This September we mark ten years since the beginning of the Global Financial Crisis. It is a period that allows all of us involved in the financial sector to pause and reflect. We reflect on the causes of the last financial crisis and we take stock of all the work that has been done in the intervening decade to prevent a future crisis; but we should also use this moment to consider what else still needs to be done in order to ensure financial stability.
The era of ‘light-touch’
Casting our minds back ten years, the United States was first hit with the subprime crisis following a decline in the real estate market, which affected the related securities, not least those held by the banks.
The eventual bankruptcy of Lehman Brothers on 15 September 2008 had a ripple effect right throughout the world. In the years prior, banks and other financial institutions had seen profits rise on the back of financial innovation and ‘light-touch’ regulation. Liquidity was taken for granted and available at any time in the market. Credit had been flowing and the world economy was growing. All the signs were that things were going in the right direction. Of course, what happened next was easy to predict in hindsight. Indeed, it was Keynes who had said many years prior that ‘the market can remain irrational longer than you can remain solvent,’ and that is exactly what came to pass.
The ripple effect - from the US big banks down to the ordinary European
The effects of what was happening in the US began to be felt right across the globe. Contagion was rife because banks were ill-prepared to deal with any bump in the road. Trust is central to the banking sector; but trust is hard-won but easily and quickly lost. This quick loss of trust meant an even quicker loss of funding for banks. Extraordinary events in the financial industry, meant that ordinary people, through their governments, were left to foot the bill for banks and institutions deemed ‘too big to fail’. The effects of mismanagement in the financial industry and light touch regulation led to recession, rising unemployment and an enormous bill for the taxpayer.
Between October 2008 and October 2011, the European Commission approved €4.5 trillion - equivalent to 37% of EU GDP at the time - in state-aid measures to financial institutions.
The status quo was no longer an option and policymakers accepted the need to reform the financial and regulatory system to end the era of implicit taxpayer guarantees & bail outs.
Response to the Crisis
Ten years on, the jigsaw that is the European response, as part of a coordinated international response thanks to the 2011 recommendations of the Financial Stability Board, is still not complete. That said, we have come some a long way. The first two pillars of the Banking Union, the Single Supervisory Mechanism and the Single Resolution Mechanism are already in place and operational.
Two pieces of legislation were designed by the European institutions to incorporate the international principles in European law and build a single mechanism to manage bank failure at the level of the Banking Union: the Bank Recovery and Resolution Directive and the Single Resolution Mechanism Regulation.
Single Resolution Board
As the name suggests, the Single Resolution Board is part of the Single Resolution Mechanism in the Banking Union. We were set up in 2015 in order to create a single European authority responsible for developing and implementing resolution plans for banking groups in the euro area. The Single Resolution Board is an EU regulatory organisation funded by banks, not the public purse. Ten years ago, the term ‘resolution’ had not even been invented and this held true globally.
In assessing the role of the Single Resolution Board, it is important to note that if a bank fails this must not be seen as a failure of the system. On the contrary, banks should be able to fail; the exit of failing firms in a free market system is normal. Part of the SRB’s raison d'être is to ensure that we end the concept of ‘too big to fail’. However while banks might be private businesses in the free market system, we must recognise the difference between them and other businesses in the free market economy because of their underlying role in areas such as credit flow to other businesses. Therefore we must have measures in place to ensure that the ‘domino effect’ is minimised as far as possible – every financial institution must be resolvable, and in accordance with free market principles, it should be banks’ investors who bear the brunt of any failure – not the ordinary citizen. The failure of a bank will hopefully be a rare event. Preparing resolution plans is the core task for the SRB and National Resolution Authorities (NRAs). As part of this work, the SRB also sets Minimum Requirements for Eligible liabilities (MREL) for banks. This is one of the SRB’s key tools for achieving the resolvability of the banks under its remit. MREL targets set the level of eligible liabilities that a bank must maintain, to ensure that banks have sufficient loss absorbing and recapitalisation capacity to be resolved. In addition, the SRB addresses any concern regarding resolvability ranging from data availability to structural complexities. Of course the SRB provides direction, but it is banks themselves that know best what needs to be done to make themselves resolvable, and it is them that have to provide solutions that work.
In 2017 we had our first resolution case. On 7 June that year, the SRB resolved Banco Popular Español, the 6th largest bank in Spain, transferring all shares to Banco Santander. The SRB and the Spanish National Resolution Authority – FROB – decided that the sale was in the public interest as it protected all depositors of Banco Popular and ensures financial stability. The SRB, by its decision, managed to avoid adverse effects on financial stability and the real economy, without using any public funds. This showed the new regime works – but of course, there is always room for fine-tuning, and the Banking Union is still not complete.
More to do
For the SRB, it is important to press ahead and complete the Banking Union. The development of the European Deposit Insurance Scheme, the third and final pillar of the Banking Union remains important. For the proper functioning of a Banking Union, there should be no difference in the strength of protection available to depositors in the individual Member States, and a failure should not fall on the public coffers.
We have also begun building up the Single Resolution Fund, which today is stands at 24.9 billion euro, and we are building this fund progressively until 2023. Implementing the Common Backstop for the Fund is also critical. A well designed Backstop, available as a last resort, will give markets the confidence that resolution will work even for large, complex banks, and reduce stress on the financial system in the event of a bank failure.
Harmonisation is essential
The harmonisation of insolvency regimes remains essential. Currently, the SRM framework for resolution is faced with 19 or more different insolvency procedures. While it is challenging to reconsider long-standing national jurisprudence, only by harmonising national bank insolvency procedures can we ensure a smooth functioning of the framework.
Time to build on our progress
It is also important to avoid weakening the standards already agreed. Following the crisis, there was a material enhancement of regulation. When memories of the crisis fade, it is important that the regulatory system is not weakened. Instead, the authorities should take advantage of positive market conditions to push forward with finalising reforms. It is important to further strengthen the Banking Union through both risk-reduction and risk-sharing measures. This will ensure the authorities are able to manage future bank failures without use of taxpayer funds.
Could we withstand a new crisis?
A recurring question these days is whether we would be able to withstand a similar crisis to the one we experienced in 2008? I suppose the truth is that nobody knows. But we do know that much of the architecture of the Banking Union is in place, even if not complete. At some point, we may have another crisis, but we have put solid measures in place to deal with failing banks. The SRB together with its partners at national and international level is committed to that work going forward.
Deregulation on the cards?
We know that European supervision is working. It has provided better transparency and banks are far better capitalised today – in both quantity and quality.
The SRB’s mission is to make every bank resolvable and contribute to financial stability. Some call this past decade the lost decade, but instead let us see the past decade as one where tough lessons were learnt, and robust solutions were put in place, putting our financial system today on a much better footing than before the crisis.