No. 15 - Towards a framework for orderly liquidation of banks in the EU

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by A. De Aldisio, G. Aloia, A. Bentivegna, A. Gagliano, E. Giorgiantonio, C. Lanfranchi and M. MalteseAugust 2019

Based on the current EU legal framework, for a bank crisis to be managed via the resolution regime the bank must pass the 'public interest test'. This implies that resolution is only available to a small subset of banks and banking groups: in the Eurozone, there are likely fewer than 100 out of a total of about 3,000 as of end-2018. The crisis of the remaining banks must be handled through national insolvency proceedings.

National insolvency regimes normally result in a piecemeal liquidation. This option gives no guarantee that the proceedings will take place in an orderly fashion. Specifically, if interested acquirers cannot be rapidly identified, liquidation will lead to the immediate disruption of the bank's core activities, to the disposal of assets and sale of collateral at fire sale prices, and to non-insured liability holders having to face long waiting times to obtain partial reimbursement. The confidence in other banks may be shaken, with eventual knock-on effects on the real economy in general. In sum, a disorderly piecemeal liquidation process is clearly not efficient and may entail serious public policy concerns given the social and economic significance of banks' activities.

The same inefficient outcome would occur with a common DGS set up in the Banking Union - a goal that should continue to be pursued in the steady state. Indeed, while the establishment of a common DGS would increase the overall level of confidence in the banking system, it would not per se avoid piecemeal liquidation. A solution has thus to be found to avoid disorderly piecemeal liquidations for banks, as has been recognized by many authorities and commentators.

This note argues that trusting in good luck and hoping for an orderly liquidation for the vast majority of EU banks is indeed not good policy. Drawing from the US experience, we lay out a proposal for a European framework for an orderly liquidation of banks failing the public interest test. Its two main building blocks are: (i) measures to rebalance the framework towards interventions by deposit guarantee schemes (DGSs) - as alternatives to paying out deposits - to support orderly liquidation; and (ii) the creation of a new national framework for transferring assets and liabilities in liquidation.

We argue that alternative interventions by far minimize the overall cost of a crisis. Also, we argue that the risk that the DGS would systematically be worse off under the proposed orderly liquidation framework is low, and that this risk would be further reduced under certain conditions.

These proposals are broadly in line with the crisis management framework and practice of the US, as well as with the FSB Key Attributes. Also, they would follow the recent advice of the IMF that, in the recently published Euro Area FSAP, argues that a transfer of assets and liabilities in lieu of a piecemeal liquidation would reduce destruction of value and ensure a level playing field for creditors.

As the proposed framework only requires new procedural rules for transferring assets and liabilities in liquidation and not full harmonization of national insolvency regimes, it could be rapidly implemented in Europe. Member States would not be required to renounce their national laws, but merely to incorporate in their legal systems the new procedural rules for transferring assets and liabilities in liquidation.

To conclude, while our proposals would not rule out the possibility of a failing bank undergoing a disorderly piecemeal liquidation, they would provide an incentive to reach a more efficient outcome in a majority of cases. This holds true both in the short term, when DGSs are still national and the orderly liquidation would be undertaken at domestic level, and in the longer term: when setting up a common DGS in the Banking Union, an orderly liquidation regime managed by a centralized authority would be an essential tool. Overall, we see our proposals as a further step towards completing the Banking Union, increasing the overall efficiency of the European economy and promoting the integrity of the Common Market.

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