VADUZ - 14 February 2013: After several major EU banks had to be rescued in the course of the crisis, policy-makers in Brussels learnt two things: First, even outside outright “bail-outs”, the orderly resolution of banks will almost always require that liquidity is available from a public source. Second, crises in a major bank or large parts of the banking system can be resolved by a single Member State only at a high economic and political cost, if at all. For example, the Irish blanket State guarantee for troubled banks brought one of the previously least debt-burdened euro members to the brink of bankruptcy, and Spain is struggling to disentangle bank from sovereign debt.

The path to a more sustainable system to deal with failing banks in the EU has proved protracted. The Union entered the banking crisis completely unprepared. Till this day, most Member States lack a legal regime that allows their authorities to intervene in a failing bank so as to avoid a collapse with far-reaching adverse economic implications. Even less was there an established tradition of information sharing or collaboration across borders in cases of bank failures. Some banking supervisors later reported that they did not know where to call to inform their colleagues abroad of their intention to put a transnationally operating bank under official administration. Most bank interventions ended up being solo attempts by the authorities of the home country. Against this background, it is perhaps surprising that cross-border collaboration did work out in one case: the Franco-Belgian Dexia was resolved by the governments of Belgium, France and Luxembourg in a commonly agreed and financed fashion.

However, the EU legislator has not remained passive since the outbreak of the crisis. In June 2012, the European Commission presented a legislative proposal that would introduce harmonized tools and funding mechanisms for the recovery and resolution of banks on a EU-wide basis. The proposal partially follows the well-established and tested U.S. example, while taking into account European particularities. The highly praised “bail-in tool”, for example, which would enable authorities to write down a bank’s debt so as to improve its solvency, is substantially more intricate and risky to implement for the European market than for U.S. banks. While the latter obtain refinancing largely in capital markets, most large-scale debt holders of EU banks are banks themselves. To avoid contagion from a failing bank to its creditors on the interbank market, authorities must either exclude debt-holding banks from the scope of the bail-in tool or first arrange for a transition of banks to new capital sources. The Commission essentially puts forward a combination of these options.

The proposed directive also translates international standards on bank recovery and resolution into EU law. Once in force, the directive would require Member States to designate a special resolution authority in charge of banks that are “failing or likely to fail” due to any form of insolvency (regulatory, balance-sheet or cash-flow insolvency). Whether and when that state is reached remains to a large extent dependent on the judgment of domestic authorities. National law must equip resolution authorities with far-reaching powers to intervene in failing banks, restructure them, break them apart, sell or otherwise liquidate parts of them and assume managerial functions that are normally subject to shareholder approval. Resolution authorities in each Member State retain substantial discretion as to the resolution tool(s) they apply in an individual case at hand. In combination with a regime that treats banks as separate entities in resolution even if they form part of a group structure, this may complicate cross-border situations. In line with the EU’s generally applicable principle of home-country control, the resolution authority of the home country extends to branches located in other Member States. A different regime applies to bank subsidiaries. While the proposed directive encourages cooperation of resolution authorities across Member States and coordination of their decisions and actions in resolution colleges, participation in a common group resolution scheme eventually continues to be voluntary.

However, the main political obstacle to the proposed directive remains – not surprisingly – money. The Commission’s proposal that Member States be required to establish so-called “resolution financing arrangements”, which would be funded primarily through contributions by the banking industry and mutually support each other in case of financial need, is brilliant and obvious at the same time. Nevertheless, chances that the proposal will survive the scrutiny of the Council have been minimal from the very beginning. Member States fear the interference of EU legislation with a matter that they perceive at the core of national sovereignty. Indeed, one can hardly deny that resolution financing bears a fiscal component. On the one hand, resolution financing arrangements have their natural limits. The private industry will provide the first line of defence through ex ante-collected funds. The losses exceeding this amount, however, will almost always need to be covered by putting taxpayer money at risk. On the other hand, the crisis underscored that people ultimately accept financial stability as a responsibility of the State. What EU politics keep neglecting – quite consciously – is the fact that financial instability does not necessarily stop at national borders.

In light of the lingering banking and sovereign crises, neglect was no longer a viable option for those EU members that participate in Monetary Union. In June 2012, the leaders of the euro area Member States declared that the European Stability Mechanism (ESM) – a EUR 500 billion loan facility for the euro area – may be used to directly recapitalize failing banks once those banks are subject to a single supervisory mechanism under the umbrella of a Banking Union. According to the proposals of the Commission on Banking Union, presented in September 2012 and amended by the Council in December 2012, all major banks of the euro area would be supervised centrally by a Supervisory Board established within the European Central Bank (ECB). While the Commission suggests complementing the single supervisory mechanism by a single recovery and resolution mechanism, the prospect of this latter project remains opaque at best. Negotiations on a single resolution mechanism for failing euro area banks will most likely turn out to be substantially more protracted than those on establishing the single supervisory mechanism, not only due to the fiscal component but also because the establishment of a European Resolution Authority requires an amendment of the EU’s founding Treaties.

In the meantime, national authorities remain responsible for resolving failing euro area banks – if need be by use of domestic fiscal or ESM funds. That this intermediary state is far from ideal does not need much illustration. The ECB will have a hard time explaining to Member States’ treasuries why they have to step in to correct supervisory blunders committed by a EU institution. The separation of supervisory and resolution authority into different levels of governance puts a serious strain on the credibility of the ECB and eventually threatens its monetary autonomy. It does also not keep the promise of a true Banking Union. To implement a harmonized resolution regime for the EU and a single resolution mechanism for the euro area should be policy-makers’ number one priority. Clearly, the work in Brussels is not done yet.