Europe is making a mistake on failing banks

The following editorial appears on Bloomberg View:

Three years since their banking union began to take shape, European Union regulators are seeking fresh powers to deal with lenders in trouble. Their plan would let them stop withdrawals from a failing bank for a few days while they address the problem, with the aim of preventing a run. But this approach could easily have the opposite effect, spreading panic to the whole financial system. There’s a better way.

Instead of freezing bank accounts, EU governments should enable regulators to keep a bank going while they restructure it and search for a new owner. This will require EU governments to commit additional resources for the task.

This approach would mirror an arrangement which is currently in place in Germany, and it’s superficially appealing: Closing a bank would certainly stop a run. But it could also have unintended consequences. Depositors may run from a bank in trouble sooner — fearing that if they wait too long they may not be able to withdraw their money. It could also lead depositors to empty their accounts as soon as the bank reopens. Most dangerous of all, freezing accounts in one bank could spread panic to the rest of the system.

Strengthening Europe’s Single Resolution Fund is the better approach. The fund’s planned capacity of 55 billion euros is too small, and even that amount won’t be fully available for years. An adequately financed SRF would give regulators the chance to resolve failing banks without putting the financial system at greater risk. If it helps to head off the next banking crisis, the additional upfront cost will be money well-spent.