Shadow Resolutions as a “No-No” in a Sound Banking Union

Luca Enriques is Allen & Overy Professor of Corporate Law at Oxford University. The following post is based on a paper co-authored by Professor Enriques and Gerard Hertig.

Credit crisis related bank bailouts and resolutions have been actively debated over the past few years. By contrast, little attention has been paid to resolution procedures being generally circumvented when banks are getting insolvent in normal times.

In fact, supervisory leniency and political considerations often result in public officials incentivizing viable banks to acquire failing banks. In our book chapter Shadow resolutions as a no-no in a sound Banking Union, published in Financial Regulation: A Transatlantic Perspective 150-166 (Ester Faia et al. eds.), Cambridge University Press, 2015, we consider this a very unfortunate approach. It weakens supervision, distorts competition and, most importantly, gives resolution a bad name.

On the bright side, recent reforms have provided EU authorities with significant incentives to follow formal resolution procedures rather than to operate in their shadow. A Regulation adopted in 2014 mandates a Single Resolution Board to verify bank compliance with measures taken by supervisory authorities in the presence of financial or other difficulties that may lead to insolvency. More importantly, the Board is empowered to adopt a resolution scheme when a bank is likely to fail and resolution action is in the public interest.

Before doing so, the Board must, however, establish the lack of reasonable prospect that any alternative private sector measures would prevent failure within a reasonable timeframe. This approach reflects two basic assumptions. Whenever possible, bank reorganizations should 1) be market-driven and 2) have no cost implications for taxpayers.

It follows that a private sector solution should neither be motivated by state interests nor be based on the exercise of state powers. In the real world, however, what is called a “private” sector solution often goes hand-in-hand with state involvement. When that is the case, such a scheme is better termed a “shadow” resolution.

Shadow resolutions can be defined as mergers and other acquisition transactions that are coerced or informally subsidized via threat of supervisory action or promise of a benevolent supervisory stance at some future time. Examples of threats include capital adequacy reassessments, regulatory investigations, and limitations in the scope of authorized activities. Examples of informal subsidies include merger assistance, facilitated market access, and compliance leniency.

Even though reliable data is not publicly available, shadow resolutions are a common phenomenon. Cases are regularly reported in the media and the practice is acknowledged in the literature. For example, it has been documented that shadow resolutions were systematically practiced throughout Italy’s banking history and for decades post-World War II in Japan. There is also turn of the millennium evidence of restructuring mergers being induced by public officials in Germany and Switzerland.

Shadow resolutions are functionally similar to formal resolutions, as both procedures are executed using M&A transactions and involve state intervention (state coercion or subsidies for shadow resolutions, state loss sharing guarantees for formal resolutions). Nevertheless, there are major differences between the two types of transactions.

First, no or limited information is available regarding state involvement in shadow transactions, whereas P&A transactions involve relatively transparent steering by state authorities. Second, formal resolutions require proper state authority and are subject to established review procedures. By contrast, shadow resolution participants essentially face diffuse moral suasion and informal complaint avenues. Third, official resolutions formally affect shareholder and creditor rights, while this only occurs informally in shadow resolution situations.

Shadow resolutions can be pervasive when it comes to smaller banks, especially in good times. This is an environment where supervisors have significant incentives to circumvent formal resolution procedures, to avoid being blamed for not having prevented the bank from failing. This, in turn, gives resolution a bad name (markets expect it to be used only in exceptional circumstances, such as a financial crisis), which in turn reinforces the attractiveness of shadow resolutions.

We propose a solution to this dilemma. To begin with, we provide evidence that it is feasible for a jurisdiction with a strong shadow resolution tradition to shift to a formal resolution approach. Japan, a jurisdiction where shadow resolutions were pervasive, managed to shift to a formal resolution environment where depositors face the prospect of real losses. We also show that a shift to formal resolutions is sustainable even in situations where shadow resolutions remain an option. Here, the US experience shows that smaller banks are subject to formal resolution in good times even though shadow resolutions persist in situations where political or reputation considerations are dominant.

Second, we emphasize that the setting up of the Banking Union provides a unique window of opportunity to get rid of shadow resolution practices within the European Union.

Under the new regime, combined action by the European Central Bank and the Single Resolution Board can de facto force national authorities to opt for a formal rather than shadow resolution. They also have the incentives to do so in view of the limited EU level impact of the resolution of a smaller bank. In turn, the existence or threat of EU intervention is likely 1) to discourage would-be acquirers or, at least, 2) make it difficult for national authorities to credibly claim that any deal they may be able to arrange is not a liquidation transaction and thus subject to formal resolution procedures.

Third, provided this strategy is effectively implemented in the Banking Union’s early stages, the member states’ collective action problems will be minimized as all are held to the same standards. One can also expect the negative stigma attached to formal insolvencies to disappear—or, at least, to be manageable. This, in turn, should curtail the risk of market participants overreacting to resolution announcements, especially if the latter are accompanied by EU authorities’ statements of support.

The full paper is available for download here.

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