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A decade after Lehman, EU still far from solution to too-big-to-fail

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A decade after Lehman, EU still far from solution to too-big-to-fail

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Europe's bank resolution regime faced its biggest tests in 2017 and 2018, nearly a decade after the financial crisis. But the framework is incomplete and observers warn major challenges remain.

The European Bank Recovery and Resolution Directive was applied for the first time in June 2017, when Spain's sixth-biggest lender Banco Popular SA was resolved, wiping out share- and bondholders. Resolution was an option in the case of two Italian banks — Banca Popolare di Vicenza SpA and Veneto Banca SpA — later that month but the ECB agreed they could be wound down and recapitalized with public money. And then, in 2018, it allowed Latvia's ABLV Bank AS to be liquidated, ruling its case did not pass the same public interest test as that of Banco Popular.

Special insolvency rules

The only way to avoid concerns about too much national discretion in liquidation cases is to improve consistency across the EU, Warwick University law professor Dalvinder Singh said in an interview. Not all banks that are supervised by the ECB and considered significant are necessarily systemically important for the whole EU financial system, which results in anomalies when it comes to resolution, he said.

"[I]n a context in which not all banks could be subject to effective bail-in under a resolution framework, it is natural to expect that in the future a higher proportion of failing banks will be subject to insolvency procedures ," Fernando Restoy, chairman of the Bank for International Settlements' Financial Stability Institute, said in a speech in March.

The creation of "specialized insolvency procedures" for failing banks in all jurisdictions may help lower the related risks to financial stability, he said. This is even more pressing in the EU, "given the difficult compatibility of a common resolution framework, operated by a European authority, with a constellation of highly heterogeneous insolvency rules applied at the domestic level," Restoy said.

Bail-in buffers

Another aspect of the Bank Recovery and Resolution Directive, namely the requirement for a buffer of bail-in-able debt, could drive a clear division of the European banking system into two distinct groups: Larger systemically important institutions which will be subject to resolution in case of failure, and smaller lenders which will go into liquidation, according to Restoy.

Under the directive, EU regulators have to set a minimum requirement for own funds and eligible liabilities, known as MREL, for all banks, not just the global systemically important institutions. Building the required MREL buffers will be a particular challenge for the plethora of small and medium-sized banks in Europe, many of which rely on deposits for their financing and have limited access to the capital markets.

Roughly 70% of significant banks under direct supervision by Europe's Single Supervisory Mechanism are not listed, some 60% have no experience with issuing convertible securities and 25% have not issued subordinated debt before, Restoy said.

Making MREL debt issuance work for smaller European banks, such as those in central and eastern Europe, will be tough for EU resolution authorities, S&P Global Ratings analyst Bernd Ackermann said in an interview. "[T]hey have to change their funding strategy and instead of having granular, and from our perspective relatively safe and reliable, retail deposits, they would have to somehow go into the market and issue bail-in-able bonds," he said.

This could increase the risk profile of these institutions and the MREL debt funding could actually be more expensive for them if there is insufficient investor base for such instruments in their home markets, Ackermann said.

The EU's MREL requirements will go beyond the global standard for total loss-absorbing capacity in terms of the size of bail-in-able buffers and they will also take longer to implement, Restoy said. EU regulators have set a general MREL of 8% of total liabilities but will determine additional MREL targets for banks on a case-by-case basis. Although a prolonged transition period for reaching the final MREL targets gives the markets more time to absorb the new issuance of subordinated debt, it also creates risks for lenders, according to Restoy.

Liquidity in resolution

Compared to the U.S. or the U.K., the EU still lags behind in terms of ensuring funding for banks in resolution, according to S&P Global Ratings analysts. The lack of progress in some areas, most notably the finalizing of MREL requirements for individual banks, in 2017, has been surprising, they said. Finding a solution is becoming increasingly urgent although getting cross-border support may be tough, they added.

The EU provides a safeguard for banks in resolution through its Single Resolution Fund, which is expected to reach more than €60 billion by the end of 2023, from €25 billion currently. However, even with the extra credit line, the fund will not have enough liquidity to back a failing large systemically important bank or a series of smaller banks, Elke König, head of the Single Resolution Board, said in a board meeting June 12.

Time is of the essence in resolution cases, which is why the ECB has introduced the concept of "eurosystem resolution liquidity" which could fill the funding gap a bank may face in a resolution, Rabobank Research credit analyst Vaclav Vikar said in an email.

However, the proposal is in its very early stages and would require eurozone-wide approval, according to S&P Global Ratings. This leaves the funding-in-resolution issue for EU banks open until the end of 2018 at least.

S&P Global Ratings and S&P Global Market Intelligence are owned by S&P Global Inc.