What does it mean when a bank is failing or likely to fail?
14 June 2017
There are four reasons why a bank can be declared failing or likely to fail:
- it no longer fulfils the requirements for authorisation by the supervisor
- it has more liabilities than assets
- it is unable to pay its debts as they fall due
- it requires extraordinary financial public support
At the time of declaring a bank as failing or likely to fail, one of the above conditions must be met or be likely to be met.
Why is special action necessary if a bank is declared failing or likely to fail?
The failure of a bank is generally considered of utmost importance because of the essential role banks play in the economy. They provide vital services to people and companies, for example by offering credit, accepting deposits and processing payments. So it is important to ensure these services continue in the event of a bank failure.
Furthermore, the financial system is highly integrated. The recent financial crisis has shown how quickly and forcefully problems in the financial sector can spread if not effectively tackled.
What happens when a bank is declared failing or likely to fail?
Once declared failing or likely to fail, the bank is taken over by the Single Resolution Board – the resolution authority for significant banks in the euro area, as well as for cross-border less significant banks. It decides whether there is a public interest in the bank’s resolution (if not, the bank is liquidated) and which resolution measures should apply.
The key objectives in resolution are:
- preserving the systemically important part of the bank’s business (the part whose failure could trigger a financial crisis)
- protecting depositors
- ensuring critical functions continue to operate
- preventing market disruption
The ECB, which directly supervises around 120 significant banks in the euro area, closely cooperates with the Single Resolution Board throughout the resolution process.
Step 1 – Recovery and resolution planning
Planning is an essential component of the effective resolution of banks declared failing or likely to fail.
Every year banks are required to prepare recovery plans, which are assessed by their supervisor (the ECB in the case of significant banks). Recovery plans specify possible scenarios that could arise should a bank get into financial difficulty, and set out actions which the bank could take to continue operating, thus preventing a failure. A bank in financial difficulty could, for example, raise additional capital, reduce planned lending or sell assets.
The resolution plan, on the other hand, is a type of living will that sets out how a bank would wind down its operations should it be decided that it is no longer viable. The purpose is to determine the bank’s critical functions, identify and address any impediments to its resolvability and prepare for its possible resolution. The resolution authority is responsible for preparing the resolution plan for each bank based on information received from the bank and from the supervisor, who is also consulted in the process.
Step 2 – The bank enters resolution
Following a decision that a bank is failing or likely to fail, the Single Resolution Board assesses whether there are alternative private sector measures which could be taken to prevent its failure within a reasonable timeframe, and whether it is in the public interest for resolution to proceed (rather than the bank being liquidated under normal insolvency proceedings). In other words, the Single Resolution Board evaluates whether the bank’s failure could, for example, cause financial instability or disruptions in the market.
If the Single Resolution Board determines that there are no feasible alternative private sector measures and that the public interest is best served through resolution, it can adopt a resolution scheme.
A number of different resolution tools are available to the Single Resolution Board:
- parts of the bank can be sold
- parts of the bank can be transferred to a temporary structure (a “bridge bank”) to ensure that banking services to customers are maintained
- certain assets and liabilities can be transferred to a “bad” bank
- the bank’s liabilities can be cancelled or reduced through a bail-in procedure
What happens if I have a deposit with a bank that has been declared failing or likely to fail?
Deposit guarantee schemes are systems in each Member State that reimburse depositors if their bank fails and their deposit is no longer available. Deposits up to €100,000 are protected. All banks must be members of such a scheme and pay contributions into the fund.