan and ICB commissioner. “This would make it more likely that the government would intervene in the first place.”

More broadly, there is a push towards splitting banking businesses seen as risky from those deemed less so. Both the Liikanen and ICB commissions proposed, albeit in different ways, the separation of deposit-taking arms from those carrying out trading and investment banking activities. Taking their cue from Liikanen, UBS and Credit Suisse each announced plans in 2013 to create Swiss subsidiaries by mid-2015, which they said would make it easier for them to be wound down in the event of a severe crisis.

Mr Mazzucchelli believes such moves will become more common among European banks. But he says that it does not spell the end of universal banking models. The intention of the Liikanen report, he says, was to advocate separation of business lines in terms of capital and funding, but still allow banks to carry out universal banking activities under a single holding company.

Subsidiarisation catches on 

Others agree, saying that local regulators, wary about the failure of a foreign bank with operations in their country, will also demand some form of separation. “There is definitely retrenchment from the pre-crisis model where firms could manage businesses pretty freely, cutting across jurisdictions and with heavy deference to home supervisors,” says Stefan Walter, leader of EY’s global regulatory network and former secretary-general of the Basel Committee on Banking Supervision. “Now you have host supervisors setting a range of additional demands and institutions therefore no longer just managing themselves globally by business lines.”

Closely linked to this so-called subsidiarisation is whether supervisors adopt a single or multiple point-of-entry approach to bank resolution. The former would create a greater role for the holding company, whereas a multiple entry process would involve a bank making its businesses self-funding in each jurisdiction so that they can be allowed to fail on their own. For cross-border banks with big wholesale divisions, which are typically harder to ring-fence than retail businesses, having to adapt to multiple point-of-entry regulations would be complicated.

“The debate about single versus multiple point of entry into resolution will have greater implications for the more complex cross-border institutions,” says Nomura’s Mr Petrov. “Some of these may have to re-organise their corporate structures or capital-raising and funding models, including, for example, by raising more capital and bail-in-able debt locally to suit a multiple point-of-entry approach by regulators.”

Not so life and death 

Over the next year, Europe’s bankers and analysts hope for more clarity about how regulators intend to implement rules that will affect their structures and operations. “There is still too much uncertainty about the final shape of the new regulatory requirements,” says Jan Pieter Krahnen, a professor of finance at the Goethe University and a member of the Liikanen commission. “There is an understandable hesitancy among banks to act quickly in a direction that might later prove unnecessary. The two major structural issues that still need to be decided, probably in the next year, are the separation issue and the philosophy of bail-in.”

Devising credible risk and resolution strategies is seen as essential for European banks. “If a bank can fail in an orderly way, the prevention of failure becomes less of a life-and-death situation,” says Mr Mazzucchelli.

Moreover, for banks in the eurozone, a failure to create a working resolution regime would imperil the planned single supervisory mechanism, under which the European Central Bank will later this year assume responsibility for specific tasks relating to the bloc’s systemically important banks.

The history of banking crises – not least that started by Lehman’s bankruptcy – suggests that regulators will work in their national interests when they come to dealing with failed institutions. There is no guarantee that will change should a major, cross-border European lender need rescuing in future. Yet bankers are on the whole optimistic that trust between supervisors in different countries can be built.

Mr Winters says there is a genuine desire in Europe to eliminate national bias and create a centralised resolution strategy. The obstacles, he believes, are more to do with how to fix the mistakes of the recent past. “There’s an underlying desire to create a proper eurozone banking system, with a single regulator and set of rules,” he says. “The impediment is the cost of the clean-up of the past, not the vision for the future. All the haggling right now over bank bailouts seems to be over who picks up the bill for the mistakes of the past decade.”

If European officials cannot agree in the near future about how to save failing banks, there is at least a silver lining. All the capital increases they have forced on the continent’s lenders since 2008 should make the chances of them having to test their recovery and resolution strategy that much slimmer. “Clearly, the sector has significantly increased its resilience since 2008,” says Jon Peace, head of European banking research at Nomura. “There has been a big increase in the amount of capital and the core capital ratios. But when you look at how difficult it has been to set up a single banking union, it suggests that the execution of any resolution would be unpredictable. Hopefully, however, the chances of us finding out are far lower than they were in the past.”

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