Unintended Consequences of Financial Regulation: Closer Look at the European Banking Union (Part II)

Written by Max Dechamps

After having set out the institutional design of the Banking Union in the first part of his article, Max Deschamps showed evidence of a credit crunch as a result of the introduction of the Single Supervisory Mechanism. In this second part, Max demonstrates that (i) the Single Resolution Mechanism may unintentionally cause bank runs and (ii) the European Deposit Insurance Scheme may increase moral hazard.

I. The Single Resolution Mechanism: The re-introduction of bank runs

A second response to the recent financial crisis by the European Commission was the implementation of the Single Resolution Board (SRB). The SRB is the central resolution authority within the Banking Union (EC, 2018).

Banking resolution can be qualified as the orderly, quick, and efficient restructuring of a bank that is already failing or expected to fail in the near future.

Therefore, as stated on its website, the SRB’s mission is: “to ensure an orderly resolution of failing banks with minimum impact on the real economy, the financial system, and the public finances of the participating member states and beyond” (SRB, 2018). More specifically, the main objectives of bank resolution are to (i) minimize the impact on the economy, (ii) privatize losses and (iii) eliminate moral hazard (Dermine, 2016). Besides, due to the large potential negative impact of the failure of a bank on the economy and financial stability, the SRB needs to be proactive. Indeed, one of the critical task of the SRB is to be able to identify a failing bank in its early stage in order to avoid substantial social costs. Working together with the National Resolution Authorities (NRAs) of the 19 members of the Eurozone, they form the Single Resolution Mechanism (SRM).

More broadly, the goal of the SRM as a whole is to ensure an orderly resolution of failing banks with minimal costs for taxpayers and to the real European economy (EC, 2018). However, one could still wonder why there is a need to bring banking resolution at a European level. As we know, financial stability is one of the primary concerns of financial regulators and supervisors. Over the years, more and more regulations have been implemented in the goal of preserving stability in banking markets. While this certainly reduces the likelihood of future financial crises, policymakers do recognize uncertainty and their inability to identify every future source of risk. Without a doubt, there will be other cases of failing banks, and thus, the need for a trusted and respected resolution authority with a strong resolution capacity and the ability to act in appropriate and consistent manner.

Whether the SRM has actually succeeded to achieve financial stability or has unintentionally increased fragility in banking markets is discussed in the rest of this section. Although there is no doubt on the fact the SRM reflects a huge improvement in comparison to the previous national frameworks, Dermine (2017) argues that the current SRM is incomplete and a potential contributor to future panic and disruption of the banking system. The first question Dermine (2017) raises is: “who gets bailed-in?”. The author goes further by asking: “what if the creditors are pension funds and insurance companies?” (Dermine, 2017). These two questions bring a lot of political implications and complexities to the process, as loan on losses do not simply disappear under the SRM.

A very sad but illustrative example of these complexities occurred in November 2015, when the Bank of Italy imposed losses on bond holders of four small local banks, with a customer of Banca Etruria committing suicide after losing the entirety of his life savings. This was one of the contributing reason why MPS, Veneto Banca and Banca Italia di Vicenza did not benefit from a bail-in as they entered financial distress. Consequently, these three banks had to either be bail-out or be given state guarantees by the Bank of Italy, imposing a total cost of €18 billion on taxpayers. These events have raised doubts on the ability of the SRB to impose losses on creditors.

A second and more important problem concerning the SRB is its ability to prevent bank runs. Indeed, as it could be observed in the case of Banco Popular in Spain, there is still considerable ambiguity around the extent to which private creditors or depositors will be wiped out when the SRM is triggered. This in turn, re-creates the risk of runs on banks. Indeed, the fact that, under certain circumstances, part of the deposits may be excluded leads customers of the banks and treasurers at other banks to run to withdraw their deposits. This ambiguity around which types of deposit would qualify as “insured” led Banco Popular to take on €3.6 billion of emergency funding in two-days to meet its liquidity needs (Bowman, 2018). This bank run was the first one since the 2007-2009 financial crisis.

Taking these two implications into account, there is a strong need to redesign and adjust the current SRM framework. A first solution would be to reconsider the seniority rankings and priority of claims among the different debt holders of the bank. As usual, senior creditors have first claim on assets, followed by more junior creditors. In order to reduce the probability of a bank run, the SRB could impose rules on seniority for short-term debt. In this way, short-term retail depositors could be ranked as senior and would therefore bear less risk of being bailed-in. A second measure could be the exclusion of short-term debt of more than seven days from the scope of the bail-in resolution tools in the SRB framework. Commonly, these loans refer to loans granted by other banks in the interbank market. In this way, short-term liabilities would be privileged in comparison to the other senior claims in the seniority ranking. This will enable banks to refinance themselves by rolling over their loans and keep the interbank market running in a time of financial distress. This measure could drastically lower the probability of bank runs as these loans would not be held accountable for the risk taken by the bank. Last but not least, another interesting measure to mitigate the problem of bank runs under the SRM could be the “corralito” solution adopted in several Latin American countries. This measure suggests closing the bank in the case of bank runs. The idea consists of having maturity-convertible securities. In particular, banks would have short maturity deposits during good times that would automatically transform into long-term debt during bad times to ensure that banks can operate with enough liquidity.

To summarize this section, the SRM framework, through the privatization of losses, is a considerable improvement from the past mechanisms. Ultimately, the implementation of bail-in, replacing bail-out, will significantly reduce moral hazard and sovereign risk. However, the current framework could really benefit from additional measures. Indeed, as pointed out by Dermine (2017), the SRM in its current form has re-introduced and increased the likelihood of bank runs, often considered to be the primary root of a financial crisis. Therefore, it is believed that, through the three previously-mentioned measures, the risk of bank runs could be mitigated without interfering with the process of bank resolution.

II. European Deposit Insurance Scheme: Increased moral hazard

On 24 November 2015, the European Commission suggested the introduction of a European Deposit Insurance Scheme in order to reinforce the protection of bank depositors across the Banking Union. EDIS represents the third pillar of the Banking Union. The EC’s legislative proposal was adopted as a part of a broader package of measures to further strengthen the EU’s Economic and Monetary Union (EMU). The EC’s legislative proposal builds on the previously established national Deposit Guarantee Schemes (DGS) regulated by Directive 2014/49/EU (EC, 2018). This EU legislation already ensures that all deposits up to €100 000 are protected, through national DGS, in case of the failure of a European bank.

However, national DGS suffer from one important drawback. Indeed, national DGS are largely exposed to local shocks. Therefore, as a solution to mitigate these shocks, EDIS could provide a strong and more uniform degree of insurance cover for all retail depositors in the Banking Union, ensuring that depositor confidence do not depend on the location of a certain bank. This legislation falls under the EC’s goal of reducing banking risks. Indeed, with the help of EDIS, the EC seeks to weaken the link between banks and their national sovereigns by means of risk-sharing among all the Member States in the Banking Union (EC, 2018). However, deposit insurance, like any deposit insurance scheme, raises moral hazard concerns. Indeed, in response to the recent financial crisis, most countries considerably increased the coverage of their financial safety nets in order to restore market confidence and to avoid bank runs on their banking sectors. Nonetheless, a widely-known unintended consequence of deposit insurance is the reduced incentive of depositors to monitor their banks, eventually leading to excessive risk-taking behaviours from banks.

Anginer, Demirguc-Kunt and Zhu (2013) investigated the relation between deposit insurance and bank risk and systemic fragility in the years leading up to the 2007-2009 financial crisis. Their findings reveal that increasing financial safety nets did increase bank risk and systemic fragility prior the crisis. On top of this already widely-discussed consequence of deposit insurance, this section identifies another future possible unintended consequence of EDIS: In the context of EDIS, depositors would be protected by a supranational deposit insurance. This, in turn, might encourage local banks to exhibit less market discipline and national supervisors to be more lenient. Effectively, the participating members might be incentivized to adopt looser regulations as the cost of failing banks would be shared across all Member States of the Banking Union. This might eventually lead banks to take-on extra risk, further increasing financial instability. It is therefore very important to address these moral hazard concerns before the actual implementation of EDIS.

A solution proposed in the literature to mitigate moral hazard would be the introduction of national compartments within EDIS (Schnabel & Véron, 2018). The idea to impose a certain limit on solidarity actually comes from the lack of political support for EDIS, notably from countries like France and Germany. Under national compartments, the initial part of the loss would be borne at the national level. EDIS would therefore only intervene after a certain threshold has been reached. However, the viability of these national compartments might be questioned during the crisis and bring a lot of political implications. Indeed, other rules and deadlines would have to be imposed on surviving banks regarding their contributions, which could, in turn, destabilize the national and European banking system and further worsen the depth of the crisis.

This article presents several ways on how to effectively address moral hazard in the case of EDIS. First of all, as proposed by Véron (2017), the European Union should introduce regulatory disincentives against highly concentrated sovereign exposures of euro area banks. As the author states in his proposal: “The home-bias problem is a key obstacle to the adoption of a European Deposit Insurance Scheme because of the suspicion that deposits protected by EDIS would be used by banks, under moral suasion from their home country’s government, to excessively increase their purchase of that government’s debt” (Véron, 2017). Therefore, in order to address this problem, there is a clear need for regulatory requirements. Besides focusing on sovereign credit risk, this requirement should most importantly focus on reducing highly concentrated sovereign exposure of banks. Secondly, as we mentioned earlier, the implementation stresses moral hazard concerns and the feared imposition of costs upon banks in healthier banking systems. Therefore, if EDIS wants to gain full support from all Member States, the ECB has to ensure a very strong monitoring of the asset quality of banks. As a solution, the ECB could incentivize participating banks to reduce their share of non-performing loans by imposing severe sanctions if they fail to comply. Besides, banks should be carefully assessed and qualified as sound and stable before entering EDIS. In fact, the ECB together with the SSM should pursue their supervisory roles and be tough in their licensing, as individual bank risk would now be shared across all banks in the euro area.

III. Conclusion

Over the past decades, the multiple financial crises have called for a stronger regulatory framework. This, in turn, has translated into an increasing number of financial regulations. While there is no doubt on their great contribution towards a safer financial sector, the introduction of new financial regulations can also come with unintended consequences. As discussed in this article, three consequences have emerged from the implementation of the European Banking Union. In particular, there is evidence that the implementation of the Single Supervisory Mechanism led to a temporary credit crunch. With respect to the second pillar, the article highlights fact that the introduction of the Single Resolution Mechanism may have re-created the possibility of bank runs, often considered to be the root of financial crises. Lastly, the article also argue that the future implementation of the European Deposit Insurance Scheme can threaten financial stability by increasing moral hazard between the different Member States of the Eurozone.

All in all, these considerations highlight the complexities behind the work of financial supervisors and regulators. In fact, the nature of the work often leads regulators to be one step behind, as it is almost impossible to predict banks’ behaviours in response to new regulations. With this in mind, the article gives concrete recommendations in an attempt to mitigate these consequences. To conclude, the evidence from the article calls for a careful monitoring of banks’ responses to the introduction of new financial regulations. If needed, adjustments to regulations should be made until its intended objective is achieved. Only then can financial regulations contribute to a safer and more robust financial system.

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