Fernando Restoy, President of the Financial Stability Institute, explained -in his speech at the Regional Conference of the Centenary of UNIDROIT (International Institute for the Unification of Private Law) in Paris on 1 September- the inefficiencies of the current banking resolution framework and how it could be improved:
Allow me to begin by congratulating UNIDROIT on its centenary. It is a little older than the Bank for International Settlements (BIS), which has to wait four more years to reach this milestone. But both enjoy extraordinary longevity.
Both the BIS and UNIDROIT were founded in the period following the Great War. It was a time when the world was witnessing the first efforts to build an international order designed to help maintain peace and stability, providing the means to resolve disputes before they degenerated into bloodshed. Both have survived the turmoil of the last century, with its devastating international conflicts, tectonic geopolitical shifts, and economic crises. The fact that these two international institutions continue to thrive and work towards common solutions – whether in the field of international law or global monetary and financial stability – is a testament to the value and necessity of international cooperation.
My knowledge of UNIDROIT was superficial when, in 2021, Professor Ignacio Tirado invited the Financial Stability Institute (FSI) of the BIS to collaborate on the development of a legislative guide on banking liquidation regimes. We gladly accepted and joined UNIDROIT in what turned out to be a demanding but rewarding experience.
Over the years, the FSI has carried out several projects on banking insolvency regimes. Two facts that systematically emerged from our studies explain our interest in UNIDROIT's initiative. The first is the diversity of regimes among different jurisdictions. This clearly represents a problem when the failure of a bank has an international dimension, but it can also lead to suboptimal outcomes at the national level if the internal framework is not adapted to the particularities of banking entities. This connects with the second fact: many of these regimes are unable to preserve value and avoid costs for taxpayers because they lack the proper tools to manage the risks posed by bank failures.
UNIDROIT's Legislative Guide on Banking Liquidation aims to address this issue by supporting jurisdictions in designing effective liquidation frameworks that recognise the special nature of banks. In time, it should also foster alignment and reduce harmful disparities. The Guide was adopted last summer and, to celebrate the achievement, the FSI organised an event alongside UNIDROIT in Basel. We now use it regularly in our training and outreach activities.
I will dedicate the rest of my remarks precisely to banking bankruptcy regimes. Given that this centenary event is being held in Europe, I will focus on the European Union or, more specifically, on how the current crisis management framework within the European banking union could be improved.
Inefficient frameworks often generate unnecessary burdens and costs for authorities and entities. The MUR is no exception.
The functioning of the Single Resolution Mechanism
The banking union project – composed of the Single Supervisory Mechanism (SSM), the Single Resolution Mechanism (SRM), and the still pending European Deposit Insurance Scheme (EDIS) – represents a significant step towards greater integration and better crisis prevention and management.
The SRM, in particular, has made remarkable progress in just over a decade. Starting from scratch, the project has set up the mechanisms and capabilities necessary to make resolution a credible option. All significant entities have established resolution plans and meet their minimum requirements for own funds and eligible liabilities (MREL), which means they should have sufficient loss absorption capacity to support their resolution. This should reduce the need for external funding from resolution funds or public backstop mechanisms. However, despite the successes of the framework, its efficiency is hampered by various features arising from the unique European institutional structure.
By “efficiency” I mean the ability of a framework to achieve its objectives without complexity, uncertainty, or unnecessary costs. The concept differs from that of effectiveness, which is the ability to produce the intended results.
Inefficient frameworks often generate unnecessary burdens and costs for authorities and entities. The SRM is no exception. Deficiencies that become particularly relevant when, following the Draghi and Letta reports, policymakers agree on the need to promote competitiveness by increasing the efficiency of EU regulation.
Moreover, the defects I will outline ultimately limit the capacity of the “pillar” of resolution to support the objectives of the banking union. Those objectives are clear: to de-nationalise banking risks and promote a more integrated European banking market. None of these goals have been fully achieved. Little progress has been made in integrating the banking sector, and the link between banks and sovereign risk has not been entirely eliminated because, once other options are exhausted, public backstop funding for crisis management remains national in nature.
In the remainder of this speech, I will outline three specific characteristics of the SRM that undermine its efficiency and I will analyse how each one is linked to the European institutional framework. I will then briefly compare the SRM with other frameworks before exploring the measures that would be needed to address these issues.
The adoption and implementation of a resolution plan by the SRB involves the ECB, the European Commission, possibly the Council, and the relevant national resolution authorities, in addition to the SRB itself.
Characteristics of the current resolution framework of the banking union
I will focus on the three characteristics that are most significant for the efficiency of the SRM. The first relates to procedural complexity. Resolution in the banking union involves multiple authorities. The Single Resolution Board (SRB) is responsible for all significant banks. However, it cannot act on its own. When an entity is on the brink of failure and rapid intervention is required, the adoption and implementation of an SRB resolution plan involves the ECB, the European Commission, possibly the Council, and the relevant national resolution authorities, in addition to the SRB itself.
This is largely due to constitutional limitations. Since the SRM is an agency and does not have an explicit basis in the EU Treaties, legal principles on delegation of powers apply. Although this doctrine is evolving – many of you will be familiar with the details of the case law of Meroni – limits on the exercise of discretionary powers by the SRB persist. This explains the involvement of the Commission and other authorities in a complex decision-making process in circumstances where time is a critical factor.
The second characteristic pertains to the multi-level nature of the framework. Resolution is governed by a complex combination of European and national legislations. This feature of the EU framework is not unique to resolution, but it generates substantial complexity and inefficiencies in this context.
The SRM coexists with national resolution regimes. In situations of operational normality, resolution planning for significant banks involves both the SRB and national resolution authorities. The requirements for loss absorption capacity – MREL – are calibrated by the SRB under European regulations, but they are imposed on entities under national legislations.
In the event of resolution, the SRB's plan must be executed by the relevant national authority using the powers granted to it by its local resolution regime.
Moreover, resolution frameworks are built on a mosaic of unharmonised national insolvency regimes. Among other things, this considerably complicates safeguards for creditors, given that the maximum losses they can incur in a resolution are determined by the losses they would have suffered in a liquidation: a benchmark that varies depending on the applicable national insolvency regime.
The third characteristic relates to financing. This is, perhaps, the area where the defects are most relevant. Financing for resolution can come from three main sources: (i) the creditors and shareholders of the entity, through its internal loss absorption capacity; (ii) external financing mechanisms, such as deposit guarantee systems and resolution funds; and (iii) taxpayers, through public backstop mechanisms (backstops).
The MREL framework –strict and detailed– is burdensome for entities and complex to implement.
In the banking union, access to external financing mechanisms is subject to conditions and the amount available is capped. For example, the Single Resolution Fund (SRF) can only be used after the shareholders and creditors of the failing bank have absorbed losses equivalent to at least 8% of the total liabilities and own funds of the entity.
Once this hurdle is overcome, the funds available from the SRF cannot exceed 5% of the total liabilities of the bank. Moreover, the SRM regulation does not provide for direct government support of an extraordinary nature during a resolution.
The corollary of these limitations on external financing is a marked emphasis on the loss absorption capacity of the banks themselves as the primary source for financing resolution. This explains the MREL framework – strict and detailed – whose deployment is burdensome for entities and complex to execute.
This approach to financing has its roots in a deep aversion to sharing the costs arising from a bank's failure, a factor that has also hindered the consummation of the banking union. It is the reason why the EDIS has not yet been agreed, why the firepower of the SRF is ultimately limited, and why, as a consequence, banking risks have not yet been fully de-nationalised.
Are other jurisdictions more efficient?
I have outlined three areas where the inefficiencies of the SRM are linked to institutional traits and inherent complexities of the banking union: the concurrency of multiple authorities, the coexistence of community and national rules, and the constraints on mutualising funds.
How does the SRM compare in terms of efficiency when compared to other frameworks? When we contrast it with two jurisdictions with developed banking markets – the United Kingdom and the United States – the SRM fares worse in several respects. I will highlight a few brief examples.
The number of authorities involved in a resolution and the complexity of the decision-making process in the SRM constitute a case sui generis. There is nothing comparable in those other jurisdictions, where a designated resolution authority – the Bank of England or the Federal Deposit Insurance Corporation (FDIC) – has the necessary powers to act. In those countries, decision-making only involves other bodies in exceptional circumstances, such as when extraordinary funding is required.
Regarding the interaction between resolution and insolvency, the SRM does not fare well either. Unlike resolution, insolvency regimes are entirely national and have very limited harmonisation. This represents a clear source of complexity that does not exist in other jurisdictions; in the United States, for example, all bank failures are managed under a single regulatory framework.
In terms of financing, the schemes in the UK and the US are more flexible. Both frameworks contemplate the possible need for extraordinary financing and articulate a procedure to authorise its use – such as the systemic risk exception in the United States. At the same time, the regulations governing the loss absorption capacity linked to resolution are substantially less complex.
Lifting the constitutional restrictions of the JUR would require a reform of the Treaties.
Measures to improve efficiency
In short, the SRM is more complex than other analogous frameworks in comparable jurisdictions. It presents inefficiencies that arise largely from institutional traits unique to the EU and the banking union, from constitutional restrictions imposed on the SRB, and from inflexible political pacts on sensitive issues such as burden-sharing. Any significant progress requires addressing those factors. I do not contend that this is an easy task. Certainly, lifting the constitutional restrictions on the SRB would require a Treaty reform. This implies that the intervention of multiple parties in a resolution will persist in the foreseeable future. Nonetheless, substantial progress could be achieved through legislative reforms aimed at mitigating the other two fronts of inefficiency.
The interaction between national regimes and that of the EU could be simplified by expanding the scope of the resolution framework in relation to insolvency. Recent reforms of the EU crisis management and deposit guarantee framework – the CMDI framework, as it is known – have taken a step in that direction by modifying the assessment of the public interest, so that a greater number of entities in crisis meet the threshold for being subjected to resolution.
However, the CMDI framework does not fully resolve the problem. Since there are fewer restrictions on the provision of external financing (including public funds) in national insolvency proceedings than in resolution, an entity in failure could still be liquidated instead of resolved, even if it is deemed systemic. This is because in a liquidation there are more funds available to address the impacts of the failure.
Moreover, action is needed to deepen the harmonisation of national banking insolvency regimes. As long as differences in creditor hierarchies and their rights during liquidation persist, the application of the safeguard that “no creditor should be worse off” (NCWO) will remain disproportionately complex for cross-border banks.
Similarly, disparities in the tools available under national liquidation regimes can further complicate the assessment of the NCWO principle.
These differences can also lead to disparate outcomes in the assessment of the public interest that determines whether a bank should be resolved or liquidated. This assessment requires the SRB to compare the outcomes of resolution against those of insolvency, and the tools available in the national regime will affect the latter. Fragmented insolvency regimes also pose a brake on cross-border banking activities.
An excessively complex methodology aimed at accurately calculating the amount of MREL that each bank will require to support its resolution. That precision is probably illusory,
Legislation can address this, although it poses a technical challenge. Nevertheless, the UNIDROIT Guide provides a good reference model.
Regarding financing, the reliance on the loss absorption capacity of the entities themselves as the primary source for financing resolution has resulted in an excessively complex methodology aimed at accurately calculating the amount of MREL that each bank will require to support its resolution. That precision is likely illusory, given that the circumstances of a failure are unpredictable. Legislation could simplify the MREL regime and reduce its rigor where appropriate.
However, changes to the MREL would be conditioned on the adoption of measures that provide greater flexibility to external financing mechanisms. This implies relaxing restrictions on the use of the SRF and providing public financial support in exceptional cases, when other instruments prove insufficient to achieve the resolution objectives.
The link between MREL levels and external financing is evident in the recent reforms in the UK, where the creation of a dedicated financing mechanism to support resolution transfers was combined with a radical simplification of MREL for those banks with a preferred transfer strategy.
The CMDI framework has taken a step in this direction by increasing the amount of financing available from the deposit insurer for transfer operations and by facilitating access to the SRF. However, it does not constitute a definitive solution for various reasons. For example, the mechanism for financing transfers is subject to complex conditions and is only fully available to banks with a threshold of assets below €80 billion. Moreover, the SRB cannot take into account any prospective external financing when setting MREL. Therefore, the CMDI would not, in principle, have any impact on the requirements and complexity of MREL schemes.
Ideally, a complete solution would include a common deposit protection scheme capable of supporting resolution actions within the banking union. Although the creation of a single deposit insurance system is not directly mentioned in its recent communication, it is positive that the European Commission foresees a proposal to “review and simplify the structure of the deposit framework to better align responsibilities and financing for crisis management and deposit guarantee measures...”. Of course, this matter will remain subject to complex political negotiations.
The reforms I have suggested require modifying the limited burden-sharing that underpins the current framework. This requires political will and a real commitment, not only to increase efficiency but, beyond that, to meet the fundamental objectives of the banking union. In fact, it seems unlikely that, without a complete banking union and a fully functioning SRM, supported by sufficient mutualised external financing, the goal of de-nationalising banking risk will ever be achieved. Moreover, these same actions constitute a prerequisite for the elimination of national ring-fencing measures that currently hinder the integration of the European banking sector.
There are some simple arrangements – simplifying information requirements or resolution plans, for example – that can be achieved through delegated acts. We have already seen progress from the European Banking Authority and the SRB in this regard. However, these types of initiatives, while constituting good administrative practice, are little more than superficial tweaks. They do nothing to address the structural factors of inefficiency that I have outlined.
Conclusion
I will conclude briefly. The resolution framework of the banking union is complex, and complexity carries costs. It increases the compliance burden for entities and authorities and restricts the efficiency of the framework.
Much of that complexity stems from institutional characteristics unique to Europe. These traits arise from insufficient delegation of powers, a lack of mutualisation of costs, and the persistent divergences between the legal regimes of member states. The institutional structure, complexity, and efficiency are interconnected, so any substantial reform aimed at addressing the inefficiencies of the system must take these factors into account: the overlap of European and national regulations and the insufficient sharing of risks and costs of bank failures. As I have argued, these reforms are also essential to achieve the de-nationalisation of banking risks and market integration, which are the true objectives of the banking union.
In other words, there are no shortcuts. However, there is a tremendous incentive to get things right, both in terms of efficiency and effectiveness. The legislative process that is likely to be initiated following the recent communication from the Commission will provide a magnificent opportunity to remedy this.