The Government and the Commerce Committee adopted a constructive stance on furthering the Banking Union – investor bail-in must not be scrapped

As attempts are again being made to take the next step towards finalising the Banking Union, defending its guiding principles is now of the utmost importance. The goal of the Banking Union is to weaken the sovereign-bank nexus or the so-called doom loop between banks and their sovereigns in the European Union. The Finnish Government is currently finalising Finland’s position on one of the key elements of the Banking Union, bank crisis management.

In April 2023, the European Commission adopted a proposal to adjust the EU’s existing bank crisis management and deposit insurance (CMDI) framework, with a focus on medium-sized and smaller banks. Although it had been in preparation for a long time, the proposal was still not fully finalised when it had to be published because of the US and Swiss banking crises that broke out in the spring.

The preparatory negotiations at the level of officials failed to produce a good result despite the best efforts of Finland and some other countries, and the Commission unfortunately ended up proposing a rather strange solution: using deposit guarantee scheme funds to cover losses that should be borne by investors. Although the proposal includes parts that help take the Banking Union forward, it is a major step backwards in terms of investor bail-in.

The Commission’s proposal would partly forfeit the ‘no bail-out’ principle, meaning that some of the losses of a bank’s investors would be covered from deposit guarantee funds. This goes entirely against the Banking Union’s fundamental principle: the losses of a failing bank must be borne fully by its investors, not by taxpayers. If we start to bail out investors using the funds collected to protect deposits, the funds will have to be supplemented. In this scenario, banks are left to cover the shortfall.

In Finland, the Government and the Parliament’s Commerce Committee have addressed the problems with the proposal and assumed – rightly so – a tough line to defend the guiding principles of the Banking Union, especially to safeguard the ‘no bail-out’ principle and to secure deposits. The Parliament’s Grand Committee confirmed the positions of the Government and the Commerce Committee in early October. It seems like Finland will not be the only EU member state voicing a critical stance.

The Commission’s proposal goes against
the Banking Union’s fundamental principle:
the losses of a failing bank must be
borne fully by its investors, not by taxpayers.

As the Commerce Committee states, covering the shortfall in the deposit guarantee fund would only add to the banking sector’s financial burden. The added financial burden pinned on the banking sector would eventually be transferred to customers in one way or another, which is a matter the European Central Bank has recently also brought up when commenting on the bank levies planned in some countries. This is what typically happens with tax-like payments, as we have seen in the news on inflation recently: the additional financial burden on banks will be transferred to their customers – the very same taxpayers the Banking Union is supposed to protect.

In so far as a bank’s added burden is not transferred to its customers, the burden puts a strain on the bank’s profitability, weakening the bank’s resilience. The situation becomes critical if the banking system also experiences a large disruption resulting from losses or increased uncertainty. This can lead to spreading problems in the sector. This is when the solution proposed by the Commission becomes a problem instead.

The Finnish banking sector is extensively protected against crises not just through banks’ strong capital adequacy, but also through the requirement for banks to keep resolution capital on their balance sheets. In the case of a potential crisis, the resolution capital is used to cover the bank’s losses and recapitalisation costs. Banks have also made resolution plans and ensured in advance that they can implement these plans. According to the European Banking Authority’s calculations, the current model entails no need to use deposit guarantee scheme funds to cover Finnish banks’ losses.

If the Commission’s proposal is adopted into legislation, the next step is likely to be the pooling of national deposit guarantee funds under a European deposit insurance scheme. In this scenario, Finland will be one of the countries left to foot the bill.

The Commission’s proposal contains many steps in the right direction in terms of improving the exchange of information and collaboration between the supervising authority and the resolution authority. These improvements would allow the authorities to react to problem banks faster, making it also easier to implement the investor bail-in principle. This goes to show that to finalise the Banking Union, there is no need to make third parties cover losses. Instead, it would be much wiser to make the most of what the current prudential, resolution and supervision frameworks have to offer.

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Financial and Prudential Regulation

Olli Salmi

Head of Banking Regulation