Resolving Europe’s Bank-Resolution Problems

The creation of a European banking union is a major step forward in the region’s financial integration. The first step in this process, single supervision, became a reality earlier this month when the European Central Bank took the helm of the Single Supervisory Mechanism. The next step, the Single Resolution Mechanism (SRM), is an effort to solve the problems of too-big- and too-interconnected-to-fail and cross-border crisis management in the eurozone.

This resolution procedure is supposed to provide European authorities with an orderly means to manage failures at systemically important institutions, not least by imposing “bail-ins” in which not only shareholders but also unsecured creditors risk having to absorb losses. However, the SRM remains a work in progress, and there are serious doubts about its effectiveness.

To work, the bail-in mechanism must be both credible and predictable. Market participants must be able to reasonably expect that authorities will follow the rules in a crisis, and they must have clarity about, for instance, the order in which various levels of bondholders will be expected to take a haircut. Such a mechanism needs to be capable of securing public acceptance and allaying fears of contagion.

Such credibility is not easily achieved. To date, very few policy makers anywhere in the world have shown the discipline to stay the course during times of crisis and force banks’ creditors to accept losses. The SRM exacerbates this problem by offering regulators the option of not forcing the resolution of a failing institution if doing so might cause significant adverse consequences, including broader instability.