Europe needs better bank rules

“We also need a common set of rules that clarifies capital requirements and procedures for the recovery and resolution of distressed banks.”

THE European Union's collective economy is the biggest on the globe, larger than the US or China, yet it is being held back by the fragmented nature of its markets. This has to change. If Europe is to stimulate the competition and growth that are essential for it to emerge from the current economic crisis, then the world's largest economy must also become the world's largest single market.

That's why the growing discussion of how to create a so- called multispeed EU of inner and outer cores, including the proposal for a new euro-area banking supervisor within the European Central Bank, offers the wrong answer to Europe's troubles. We need to stick together and develop the union that we have, and that includes building a single financial market for all 27 member states.

For such a pan-European financial market to work, we do need better bank supervision and safer systems for deposit guarantees. We also need a common set of rules that clarifies capital requirements and procedures for the recovery and resolution of distressed banks.

As the European Parliament's rapporteur on banking resolution, this is my point of departure for the work that's now under way to create rules on how to recover or safely dissolve troubled banks, a central part of the discussion on how to create a banking union. The European Commission issued a draft directive in June, and it is our job in Parliament to amend it and later negotiate the final text with the Council of Ministers. We hope to reach a final agreement next spring.

In my proposal for the directive, currently up for consideration in the Parliament, I have laid out the set of principles that I believe should be followed.

First, recovery and resolution need to restore the basic rule of capitalism that owners should not only be entitled to prof- its but also bear potential losses. That means not using public money to rescue bank owners when the authorities are trying to protect the financial system or its critical functions. Shareholders must risk losses, and failing banks must run the risk of liquidation.

Second, management of distressed banks must be designed in a way that forces creditors to scrutinize the creditworthiness of those to whom they lend. Credits should not be granted on the basis that a public backup system for rescuing failing institutions exists, but because of trust in the bank's ability to repay its debt on commercial terms.

The commission's proposal states that regulatory authorities -- whether national or supranational -- should intervene and force banks that get too close to solvency and liquidity problems to change direction or management. In my report, I set out explicit rules for when authorities should be allowed to intervene in order to reduce the risk of arbitrary or premature intrusion. I have also excluded liquidity as a trigger for intervention and instead sought to provide quantitative criteria on the basis of the EU's future rules on capital require- ments. Liquidity-related triggers could further systemic risk, as the mere expectation that an institution may end up in resolution might provoke a liquidity crisis and thus be self-fulfilling. Equally, severe liquidity problems often rapidly develop into capital problems and would then be covered anyway.

The commission has also proposed that the resolution authorities should be able to intervene when a bank is in a crisis by: forcing the institution's sale to a third party; separating good and bad assets; setting up a bridge bank and bailing in longterm creditors, for example by converting bonds they hold to equity; or writing down the notional value of bank liabilities.

Each of these tools is relevant for the management of individual banks in crisis, but they may not be sufficient if an economic and financial crisis were to hit the banking system. So, I've proposed a clear distinction between what is required when an individual bank is in trouble, and what might be needed when a crisis threatens the banking system.

In the first example, it is often bad management or an inferior business model that has led to excessive risk-taking. In such cases, lost asset and collateral values will probably not be possible to restore. Public money should not be spent and the institution should be wound down.

In the case of a systemic crisis, by contrast, banks will have ended up in smaller or bigger difficulties depending on how their managements responded to challenges in the macroeconomy. In most cases external factors, such as an overall economic shock or the bursting of an asset price bubble, will have caused the banking system's crisis.