Too big to fail is nearly over but regulators must avoid new moral hazards

Anthony Browne
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THE end is in sight for the era of too-big-to-fail. Earlier this week, George Osborne and the other EU finance ministers met to discuss the Resolution and Recovery Directive (RRD) – the key to ensuring that banks will never again have to be bailed out by the taxpayer, and a measure which the banks have thrown their full weight behind. RRD will give the regulator the power to step in and take over a bank if it stops being financially viable.

The centrepiece is bail-in, a new tool to ensure that shareholders and creditors – not taxpayers – bear the cost if a bank fails. And because taxpayers will not bear the cost, the link between banks and their host country’s financial health will be broken, reducing the chance of another sovereign debt crisis.

It will also mean that investors – particularly big, sophisticated investors like hedge funds and pension funds – will have to take more responsibility for the health and conduct of their banks. And the management, if they want to borrow cheaply, will have to make sure their bank is a safe one to lend to.

Moreover, bail-in will ensure a failed bank can continue to offer the critical functions that businesses and households need – like working ATMs and direct debit facilities. It will also reduce the chance of contagion as the resolution process happens much faster than bankruptcy, preserving rather than destroying much of the value of creditors’ investments.

RRD builds upon a raft of measures to fix too-big-to-fail. For example, banks are fast increasing their capital and liquidity. UK banks already hold three times as much of the safest form of capital as before the crisis. In fact, the main UK banks alone have already increased their capital by £165bn since 2008, and are now among the best capitalised in the world. On top of this, all customer deposits up to £85,000 are now 100 per cent guaranteed by an industry-funded scheme. Combined, these measures should make the banking system more stable, make depositors’ savings safer, and reduce moral hazard – ensuring those responsible for risks pay the costs when they go wrong.

But the ministers are also close to creating a new moral hazard. There was broad support – though not from the UK – for a pre-funded “resolution fund” that risks undermining much of the progress so far. Depending what the fund is used for, a pre-funded “resolution fund” could provide banks with a pot of money that will be used to bail them out, meaning banks and their investors will not have to take as much responsibility for their risks because they can simply turn to the fund.

The proposed fund – which will be around €10bn (£8.4bn) in the UK – also pales into insignificance compared to the €1.1 trillion total of bail-in-able debt across the EU. This is a loss absorbing capacity 10 to 15 larger than the resolution fund.

The banks are committed to making sure they are not again bailed out by the taxpayer. But the disorderly collapse of banking in Cyprus shows what happens if we don’t get bank resolution right. There is much to welcome in the new RRD package, but legislators should be aware that the unintended negative consequences of the proposed resolution fund might be to undermine much of the rest of the reforms.

Anthony Browne is chief executive of the British Bankers’ Association.