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Europe Needs Better Bank Rules

By Gunnar Hokmark
November 12, 2012 6:50 PM EST

The European Union’s collective economy is the biggest on the globe, larger than the U.S. or China, yet it is being held back by the fragmented nature of its markets. This has to change.

If Europe is to stimulate the competition and growth that are essential for it to emerge from the current economic crisis, then the world’s largest economy must also become the world’s largest single market.

That’s why the growing discussion of how to create a so- called multispeed EU of inner and outer cores, including the proposal for a new euro-area banking supervisor within the European Central Bank, offers the wrong answer to Europe’s troubles. We need to stick together and develop the union that we have, and that includes building a single financial market for all 27 member states.

For such a pan-European financial market to work, we do need better bank supervision and safer systems for deposit guarantees. We also need a common set of rules that clarifies capital requirements and procedures for the recovery and resolution of distressed banks.

As the European Parliament’s rapporteur on banking resolution, this is my point of departure for the work that’s now under way to create rules on how to recover or safely dissolve troubled banks, a central part of the discussion on how to create a banking union. The European Commission issued a draft directive in June, and it is our job in Parliament to amend it and later negotiate the final text with the Council of Ministers. We hope to reach a final agreement next spring.

Proposed Principles

In my proposal for the directive, currently up for consideration in the Parliament, I have laid out the set of principles that I believe should be followed.

First, recovery and resolution need to restore the basic rule of capitalism that owners should not only be entitled to profits but also bear potential losses. That means not using public money to rescue bank owners when the authorities are trying to protect the financial system or its critical functions. Shareholders must risk losses, and failing banks must run the risk of liquidation.

Second, management of distressed banks must be designed in a way that forces creditors to scrutinize the creditworthiness of those to whom they lend. Credits should not be granted on the basis that a public backup system for rescuing failing institutions exists, but because of trust in the bank’s ability to repay its debt on commercial terms.

The commission’s proposal states that regulatory authorities -- whether national or supranational -- should intervene and force banks that get too close to solvency and liquidity problems to change direction or management. In my report, I set out explicit rules for when authorities should be allowed to intervene in order to reduce the risk of arbitrary or premature intrusion.

I have also excluded liquidity as a trigger for intervention and instead sought to provide quantitative criteria on the basis of the EU’s future rules on capital requirements. Liquidity-related triggers could further systemic risk, as the mere expectation that an institution may end up in resolution might provoke a liquidity crisis and thus be self-fulfilling. Equally, severe liquidity problems often rapidly develop into capital problems and would then be covered anyway.

The commission has also proposed that the resolution authorities should be able to intervene when a bank is in a crisis by: forcing the institution’s sale to a third party; separating good and bad assets; setting up a bridge bank and bailing in long-term creditors, for example by converting bonds they hold to equity; or writing down the notional value of bank liabilities.

Systemic Differences

Each of these tools is relevant for the management of individual banks in crisis, but they may not be sufficient if an economic and financial crisis were to hit the banking system. So, I’ve proposed a clear distinction between what is required when an individual bank is in trouble, and what might be needed when a crisis threatens the banking system.

In the first example, it is often bad management or an inferior business model that has led to excessive risk-taking. In such cases, lost asset and collateral values will probably not be possible to restore. Public money should not be spent and the institution should be wound down.

In the case of a systemic crisis, by contrast, banks will have ended up in smaller or bigger difficulties depending on how their managements responded to challenges in the macroeconomy. In most cases external factors, such as an overall economic shock or the bursting of an asset price bubble, will have caused the banking system’s crisis.

Asset values that deteriorate and undermine collateral as a result of such a situation will probably revive as time goes on and the economy recovers. The risk of an eventual taxpayer loss associated with public intervention will therefore be smaller than in the case of a bank that fails due to its flawed business performance. At the same time, public intervention will protect the economy and prevent a deepening of the crisis.

This is why I’ve proposed the possibility for EU member states to intervene with a blanket guarantee, capital injection or temporary public ownership of banks to ensure the maintenance of critical functions in the financial system -- provided that the shareholders of affected banks, as well as long-term debt holders to an appropriate extent, have taken the associated losses. I shall also work to ensure that national resolution funds are pre-financed, thereby contributing to stability when a crisis hits.

We can tighten the rules for the supervision and monitoring of cross-border banks and systematically important banks. This can be done by giving the European Banking Authority, which is based in London and covers all EU countries, a further mandate to monitor and follow up on the supervision that’s performed by national authorities.

Firm Framework

If the countries in the euro area, as a part of their monetary union, want to consolidate their supervisory authorities and create common deposit guarantee plans or, within the requirements of crisis management for banks, want to use the European Stability Mechanism, then this should be done within the framework of existing EU law. It would not require new unions within the EU.

We don’t need to create new institutions to fix the EU’s banking woes, a move that inevitably will risk dividing the EU into those who sign up to the new bodies and those who don’t. We should use and develop the union that we have and hold our 27 nations together rather than encourage division. This will enable us to act now instead of getting lost in never-ending treaty discussions.

(Gunnar Hokmark is vice chairman of the European People’s Party group in the European Parliament, and responsible for the report on the recovery and resolution directive. The opinions expressed are his own.)

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To contact the writer of this article: Gunnar Hokmark at Gunnar.hokmark@europarl.europa.eu.

To contact the editor responsible for this article: Marc Champion at mchampion7@bloomberg.net.

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