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#ECB: Banks must be allowed to fail

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Danièle Nouy, Chair of the Supervisory Board of the ECB, says that great strides have been made towards achieving  the safety and soundness of banks. Nouy said the benefits of taking a European perspective is reaping benefits, allowing supervisors to spot common issues and risks earlier. She used the occasion was an opportunity for the supervisor to reiterate that banks should be allowed to fail, writes Catherine Feore.

By being one step removed from national interests, she argues that the European supervisors are able to be both tough and fair. Apart from aiming to make the banking sector safer Nouy says that supervision helps prepare the ground for a truly European banking market that ‘will trigger cross-border consolidation sooner rather than later.’ The supervisor was addressing a Handelsblatt conference (5 September)

To bad to succeed

The Chair of the Supervisory Board said that whilst she is striving for a well-functioning market, companies fail from time to time and that this is as true for banks as it is for any other business:

“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

Nouy recalled that to protect financial stability and avoid a systemic crisis, governments often propped up failing banks with taxpayers’ money:

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“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.”

The ‘Bail-in’ is the main core of the new way to resolve failing banks and protecting tax payers in future. Nouy said that as bond holders earn the returns in good times; they also have to accept the losses in bad times. Given recent intervention in Italy, Nouy said that retail investors should not invest in instruments that could substantially endanger their financial position.

A view from across the pond

Neil Kashkari, president of the Federal Reserve Bank of Minneapolis and a member of the Federal Open Market Committee, is critical of the ‘bail-in’ approach, saying that it is not a replacement for adequate bank equity.

Kashkari was in the eye of the storm in 2007/8 and is one of the main architects of the US TARP (Troubled Asset Recovery Programme) which was used to recapitalize failing banks.

In a recent article for the Wall Street Journal voiced his scepticism over the bail in mechanism. Kashkari wrote:

“In the past few weeks [following Spanish and Italian bank failures], four European bank failures have demonstrated that a signature feature of the post-crisis regulatory regime simply cannot protect the public. There’s no need for more evidence: “bail-in debt” doesn’t prevent bailouts. It’s time to admit this and move to a simpler solution that will work: more common equity.”

Kashkari said that bail-in debt was envisioned as an elegant solution to the “too big to fail” problem. When a bank ran into trouble, regulators could trigger a conversion of debt to equity: “Bondholders would take the losses. The firm would be recapitalized. Taxpayers would be spared.”

Kashkari reiterates that only an adequate amount of equity will really prevent, if not remove the need for tax payer intervention:

“Large banks need to be able to withstand losses of around 20%, according to a 2015 analysis by the Federal Reserve. But they have only about half that amount in equity because regulators have generously assumed bondholders would take losses. Italy demonstrates that this is wishful thinking. Too big to fail is alive and well, and taxpayers are on the hook.”

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