The crisis management of smaller banks: perspectives of reform

The current common framework for bank crisis management and national deposit guarantee schemes (CMDI) is tailored for banks which are considered too big (or too complex) to fail. Smaller banks, theoretically posing no risk to financial stability, are de facto excluded from the application of resolution.

However, in practice, not even the size element has been decisive and the crises of significant as well as less significant institutions have been mainly managed at the national level instead of within the framework and conditions set by Directive 2014/59/EU (Bank Recovery and Resolution Directive, BRRD). Thus, while the objective of the European Banking Union was to contribute to the creation of a single market for financial services, the first years of the application of Pillar II demonstrate the existence of persistent fragmentation, fuelled by the recourse to public funding (bailout).

In response to these shortcomings, the European Commission recently published a proposal for a revision of the BRRD, the related Regulation (1093/2010/EU)  and the Directive on deposit guarantee schemes (2014/49/EU). The proposal aims, inter alia, to make it easier to resolve failing smaller and medium-sized banks.

In a recent working paper, I suggest that for the CMDI to be effectively applied, the scope of resolution must include smaller banks. This reform is also contained in the European Commission's proposal. However, the envisaged interventions on the current framework, while appreciable, are not sufficient to achieve this goal.

In support of this idea, I identify the notion of a smaller bank, emphasising the role and importance, in addition to size, of the core business carried out. The smaller bank has a business model primarily based, in terms of funding, on retail deposits. This feature implies that a smaller bank cannot easily issue the required amounts of liabilities (other than deposits) that could be loss-absorbing in resolution (Minimum Requirement of Eligible Liabilities, MREL). For the same reason, a smaller bank faces difficulties to fulfil the precondition for using the national resolution financing arrangements or the Single Resolution Fund, namely a bail-in of at least 8 per cent of total liabilities including own funds (8% of Total Liabilities and Own Funds (TLOF)). In substance, banks with traditional funding will probably have to apply the bail-in even to unprotected deposits to reach the 8% TLOF or, in particularly adverse scenarios, may not even be able to meet this requirement, thus jeopardising their ability to access external resources to manage resolution. In essence, the current framework is not a good fit for smaller banks.

Against this background, the existence and permanence of smaller banks in the banking ecosystem should not be underestimated.  Recent banking crises which have occurred in the US have shown that a limited territorial banking network may not allow for an adequate fractioning of retail market deposits, thus exposing the intermediary to a bank run of large and uncovered depositors. From a different but related angle, the crisis of the Veneto banks has proved that the evaluation of the ‘public interest’ for accessing resolution (and liquidation aids) does not always depend on the significance and the size of the intermediary. Moreover, the Veneto banks case has made it clear that resolution tools may be used at the national level outside the BRRD framework, despite the absence of a ‘public interest’ determined at the EU level by the Single Resolution Board. Such decisions remain subject to the EU State aid burden-sharing regime , which is less restrictive than bail-in, as it only involves shareholders and subordinated debt holders, regardless of the amount of their claims and the relationship to the total liabilities of the bank (para 6.2.3, Banking Communication 2013).

Broadening the scope of the resolution is therefore a condicio sine qua non for the proper functioning and, above all, for the concrete application of the CMDI. This solution, however, requires not only the reform of the public interest assessment but also ensuring adequate funding, including, on the one hand, the credit institutions’ internal loss-absorption capacity and, on the other, the access to deposit guarantee scheme (DGS) resources and resolution financing arrangements. The proposed revision of the CMDI partially addresses these problems. In fact, MREL are expected to be proportionally calibrated for transfer strategies, considering bank-specific features, including size, business and funding models, risk profile and the needs identified to implement the resolution analysis. Together with the new approach concerning the public interest assessment, the positive side of the reform is that smaller banks may fall under the resolution regime more easily; this means, consequently, that they will increasingly be subject to MREL requirements. Nevertheless, the watering down of the MREL is not accompanied by the reform of the 8% TLOF. Therefore, the constraints resulting from the latter rule remain. Smaller banks, due to their business and financing models, will still face difficulties in issuing and placing this amount of MREL (ex ante), which means, ex post, an inability to access the resolution funds.

These shortcomings should, according to the Commission, be limited by several reforms regarding the DGS framework, such as: 1) the potential role of DGSs in supporting transfer strategies as an alternative to the basic pay-out function and 2) the replacement of the ‘super priority’ of the DGS/covered deposits with a single-tier depositor preference, resulting in all deposits ranking pari passu (same among themselves) and above ordinary unsecured claims. The latter reform should facilitate the use of the DGS in resolution under the least cost test safeguard. In this regard, the proposed reforms of the DGS discipline mark a significant and welcome departure from the current framework. However, the bridge role of DGSs is not provided for as a general rule but is subject to assessment by the resolution authority on a case-by-case basis, according to a complex procedure which lacks the degree of predictability essential in any bank crisis prevention and resolution planning.

In conclusion, although the proposals are welcome and desirable, they do not solve the existing problems posed by the current regime. Moreover, three fundamental issues remain untouched: the introduction of a European Deposit Insurance Scheme, the difference between burden-sharing in resolution and liquidation and the fragmented architecture of the European resolution decision. These issues make, for the various reasons analysed in the paper, liquidation more attractive than resolution.

Irene Mecatti is Senior Lecturer and Adjunct Professor of Business and Banking Law at the University of Siena, Department of Law.