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European Lehman Moment Wouldn’t Cause a Lehman Moment, ECB Says

Europe’s biggest banks can be shut down in line with the bloc’s new bank failure rules without losses snowballing and causing wider mayhem, according to a European Central Bank study.

Based on confidential bank-by-bank data, the study shows that resolving any one of the euro area’s 26 largest banks by applying the tools of the new European Union’s new rule set — imposing losses on shareholders and creditors instead of resorting to state aid — wouldn’t bring down another lender. Spillovers among the top group would be small and those outside of the network “contained,” according to the study by four ECB economists and one from the University of Frankfurt.

germany“For most of the shock sizes considered, the direct contagion effect on banks within the network considered is subdued,” the authors said in the study. “This shows the effectiveness of low interbank cross-holdings of bail-inable debt and the advantage of dis-incentivizing interbank” holdings.

The results support the view that the EU’s new rules for how to deal with failing banks could work as advertised. The Bank Recovery and Resolution Directive foresees small banks going insolvent like non-financial companies. Big ones that could cause mayhem would be restructured and recapitalized under a separate procedure called “resolution,” with owners and creditors bearing losses.

The study applies shocks of different size — wiping out 1 to 12 percent of total assets — to the 26-strong group of banks that report a precise breakdown of their securities holdings to a confidential ECB database, allowing targeted analyses.

To deal with the shock, the study assumes the application of the BRRD’s “bail-in tool,” first absorbing the losses and then recapitalizing the bank to a level of 10.5 percent common equity Tier 1 capital by wiping out or converting into equity shareholders and creditors, according to their insolvency ranking.

Banks have reduced their exposures to peers. As a result, they would be unlikely to experience losses large enough to put them in violation of capital requirements if there’s a failure, preventing its proliferation. Looking at the broader banking system beyond the 26 giants doesn’t change the picture, the researchers say.

The BRRD’s bail-in tool was first applied to Austrian bad bank Heta Asset Resolution AG last year. In contrast, Italy is avoiding the method for Banca Monte dei Paschi di Siena SpA and instead using a provision in the BRRD that allows to revert to old-style state support in a bailout that is slated to cost 8.8 billion euros ($9.5 billion) of tax funds.

The study’s authors are Goethe University’s Anne-Caroline Hueser, ECB’s Grzegorz Halaj, Christoffer Kok, Cristian Perales, and Anton van der Kraaij.