Lessons from Silicon Valley Bank and Credit Suisse: What would happen if a Belgian bank were to fail?
Following the 2008 financial crisis, prudential requirements for EU banks were significantly strengthened. On the one hand, banks are now required to have additional capital buffers so as to be able to absorb potentially significant losses. On the other hand, they need to ensure sufficient liquidity to cope with exceptional withdrawals. It should be noted though that the prudential requirements were not designed to prevent all bank failures, as this would overly constrain the ability of banks to finance the economy. Moreover, it is logical for a poorly managed bank to be restructured or exit the market.
What should be done when a bank fails?
While bank failures remain exceedingly rare in Belgium, they cannot be ruled out. If one occurs, it is often necessary to intervene quickly in order to restore confidence in the banking system. To this end, the 2014 Bank Recovery and Resolution Directive (BRRD) introduced four tools at EU level to resolve banking crises. Together, these four tools form the core of the resolution framework which aims to protect:
- the real economy, by ensuring the continuity of the ailing bank’s critical functions;
- the State and taxpayers, by minimising the risk that public resources will have to be used;
- the ailing bank’s customers and their deposits, assets and funds; and
- financial stability, by avoiding contagion effects.
These tools can only be used if they are found to offer better protection than normal insolvency proceedings, in which case their use is considered to be in the public interest. Otherwise, the normal bankruptcy regime will apply.
No magic wand
That being said, the authorities do not have a magic wand. Losses arising from a bank failure must be borne by someone. The investors in the failing bank will have to absorb the first tranche of losses, even if this means losing their entire investment. Furthermore, since experience indicates that shareholder capital may not be sufficient to resolve a banking crisis, the authorities require that banks finance themselves in part through so-called subordinated instruments, i.e. those whose holders absorb losses before other creditors. Banks cannot distribute this type of investment product indiscriminately to their retail customers and must first make sure that the product is suited to the customer’s profile. Thus, after shareholders, the authorities will turn to the holders of such instruments in the event of a bank failure.
In this way, the authorities can write down the capital of the distressed bank, in order to absorb its losses, and then convert certain claims into capital in order to keep it afloat, starting with those of subordinated (or unsecured) creditors. This technique is known as a “bail-in” and is the first of the four resolution tools referred to above. Thus, a failing bank is now no longer recapitalised using external (public) funds (a bailout), as was done in 2008, but rather using the bank’s own internal resources (private funds).
In addition to the bail-in, authorities have three other tools at their disposal which enable them to transfer all or part of a failing bank’s activities to:
- a buyer, often a larger, healthy bank (the sale of business tool);
- a temporary structure that is controlled and partially or wholly owned by the authorities (the bridge institution tool); or
- a separate asset management vehicle (or “bad bank”), in order to separate problem assets from sound ones (the asset separation tool).
These transfers cannot be challenged by the distressed bank’s management or shareholders.
Everyone plays a part
While only the resolution authorities can decide to apply these tools, it is the responsibility of each banking group to prepare for their possible application. The authorities have begun preparatory work to ensure that all banking groups have the necessary capacity to ensure swift implementation of these tools. These measures have practical implications for e.g. the governance, organisation and funding structure of banking groups. No group can afford to take a cavalier attitude in this regard.
Thanks to these tools and preparation, the authorities should be able to restore the financial situation of an ailing bank by transferring losses to its shareholders and creditors and then restructuring it or bringing in a private partner.
Protection of deposits up to €100 000
When a bank’s own resources or the transfer of its activities are insufficient to stabilise it, the authorities may, under certain conditions, draw on the European Single Resolution Fund (SRF). The SRF, which has been funded by annual contributions from euro area banks since 2016, represents a private source of financing. Its reserves are expected to amount to around €80 billion by July 2023.
In any case, Belgian and - more broadly - EU depositors benefit from harmonised protection of €100,000 per bank and per person, meaning deposits of up to this amount are guaranteed. This protection is provided through a fund, in the case of Belgium the Guarantee Fund. The Guarantee Fund, which is pre-financed through an annual contribution by Belgian banks, currently amounts to almost €5 billion.
An example of resolution: a symbolic price of €1 for Banco Popular
In Belgium, the National Bank was designated as the country’s resolution authority in 2014. It carries out its tasks in this regard in the framework of the Single Resolution Mechanism, the second pillar of the European banking union, along with the Single Supervisory Mechanism (the first pillar, centred around the ECB) and deposit guarantee schemes (the third pillar). An independent European resolution authority, the Single Resolution Board (SRB), was set up in 2015. It is responsible for the resolution of significant banks and all cross-border banking groups. In practice, this means that if, for example, one of the ten largest Belgian retail banks were to fail, the SRB would determine whether resolution is necessary and, if so, which resolution tools should be used and how. Although the National Bank would be involved in the SRB’s decision-making, it would not be able to impose its views and would have to faithfully implement the SRB’s decisions.
Of course, this is a legal and theoretical framework, essentially focused on restoring solvency, and there must remain room for a certain degree of flexibility, for example in the event of a liquidity crisis or a systemic crisis, i.e. one affecting the entire banking system. That being said, the framework has already been put to the test. The resolution of the Spanish Banco Popular in June 2017 was a perfect example of how this process should be organised in the banking union. The SRB first wrote down the bank’s equity and subordinated instruments, for an amount of € 4.1 billion, thereby absorbing the group's losses. It then sold the bank, together with its Portuguese subsidiary, to the Santander Group for a symbolic amount of one euro. This transaction preserved financial stability and ensured that the bank’s customers maintained access to their deposits and funds, at no cost to Spanish taxpayers.
Silicon Valley Bank: the avoidance of contagion effects
The measures taken by the US and Swiss authorities with regard to Silicon Valley Bank and Credit Suisse, respectively, differ in certain respects from those that would be applied in the European Union. In the case of Silicon Valley Bank, the US resolution authority (the Federal Deposit Insurance Corporation or FDIC) transferred all of the bank’s deposits, both covered and uncovered, and practically all its assets to a bridge bank, thereby guaranteeing customers’ access to their funds. As a result, Silicon Valley Bank’s shareholders and some of its creditors lost all of their investment. Such a measure would be possible in the European Union, where the authorities have similar tools at their disposal.
To restore the stability of the financial system and avoid financial contagion (to other regional banks), the US authorities also had to extend coverage of the deposit insurance scheme. At the same time, the Federal Reserve introduced the Bank Term Funding Program, offering banks loans with a term of up to one year in exchange for high-quality collateral, valued at par. The objective of the programme, which is backed by $25 billion from the US Treasury, is to avoid the need for US banks to sell securities to meet their liquidity needs.
Credit Suisse: a private transaction backed by the State
The acquisition of Credit Suisse by UBS was considered a private transaction. Although supervised by the Swiss authorities, it was not considered to fall under the resolution rules. In exchange for their shares, Credit Suisse shareholders received shares in UBS valued at CHF 3 billion. On the other hand, certain subordinated instruments with a nominal value of CHF 16 billion - known as Additional Tier 1 capital instruments - were fully written down.
It is interesting to note that the ECB, the SRB and the European Banking Authority reacted immediately to the acquisition in a joint statement emphasising that, when resolution occurs in the banking union, such a write-down is only possible after the common equity - the shares – have been fully used. Finally, although private, this transaction was backed by the Swiss government. The Swiss Confederation granted a CHF 9 billion guarantee to UBS, to cover potential losses on a portfolio of Credit Suisse assets. Similarly, both banks could obtain liquidity support from the Swiss National Bank and access the latter’s financing facilities, possibly covered by a Swiss-government guarantee.
Drawing lessons for the future
Each case has its own specificities and offers many lessons. Going forward, we will need to learn from recent crises and determine to what extent the European framework should be adjusted. On 18 April, the Commission adopted a legislative proposal amending certain aspects of the crisis management framework and specifically focusing on the resolution of medium-sized and smaller banks.
