There could have hardly been more appropriate/inappropriate timing for the publication of the ideas of the European Commission for banking resolution than an inflaming by the hour banking crisis in Europe. Spain is on the edge of asking the EU to bailout its ailing banks, which still cannot overcome the bust of the property bubble 2 years ago. Cypriot banks are also squatted because of their excessive exposure to Greece and there are rumours that Cyprus might prove to be the fourth country in the eurozone to be rescued (after Greece, Portugal and Ireland). International credit rating agencies downgraded several German and Austrian banks. The world is jittery, the investors are concerned, the European politicians are in an impasse, and the citizens of Europe are already desperate with growing unemployment, lack of perspectives and disappointment from the political class.
This is precisely why the Commission's proposal for a directive for banks resolution was expected with huge impatience by all. Internal Market Commissioner Michel Barnier was quick to say that democracy needed time to get texts voted, so no one should rely on the new rules to save the Spanish banks. And if everything goes by the plan, the directive will enter into force as of 1st of January 2015 if, of course, Europe had survived by then. Mr Barnier acknowledged, however, that these proposals had to be put some 10-15 years ago.
The draft directive is a result of nearly a two-year consultation process. Precisely two years ago (May 2010) the Commission came up with a communication on the creation of special resolution funds, aimed at helping ailing banks to be restructured without this to threaten in any way the financial system. On the basis of these thorough consultations the Commission has decided to propose a directive because this is such a type of European legislation that requires harmonisation with European legal norms and not a direct application of European regulations. As the proposal explains, this would allow the member states to take into account their own national specifics and to adjust the directive according to their own peculiarities.
The main purpose of the proposed legislation is to avoid in the future financial institutions to be bailed out with taxpayers' money. According to Commission data, between October 2008 and October 2011 the institution had approved 4.5 trillion euros, which is equal to 37% of the gross domestic product of the EU, in state aid in support of financial institutions. Of them 1.6 trillion or 13% of EU GDP were used in the period 2008-2010. Guarantees and measures to stimulate liquidity amount to 1.2 trillion euro or roughly 9.8% of GDP. The remainder was spend for recapitalisation and other measures, totally amounting to 409 billion euros or 3.3%. Those are direct costs. Indirect costs are estimated at 0.7 trillion euro in 2009, the number with which the EU gross domestic product shrank as a result of the severe recession, caused by the crisis in the financial sector.
Citizens are in a very rebellious mood against the financial sector these days because of the job losses, the economic activity decline and not least because of their conviction that banks always get away at taxpayers' expense. The feeling that the poor rescue the rich led to significant political shifts across Europe, increased strongly the credit of confidence for nationalists in more and more member states, created the Occupy movement which started from Wall Street but is quickly spreading across the developed world.
The Commission points out though, that "banks (and other providers of financial services) perform many critical functions for the wider economy - safeguarding deposits, managing payments systems, providing loans and channelling capital for investment and innovation. When these functions are disrupted, the consequences can be massive: jobs are lost, savings, pensions and investments lose their value, people cannot access loans or withdraw cash". In the same time it is pointed out that the losses will be allocated to the shareholders and the creditors of a troubled institution. After a proper valuation of the losses, they will first be allocated in full to the shareholders and then to the creditors. It is allowed, however, creditors of the same class to be treated differently if it is justified by reasons of public interest and in particular in order to underpin financial stability.
The three main pillars of the proposal
Prevention. This means that all big banks must draw up recovery plans or as the economist Dimitar Ashikov explained they have to prepare their "living wills". The purpose is every bank to be able to draw its own plans which functions can be closed, restructured or sold without this to disrupt its main activities - to continue to service the real economy. The purpose is, in case of a crisis, these plans to be ready in order to avoid a case when the states must analyse every institution separately and recommend treatment.
Early intervention. This option will be triggered when the capital reserves of a bank fall below a certain level. The bank will have to undertake the necessary steps to restore its financial situation by for example activating the recovery plan, undertake some key reforms or to restructure its debt after an agreement with its creditors.
Resolution is the third option. This option gives powers to the relevant national authorities in any member state to take control over a failed bank, if the other two instruments (prevention and early intervention) had not done their job. Among the measures which the local authorities can undertake are selling the bank (the whole or parts of it); hiving off critical functions or bad assets; converting debt owed to unsecured creditors into shares.
Resolution is actually an alternative to normal insolvency procedures and the purpose of this tool is to achieve results similar to those of the normal insolvency procedures, taking into account the EU rules for state aid in terms of allocation of losses to shareholders and creditors, while safeguarding financial stability and limiting taxpayer exposure to loss from solvency support.
Sounds like too complicated a task, which is why it is interesting to know how will this happen given that the Commission had found out that many of the national legal systems currently do not provide the necessary powers to authorities to deal with financial institutions in the right way, while preserving those services essential for financial stability. As the draft directive provides the legal framework, it is expected that the rest will be done by the member states, who are given concrete parameters.
The draft is trying to harmonise national legislation on recovery and resolution of credit institutions and investment firms to ensure that all member states have equal tools and procedures to deal with systemic failures. Substantial differences in national procedures for resolution could result in unacceptable risks to financial stability and jeopardise the effective resolution of cross border groups, the proposal says, based obviously entirely on already available data for the results of the lack of proper tools (the current crisis). The legal base, used for the draft directive, is Article 114 of the Treaty on the Functioning of the EU (TFEU), which relates to the convergence of European legislation in support of the functioning of the internal market.
The member states are required to create financial arrangements in such a manner that will ensure effective application by the resolution authority of the resolution tools and powers. Besides, the member states have to ensure appropriate mechanisms for financing of these arrangements. Regarding financing, the countries are required to raise ex ante contributions in a special resolution fund. For a period no longer than 10 years from the entry into force of this directive a level of at least 1% must be achieved of the amount of deposits in all credit institutions on the territory of a country. If the necessary funds prove to be insufficient to cover the losses, costs or other expenses arising from the application of the financial arrangements the member states can avail themselves of the option of extraordinary raising of funding from the financial institutions on their territory until the required amount is reached.
The directive provides for the member states to resort to raising funding for the resolution fund through the deposit guarantee scheme, as in this case their contribution will be proportionate to the size of its liabilities, excluding its own funds and deposits. To a question if this did not pose risk for the deposits, Commissioner Barnier explained that if there is no good prevention deposits should be safeguarded. "We have to ensure that banks have the appropriate capital requirements. A guarantee of 100 000 euros per depositor must be to a large extent a priority. All this will be subject of supervising by the authorities in the member states".
The member states have to approve and publish by 31 December 2014 at the latest the laws, arrangements and administrative regulation necessary for the application of the directive, so that it can enter into force as of 1st of January 2015. By June 1st, 2018, the Commission has to make a review of the application of this legislation and to decide whether amendments are needed. The big question, however, is whether there will be anything left to be rescued by then?