Eurofi Article by Elke König - Gaps in the Banking Union regarding funding in resolution and how to close them

A key task of resolution authorities (RA) is to ensure financial stability and continuity of critical services of a failed bank so that it can meet all obligations due after resolution. To achieve this RA have been given a number of tools. However, while the bail-in of creditors and restructuring measures will restore and improve a bank’s solvency and viability, it is reasonable to expect that a resolved bank will experience liquidity stress after the resolution weekend.

By definition a recapitalised bank that has absorbed losses will be solvent and have better access to funding. However, given that analysts and creditors will likely require time to re-assess the financial position, the return to market funding will be a process rather than a one-off fix. Addressing the risk of banks having insufficient liquidity following resolution action therefore presents a crucial task in resolution planning.

It is important that RA follow fundamental principles, but at the same time adopt a flexible approach to ensure an orderly transition to private funding. According to FSB guidance, the way is clear: first, the bank’s own resources are expected to contribute. From a market discipline perspective it is important to rely on the bank’s assets and secured financing. However, the availability of collateral is not static. In fact, we expect limited and decreasing collateral approaching the point of non-viability. This situation is exacerbated if a failure is caused by a deteriorating liquidity position and recovery options are exhausted. Close monitoring of asset encumbrance and a timely FOLTF are a must, but will not solve all problems.

While private measures are expected to narrow gaps, the impact must be seen against the backdrop of potential sizes of liquidity needs. Looking at historic cases, support to individual banks in stress easily count triple billion figures. Precisely for this reason, FSB guidance recommends establishing temporary public backstop funding mechanisms. Such a tool currently does not exist in the Banking Union (BU), which is a missing piece in the overall framework. While the SRF can play a role in providing liquidity, the role can only be limited, given the SRF’s size, even if secured by a common backstop. We should however be mindful that the SRF was primarily designed for capital restauration.

Other solutions therefore need to be explored, particularly with central banks. When designing a credible tool some fundamentals must be fulfilled: first, all pre-conditions must be clear and RA should have certainty they can rely on the tool for finalizing all features of the resolution scheme, including funding, i.e. liquidity on day 1. Second, the scale must be sizable and flexible enough to support the effective implementation of any resolution strategy. It goes without saying, that only viable and solvent institutions in resolution should be supported with funding. Finally, the creation of a new sovereign-bank nexus should be avoided. Provided these objectives are met, the tool would address open issues in the current system and put the BU framework at equal footing with other jurisdictions such as the US or UK. A credible temporary public solution will provide markets with the needed confidence and allow fast return to private funding.

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