Restructuring, resolution and insolvency: shift of tasks from judicial to administrative authorities

Discussant Remarks by Pentti Hakkarainen, Member of the Supervisory Board of the ECB, at the ECB Legal Conference, Frankfurt, 5 September 2017

It was a pleasure to listen to the fascinating presentations of our three esteemed panelists. As discussant, I have read the papers written by Sabino Cassese, David Ramos Muñoz and Seraina Grünewald^[1] and I will now seek to draw out some of the common themes that run through each of their contributions.

In doing this, I should explain that I approach these issues as a man of practice – having experienced a very severe banking crisis in Scandinavia in the early 90s and also having closely dealt with Icelandic banks in Finland. At those times we didn’t have any rules for banking resolution, and so everything had to be invented ad hoc. Given this background, I won’t be going into academic legal discussions, but will instead deal with the issues from a practical point of view.

The case for a special bank resolution regime

To begin, let me point out that the papers from Sabino and Seraina both provided a useful reminder of the desirability of having a special insolvency regime for the banking sector – separate from the normal procedures. I heard three key elements of the rationale that they outlined.

First, there is a “need for speed” when dealing with bank failures. Speed in managing the clean-up of a bank in crisis is necessary as a loss of confidence in a bank can lead to dangerous and precipitous liquidity runs. Swift remedies for bank failures are also required to limit the costs – as otherwise bank assets sour very quickly, thereby making the losses greater for creditors. Normal insolvency procedures do not provide this speed – so different procedures are required that allow a more proactive approach and thereby to swifter outcomes.

Second, there exists a widely acknowledged need to “preserve financial stability”. Unmanaged bank failures do not merely inconvenience those that are directly impacted – i.e. customers, employees, and investors. Instead, they can threaten the stability of the entire financial system. Lending can be disrupted, with knock-on effects to unemployment, GDP and tax receipts. Sometimes governments therefore feel obliged to provide bail outs in order to protect society from these disruptions. The response to a bank insolvency must therefore reflect the need to protect society from the potentially massive negative spill-over effects associated with bank failures.

Third, and related to the second point – the response to a bank insolvency must ensure the “continuation of the critical functions” of financial institutions. This is a logical consequence of the desire to avoid negative spillover effects to the real economy from bank failures. Citizens and businesses require continued access to certain financial services – such as deposit-taking, lending services, and payment systems. The authorities must be sensitive to this reality when they are managing bank failures.

A special system is therefore clearly desirable. If such special systems had been in place prior to the previous crisis, the cost to the taxpayer would undoubtedly have been lower, as would have been the disruption to the real economy.

Bank resolution frameworks need to be trans-national

The next theme I detected across the interventions was a clear consensus on the desirability of a trans-national framework for bank resolution. Sabino in particular provided an articulate explanation in saying that – “If the problem crosses national borders, then the solution too cannot remain in the hands of national governments alone”. And David also pointed to the challenges associated with legal recognition in foreign jurisdictions of a resolution action.

Given recent history, it is self-evident that the problems of failing international banks do indeed span national borders. Seraina and David listed some notable examples that demonstrate this clearly, including – Royal Bank of Scotland, Fortis, and Iceland. I personally experienced close-hand the Iceland crisis – and so I am acutely aware of the difficulties in allocating the costs of bank failures across borders. This difficulty was even higher at that time, given the complete absence of any framework to structure the conversation on how to resolve a bank.

We are now further along the path of developing our resolution framework compared to where we were when these unfortunate cases played out. The BRRD and the SRM Regulation have provided a useful step forwards in enhancing authorities’ ability to organise ourselves across borders, and to thereby avoid excessive costs arising from unmanaged and drawn out resolution processes.

Nonetheless, as David has pointed out, we still have progress to make, as it remains possible for legal problems to arise in the resolution of cross-border banking failures. His explanation of the cross-border legal risks that can arise when attempting to apply bail-in to foreign liabilities revealed an important issue which is worthy of further contemplation.

The protection of fundamental rights in the new framework

One aspect of any design for an effective trans-national resolution framework is a shift from judicial to administrative decision-making. Sabino explains well the reasoning behind the need for this shift. He explained that courts are not well suited to being the initial decider for bank resolution cases. They are too slow, given that they are reactive – and can only act upon request of a particular party. They are ill-suited to consider the structural economic effects of bank failures for the rest of the economy. They also cannot coordinate their actions within a hierarchical supranational system, given their overarching need to retain full independence.

We have therefore moved to a system whereby losses can be imposed on creditors ahead of any judicial review. It is fair to ask whether this new process protects citizens’ fundamental rights – in particular those of investors. Here, my overall impression is that the new process remains rather fair in protecting property rights – and Sabino and Seraina’s interventions generally endorsed this view.

The right starting point for such a discussion is to recognise that prior to the instigation of proper cross-border resolution regimes, bank creditor and shareholder “property rights” were excessively prioritised ahead of the “property rights” of taxpayers. It has been a deliberate and correct decision by policy-makers to make the risks to bank investors more explicit in the new system – and this has been a legitimate and important step forwards.

Within the new framework – Seraina points out that property rights are protected by important principles established in legislation. The two key principles are that resolution actions must be justified via a public interest test, and that no creditor should face losses that leave them worse off in comparison to if the institution had been wound up under normal insolvency proceedings.

However, while these principles are strong, they cannot provide 100% certainty upfront. This is not possible as it is necessary for the authorities to retain some discretion when they are deciding upon what actions are in the “public interest”. In addition, a degree of uncertainty arises because resolution actions are based on estimated valuations rather than actual liquidation.

These uncertainties for investors are balanced by the ex-post right to legally challenge administrative decisions. This appeal right provides a substantial final safeguard for property rights.

Observations on some ways forward to improve the bank resolution framework

I will now look forwards by reflecting on the potential areas for useful future reform that have been identified so far.

Within his endorsement of the shift towards administrative decision-making, Sabino identified two ways how fundamental rights might be more comprehensively protected in future. First, was the idea of consolidating and boosting the independence of administrative actors by improving their means to resist capture by interest groups. As an employee of an administrative body, I very much appreciate the importance of establishing independence within the legislative framework – and it is right to think about how further progress can be made in this regard.

Second, was the idea to expand the potential grounds for appealing administrative decisions on bank resolution. On this topic, I think we can all agree that the right of appeal must exist, but I open this topic up to the comments from the audience – especially addressing whether expanding appeal grounds would potentially make legal challenges too easy.

David referred to on-going work on European level to improve the loss absorbency framework via MREL instruments. That work aims to implement the TLAC standards into the European legal sphere. Of course, it will take time and effort for banks to build up their loss absorbing capacity in this respect. I am confident though that this effort will be worth it, as it will make future resolution cases easier. Moreover, I believe it will simplify things – by at least partially addressing the layers of complexity that David identified. I am keen to hear views from the audience and other panelists on this.

From my own perspective, I think it is important to note the importance of making progress towards building a single European Deposit Guarantee Scheme. For me, this is the natural next step in deepening financial integration across the Banking Union. Amongst other benefits it would greatly simplify the task of cross-border banking resolutions.

Clearly, this is a difficult and politically sensitive topic – and we therefore need to find innovative ways to move forwards. Difficult problems include the legacies of problem assets, and the associated question of how to alleviate concerns that risk mutualisation proceeds too quickly.

In recent talks with a senior central banker, I was told of an idea to begin by creating a single DGS merely for the banks supervised directly by the ECB. This would make resolution of these banks far more feasible, especially as many of them operate across multiple borders.

Further, given that banking supervision and banking resolution – i.e. the SSM and SRM – are already aligned at the euro area level, it also makes sense for the Deposit Guarantee Scheme to adopt this alignment. The European Deposit Guarantee Scheme would apply for the biggest and most internationally active banks, with national schemes continuing to take care of smaller banks. Such a solution may alleviate the concerns of those that are worried that a European Deposit Guarantee Scheme should wait for further progress on risk reduction.

I would welcome the audience’s feedback and thoughts on this area.

Conclusion

I conclude by thanking the speakers once again for their thoughts today.

Overall, I see that we have made progress in developing the resolution framework in Europe. At a minimum, we have now at least established clarity that a substantial private sector burden-sharing is a non-negotiable prerequisite prior to public funds being touched. This represents important progress.

However, we must recognise taxpayers are still not fully insulated from the risks of bank failure. One question for the audience’s comments is whether, as resolution regimes mature, we should continue to aim for the goal of full taxpayer protection?

Another question that I will leave you with where I would invite further audience comments regards the degree of protection that is afforded to depositors within Deposit Guarantee Schemes. My view is that it is important to cultivate the interest of bank clients in the risk-profile of the banks that they do business with. In regulating and supervising financial institutions, we should still make space for market forces and market discipline to act.

I’d be interested to hear the comments of the audience on how best to address this aspect in policy design, and on the other elements of the excellent presentations that we heard today.