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Why is the financial system’s stability so important for the economy?

The potential resolution of a bank could have major ramifications on the economies where it operates. During the recent financial crisis, authorities have had to pump funds to prevent some institutions from collapsing.  Having learned their lesson, they are taking steps to prevent taxpayers from having to foot the bill of eventual bank insolvencies in the future. This means that, from now on, the ailing bank’s shareholders and investors will shoulder part of the bailout. And the key to who pays first lies in a bank’s balance sheet. Therefore, banks with robust balance sheets, i.e., which have the resources to assume unexpected losses, will become more attractive both for investors and savers.

Why shouldn’t we let a bank at risk of insolvency fail?

Now that we know what makes up a bank’s balance sheet, it’s easier to understand why it is not advisable to look the other way when a bank begins insolvency proceedings.

An insolvent company, or a company at risk of resolution, is one that does not have sufficient funds to pay its obligations or one that has more debts (liabilities) than assets. This situation can arise from a variety of different situations, ranging from a financial crisis to misconduct carried out by the institution itself.

Regardless of the cause leading to this situation, that fact that it is a bank entails some risks that extend beyond the institution.

  • On the asset side, lending declines since the bank in question doesn’t have sufficient funds to grant loans.
  • Furthermore, customers afraid of losing their money could lead to a bank run and a massive decline in deposits.

If the bank in question is large and has a substantial role in the country, region or at a global level (called a systemically important financial institution) the risk multiplies. On the one hand, it could paralyze economic activity (as lending declines dramatically) and concurrently, it could create a contagion effect that leads to continuous capital flight resulting in additional insolvency proceedings.  If they both occur simultaneously, it could have devastating effects on a country’s economy.

In order to mitigate the economic declines to the extent possible and prevent depositors (who, at the end of the day, are the banks’ creditors) from assuming losses, as occurs when an institution  enters into resolution, government authorities have decided to “rescue” ailing financial institutions so they can continue their activity and avoid an economic collapse. These bailouts have taken place in different ways, ranging from capital injections to asset protection schemes and issuing debt backed by the government. The common denominator is that public funds were used to rescue these institutions. In other words, taxpayers bore the cost through their taxes.  But we can’t forget that this was done to prevent depositors (who are also taxpayers) from having to assume part of the losses – something that is less likely to reoccur with the new regulations.

Who will pay for bailouts?

The complicated situation created by the crisis and the massive amount of public funds used for financial bailouts have generated broad international consensus that each institution should assume the cost of problematic situations to a greater extent.

With this goal in mind, the EU created the so-called Single Resolution Mechanism (SRM) which seeks to ensure an orderly resolution of failing banks with minimal costs to taxpayers and the real economy.  A crucial element of this new resolution framework is the fact that bank creditors, and not taxpayers, have to assume the recapitalization costs in case of resolution.

This means that shareholders and hybrid bond holders (a combination of equity and debt, like CoCo bonds, for example) will be the first to lose out if the bank becomes insolvent.  Next in line are the creditors (for example, regular bond holders), who would have to give up their right to payment of all or part of the debt (commonly referred to as a savings levy). If the gap is not covered, it will be savers who will end up losing part of their money, depending on the balances in their bank deposits. The Spanish Deposit Guarantee Fund currently guarantees bank deposits to a limit of €100,000 although the European Commission is in the process of creating an EU-wide guarantee system. Both funds are funded by capital allocations from banks themselves.

Also, financial authorities are also toughening up both the supervisory mechanisms and the regulatory requirements that the industry is required to meet, in order to increase the resilience and stability of banks, while protecting the public interest.

Therefore, a series of measures have been adopted aimed at strengthening the banks’ balance sheets, and increase their capacity to cope with unexpected losses and survive, preventing contagion to other institutions. In this sense, institutions now have to meet stricter capital requirements – in terms of both amount and quality – and liquidity requirements, which have been imposed to moderate their vulnerability against possible shocks. Also, a set of minimum bail-in-able liability requirements, i.e. liabilities capable of bearing losses, will be established. Spanish and European institutions will need to start complying with these as of 2016 (the so-called MREL).

The major drawback of all these measures is that these requirements translate in higher costs for the institutions and lower return ratios, which will probably lead to a decline in their lending activity and a negative impact on the real economy.

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