Banks must be allowed to fail

Contribution by Danièle Nouy, Chair of the Supervisory Board of the ECB, for Handelsblatt conference brochure, 5 September 2017

European banking supervision contributes to safe and sound banks…

The goal of European banking supervision is to contribute to the safety and soundness of banks. And we have made great strides towards achieving that goal.

For example, we have harmonised our main tool for supervising banks, the Supervisory Review and Evaluation Process. As a result, all large banks in the euro area are now assessed against the same yardstick. And we have contributed to harmonising the rules for banks, by agreeing to exercise options and discretions contained in the European rulebook in a uniform way across the euro area.

At the same time, we are benefiting from having a European perspective on banking supervision. We see across borders. We compare banks across the euro area and spot common issues and risks earlier. And what’s more, we are not influenced by national interests that might stand in the way of tough and fair supervision.

So, for the first time ever, banks across the euro area are supervised according to the same high standards; they operate on a level supervisory playing field. That helps us achieve our goal of making the banking sector safer. But it does more than that. It also helps to prepare the ground for a truly European banking market that will trigger cross-border consolidation sooner rather than later.

…but its job is not to prevent each and every bank from failing

What we are striving for is a well-functioning market. And in a market economy, companies fail from time to time – that is as true for banks as it is for any other business. As the economist Allan Meltzer said: “Capitalism without failure is like religion without sin. It doesn’t work.” Companies that fail exit the market and make room for those that are more efficient, more innovative and that serve customers’ needs better.

Thus, while our job is to contribute to the safety and soundness of the banking system, we should not prevent each and every bank from failing. If a bank sticks to an unsustainable business model or takes unwise investment decisions it can get into trouble and might even fail. Failure is always painful but, in certain circumstances, it cannot be avoided.

The necessary tools to deal with bank failures are in place at European level…

During the financial crisis, the market mechanisms did not work well. To protect financial stability and avoid a systemic crisis, governments often propped up failing banks with taxpayers’ money. This blew enormous holes in government budgets and set all the wrong incentives for banks and investors. Confident that they would be rescued if things went wrong, banks had an incentive to take on too much risk.

Today, we have a European framework to resolve failing banks in an orderly manner and avoid disrupting the financial system. At the core of this framework is the “bail-in”, which requires banks’ shareholders and creditors to bear the costs when a bank fails. They earn the returns in good times; they also have to accept the losses in bad times.

This protects taxpayers and exerts market discipline. Banks must be aware that they might actually fail, so they should behave more responsibly and manage their risks more effectively. Likewise, investors must be aware that they might lose their money, so they should invest it cautiously. In particular, retail investors should not invest in instruments that could substantially endanger their financial position.

…but although the framework works, it could benefit from some improvements

In a well-functioning market banks must be allowed to fail. It is therefore crucial to ensure that they can do so in an orderly fashion. Against that backdrop, Europe has established a relevant legal framework with the Bank Recovery and Resolution Directive (BRRD) and the Single Resolution Mechanism Regulation.

With the three recent “failing or likely to fail decisions, this new crisis management framework has now passed the test. From an operational point of view, the system works. The ECB, the Single Resolution Board (SRB), the European Commission and the relevant national authorities proved that they can cooperate closely to deal with failing banks effectively and to handle the whole process smoothly. Given that each bank failure is very delicate and has its own unique features, this is a major achievement. Besides, the bank insolvencies did not spill over to other banks and lead to financial system contagion.

It is ECB Banking Supervision that declares a bank to be failing or likely to fail. Then, the SRB takes over. And it is the SRB that decides whether it is in the public interest to resolve the bank using the tools available at European level. An example of resolution being in the public interest is when the bank fulfils critical functions for the financial system that need to be preserved.

If the SRB decides that resolution is not in the public interest, it is then up to the national authorities to liquidate the bank, according to national insolvency laws. This framework ensures that systemic banks can fail in an orderly fashion, while other banks are liquidated like any other business.

The goal of European banking supervision is to ensure the safety and soundness of banks. This also means allowing banks to fail when there is no reasonable prospect of them restoring their situation; and being prepared to deal with the consequences when they do fail. Naturally, there are lessons to be learned from the recent bank failures, and we will take advantage of the fact that the BRRD is currently being reviewed to make improvements.

Still, the recent cases of banks failing have shown that the crisis management framework is sound and that, overall, the euro area banking sector is much safer than it was before the crisis.

To make further progress in that direction, we need to complete the banking union by implementing the missing third pillar: a European deposit insurance scheme. If banks are supervised and resolved at European level, it would make sense to have deposit insurance at European level as well.