## _sdn1301technt

## Source details

**Canonical URL:** [_sdn1301technt](https://www.imf.org/-/media/websites/imf/imported-publications/external/pubs/ft/sdn/2013/_sdn1301technt.pdf)

## Other formats

- [Markdown version](/-/media/websites/imf/imported-publications/external/pubs/ft/sdn/2013/_sdn1301technt.pdf.md)
- [Structured JSON version](/-/media/websites/imf/imported-publications/external/pubs/ft/sdn/2013/_sdn1301technt.pdf.json)

---

### Supervision: objectives, structures, and SSM roadmap
- Objectives:
  - Ensure bank soundness by verifying and enforcing prudential rules and providing discretionary powers to control undue risk taking.
- National-based supervision:
  - Banking supervision in the EU is performed at the national level; minimum harmonization guided by the Basel Committee Core Principles implemented through EU Directives.
  - Supervisory handbooks and practices vary across euro area countries; CRR/CRD IV draft will strengthen supervision (supervisory plans, onsite inspections, intrusive assessments) and harmonize sanctions.
  - Draft Directive on bank recovery and resolution aims to ensure national authorities have preventative and harmonized tools and early intervention powers.
- Cross-border cooperation:
  - Supervision of cross-border banks coordinated within supervisory colleges; draft Directive clarifies home-host relations in a non-binding way.
  - Colleges are a major step forward but national emphasis may distort incentives to share information; participation can be cumbersome for small countries.
- EU Commission proposal (EC draft Regulation published September 12, 2012):
  - Mandates the ECB to perform supervision of all euro area banks starting January 2013 (dates later pushed back); sequence: banks receiving/requesting public financial assistance targeted first; systemically important banks from July 2013; all other credit institutions from January 2014.
  - Commission announced draft legislations for the single rule book (CRR/CRD IV), harmonizing resolution regimes and deposit guarantee schemes to be adopted by end-2012; Council adopted plans for a single resolution mechanism on December 14, 2012.
- Council agreement main elements:
  - Risk-based transition sequencing; Council agreed SSM would come into operation in March 2014, or one year after legislation enters into force, whichever is later.
  - Coverage: SSM to cover all credit institutions established in participating countries; under Art 5(4) banks accounting for about 80 percent of euro area banking assets would be under direct ECB supervision.
  - Specific criteria for direct ECB supervision include: assets exceed €30 billion; ratio of total assets to GDP of the home member state exceeds 20 percent; national competent authority deems institution significant; ECB may designate significant banks based on cross-border assets/liabilities, ESM assistance, or being among three largest in home state.
  - ECB mandate for bank safety and soundness and financial stability; broad investigatory and supervisory powers (enforce prudential norms, licensing, M&A assessment, on-site inspections, stress tests, macroprudential buffers, consolidated supervision, early intervention).
  - Governance: supervisory board with Steering Committee; "silent procedure" for draft decisions—deemed adopted unless Governing Council objects within 10 days in normal times, 2 days in stressful times.
  - Accountability: Governing Council and Chair of supervisory board accountable to Eurogroup and EU Parliament, annual report, internal/external audits, judicial scrutiny.
  - National authorities: prepare/implement ECB acts, perform day-to-day supervision, directly supervise "less significant" banks; remain responsible for consumer protection and AML tasks.
  - Macroprudential powers: ECB and national authorities both empowered to use macroprudential instruments; either party must inform and hear the other ahead of taking steps.
  - Resources: supervision could be financed partly by risk-based levies on credit institutions.

### Regulation, single rule book, and national flexibilities
- Purpose:
  - Prudential rules promote safety and soundness, limit excessive risk taking, correct informational imperfections, and build buffers.
- Single rule book:
  - Commission aims to create a single set of harmonized prudential rules starting with CRR and CRD IV to ensure uniform application of Basel II and III by limiting national options.
  - CRR tightens large exposure limits, liquidity ratios, public disclosure requirements, and proposes an indicative leverage ratio.
- National flexibility (Danish compromise, May 2012):
  - Member states can impose stricter temporary prudential requirements for domestically licensed institutions (up to two years, extendable).
  - National authorities can require Pillar 2 capital add-ons.
  - Draft numeric flexibilities include: Common Equity Tier 1 capital ratios increased by up to 3 percent ("systemic risk buffer") on all exposures or up to 5 percent on domestic or non-EU exposures without Commission pre-approval; sectoral risk weights up to 25 percent beyond common rulebook for real estate and financial sector exposures; stricter large exposure limits (up to 15 percent).

### Role of the EBA and macroprudential oversight
- EBA mandate:
  - Issue technical standards, contribute to consistent application of EU legislation, organize peer reviews, promote supervisory convergence, coordinate EU-wide stress tests, ensure smooth functioning of supervisory colleges, advise EU institutions, and hold back-up enforcement authority under strict conditions.
- Macroprudential oversight:
  - National authorities responsible but frameworks lacking in several euro area countries; ESRB coordinates cross-border spillovers via "comply or explain."
  - ESRB issued recommendations on macroprudential mandates in December 2011 and is developing guidance for common toolkits.

### IMF assessment: positives, requirements, and areas needing clarity
- Positives:
  - Inclusion of elements necessary for Banking Union effectiveness: ESM can request ECB to take over direct supervision as precondition for direct recapitalization; direct ESM recapitalization viewed as critical.
  - Clear mandate and accountability for ECB, broad investigatory and supervisory powers, fast adoption of Directives on regulation, DGS, Bank Recovery and Resolution, and call for single resolution mechanism and explicit backstops welcomed.
- Requirements for effectiveness:
  - Rapid establishment of resources and frameworks; operational arrangements ensuring adequate division of labor, compatible incentives, and information sharing within SSM.
- Areas needing clarity:
  - Delegation of supervisory tasks and controls; macroprudential oversight arrangements; powers to assume national discretion per CRR/CRD IV; allocation of powers to intervene, enforce sanctions, and trigger resolution; home-host arrangements for non-EU banks and interaction with EBA.
  - Legal basis: Article 127(6) allows conferral of supervisory tasks on ECB but Treaty change may be required over time to minimize litigation risk.

### Powers required for ECB supervision (paragraph 20)
- Powers list (exactly as specified):
  - Enforce minimum prudential standards and any restrictions prescribed by the supervisory review, including increasing prudential requirements for individual banks and banking groups based on their risk profile and systemic importance (BCP 1 and 16).
  - Request information and have full access to banks’ boards, management and staff records, and perform general investigations and onsite inspections (BCP 1 and 10).
  - Require all necessary early corrective actions to address unsafe and unsound practices or activities that could pose risks to banks or to the banking system, and prevent banks from breaching standards (BCP 11).
  - Ring-fencing of the bank from the actions of parent companies, subsidiaries, parallel-owned banking structures and other related entities in matters that could impair the safety and soundness of the bank or the banking system (BCP 11).
  - Take measures and sanctions in line with the gravity of the situation, including revoking the license (BCP 11).
  - Determine supervisory plans (BCP 8).
  - Review, reject, and impose conditions on transfers of ownership and major acquisitions (BCP 7).
  - Perform consolidated supervision, including application of prudential standards for the entire group (BCP 12).
  - Withdraw licenses, and collaborate with relevant authorities in deciding when and how to effect orderly resolution (BCP 11).
  - Identify and assess the build-up of risks, trends and concentrations within and across the system, in coordination with other relevant authorities, and address proactively any serious threat to the stability of the banking system (BCP 8 and 9).

### Delegation design and supervisory model (Hub-and-Spokes, paragraphs 23–30)
- Model principles:
  - All banks included in SSM; division of labor between center (ECB) and national authorities necessary.
  - Full centralization and full decentralization both undesirable.
  - Conferring formal responsibilities without enforcement power risks weak supervision.
- Common risk-based supervision:
  - Agree and apply a common analytical, risk-based framework; risk classification for each bank; ECB develops protocol for supervisory action frequency, level, type.
- Grouping banks:
  - Group I: global SIFIs (G-SIFIs), euro-area systemic banks, banks requiring (or nearly requiring) direct recapitalization by the ESM.
  - Group II: intermediate size, simple but potentially systemic for their sovereign.
  - Group III: very small banks unlikely to be systemic.
- Delegation by group:
  - Group I: direct and intrusive ECB supervision, onsite presence, international supervisors led by ECB.
  - Group II: mainly supervised by national authorities with onsite presence; mixed-nationality teams appointed and compensated by home countries; offsite monitoring by ECB and local supervisor.
  - Group III: day-to-day supervision fully delegated to national authority; ECB entitled to request participation equivalent to other groups at any time.
- Delegation by task:
  - Less standardized, more intrusive, discretionary or critical tasks less conducive to delegation (e.g., supervisory reviews, licensing, corrective actions, inspections, imposition of buffers, sanctioning, initiating resolution, approval for advanced approaches, model validation, thematic inspections).
- Escalation and two-dimensional delegation:
  - Preliminary recommendations accompany inspection teams; center review required for higher risk banks; flexible approach combining delegation by bank category and by task with escalation as institutions become more systemic.

### Transition steps (paragraph 31)
- First phase (urgent):
  - Provide ECB full legal powers and protections; create embryo off-site supervisory structure and decision-making body at ECB; develop standardized templates and centralized analysis; consider solvency and liquidity stress test of most important euro area banks.
- Second stage:
  - Develop consistent risk-based supervision protocols; front-load common corrective action protocols and escalation settings.
- Third stage:
  - Bring SIBs and higher-risk banks under direct ECB supervision; international teams perform risk assessments and develop supervisory plans; ECB to decide on permanent presence in some banks, intensive onsite inspections, or mixed teams for supervisory review.

### Risks associated with SSM establishment (paragraphs 32–37)
- Main risk categories:
  - Insufficient resources, skewed incentives, powers not commensurate with responsibility, governance conflicts, incomplete reforms.
- Specific concerns:
  - Overdependence on national authorities risks national favoritism and unclear accountabilities.
  - Governance conflicts between monetary policy/LOLR and supervisory roles could arise.
  - Incomplete framework: need single resolution authority and adequate common safety net; without centralized resolution, least-cost resolution is difficult and burden sharing problematic.
  - Single market risks if member states remain outside Banking Union; need efficient collaboration with non-participating countries.
  - TBTF persists; G-SIBs may continue to grow; common fiscal backstops and single resolution authority aligned with FSB Key Attributes would support stability.

### Macroprudential oversight considerations (paragraph 38)
- Case for centralization:
  - ECB should act as macroprudential oversight institution with binding powers to use macroprudential instruments if necessary to internalize cross-border externalities.
- Mixed model:
  - Pragmatic mixed model: both ECB and national authorities involved; ECB could impose systemic or countercyclical capital buffers if national authorities do not act.
  - Additional tools (e.g., limits on debt-to-income and loan-to-value ratios) could be provided to ECB when common toolkit exists.
- Costs and limitations:
  - Building capacity for country-specific macroprudential policies has costs and potential political pressures; coordination with ESRB required.

### ESRB role and implications for other EU countries
- ESRB interaction:
  - ECB provides resources to ESRB; ESRB should interact with ECB on macroprudential toolkits; strengthening ESRB powers/resources may be considered.
- Implications for non-euro area countries:
  - Concerns about uneven access to safety nets and opt-in/opt-out governance; benefits from Banking Union include greater stability, simplified supervision of cross-border banks, and positive spillovers.
  - Opt-ins motivations: pegged to the euro, high foreign currency liabilities, significant presence of euro area banks.
  - EBA role: voting procedures to be modified; EBA role in supervisory and resolution colleges should be strengthened.

### Resolution, safety nets, and common backstops
- Bank resolution: current national regimes and EU proposals
  - Many EU countries rely on corporate insolvency for bank failures; some countries strengthened frameworks aligned with FSB Key Attributes.
  - EC June 2012 draft directive for harmonized crisis management and resolution across EU; proposal for Single Resolution Mechanism to follow adoption of SSM.
  - December Council reaffirmed need for single resolution mechanism with financial sector contributions and backstops; EC to propose in 2013.
- Deposit Guarantee Schemes (DGS) and funding:
  - DGS are national and diverse; prefunding limited in many countries; harmonized deposit insurance limit set to €100,000 post-2008.
  - Draft DGS Directive (July 2010) proposed target pre-funding 1.5 percent of eligible deposits; June 2012 Directive establishes "financing arrangements" with target pre-funding of one percent of total liabilities excluding own funds within 10 years.
  - Example: French Fonds de Garantie des Depots about €2 billion at end-2010, about 0.1 percent of insured deposits.
- Safety nets and backstops:
  - Fiscal backstops and guarantees remain nationally-based; common fiscal backstops essential for systemic crises.
  - Article 97(2) quote: national financing arrangements not obliged to lend to another national financing arrangement when the lending national financing arrangement's resolution authority considers it lacks sufficient funds; not obliged to lend more than half of funds available when borrowing request formalized.
- Lender of Last Resort (LOLR):
  - Eurosystem provides liquidity via OMO and Standing Facility; ELA provided by NCBs; ELA losses borne by NCB, reinforcing sovereign links.
  - Argument for centralizing ELA at the ECB when ECB assumes supervisory responsibility to delink sovereigns from ELA losses.

### Design of Single Resolution Authority and coverage (sections 11, 16–19)
- Coverage:
  - Eventually include all banks licensed in eurozone; no bank should remain under non-bank national insolvency proceedings; consider extending coverage to holding companies, non-regulated operational entities, branches of foreign banks.
- Powers and tools (sections 12–14):
  - Preparation and prevention: review/validate recovery plans, prepare resolution plans, investigatory powers, require actions to remove impediments to resolvability, involve in intra-group support agreements.
  - Early intervention: require capital conservation measures, impose restrictions on activities, trigger resolution.
  - Resolution tools: take control, transfer assets/liabilities (P&A), set up bridge bank, create asset management vehicle, apply "bail-in tool", override shareholders’ rights subject to shareholders not being worse off than under liquidation.
- Central resolution authority design:
  - Fully-centralized authority in steady state recommended, with delegation possible; must align with FSB Key Attributes.
  - Burden sharing: ex ante rules, bail-in mechanisms, depositor preference, pooled industry contributions for normal resolution, pooled taxpayer contributions subject to systemic exemption.
  - Funding: euro-area resolution fund built from risk-based contributions; target to cover net fiscal costs of up to a large or few medium-sized bank failures; common fiscal backstops crucial.
  - Institutional considerations: independent EU institution on par with ECB preferred; transitional arrangements (temporary body/EU agency) could be used.
- Transition strategies:
  - "Big-bang" rapid centralization preferred but constrained by political/practical issues; "gradual" harmonize then centralize has pros/cons; risk of stalled reforms in gradual approach.

### Common safety nets, funding, and sizing (sections 26–27)
- DGS Directive harmonization elements:
  - 75 percent share of ex ante financing; target coverage ratio of 1.5 percent of eligible deposits after 10 years; permits ex post financing up to 0.5 percent of covered deposits; borrowing across national schemes up to 0.5 percent repayable within five years.
  - Bank contributions risk-based; prefunded target steady-state fund size of about €100 billion; coverage limit could remain at €100,000.
- Resolution funding:
  - National financing arrangements: target funding level at least one percent of covered deposits after 10 years; contributions on total liabilities excluding own funds.
  - DGS resources could be used for resolution; DGS would rank pari passu with unsecured creditors for covered deposits.
- Pan-euro area alternatives:
  - Preferred long-term approach: pan euro area deposit guarantee scheme and resolution fund covering all euro area banks.
  - Desired fund sizes: typical target size could range from about 1–2 percent of insured deposits in large systems to 4–5 percent in smaller systems (aiming to cover 2–5 mid-size banks or 4–6 small bank failures).
- Legal/governance concerns:
  - Single resolution fund may require Treaty change if "joint and several" due to Article 125 no bail-out clause.
  - Governance must allow swift decisions, ex ante burden sharing rules, and bail-in of unsecured senior creditors.
- Pecking order for burden sharing (suggested, subject to systemic exemption):
  1. Haircutting shareholders.
  2. Junior creditors.
  3. Bailing-in senior unsecured creditors.
  4. Bailing-in resolution and deposit insurance funds.
  5. Taxpayer contributions.
- Layers of common backstops:
  - Common resolution fund; ESM direct recapitalization (if needed, capable of covering crises requiring up to about 5 percent of euro area GDP of fiscal outlays if all ESM resources used); earmarked contingent euro-area taxation; ECB line of credit contingent on fiscal backstop.
- Historical support (Table II.2, Financial Sector Support, 2008–11, percent of 2011 GDP):
  - Belgium 7.0; Ireland 41.2; Germany 12.2; Greece 6.1; Netherlands 14.1; Spain 19.5; United Kingdom 6.8; United States 5.3.
- Euro Area Deposit Insurance key statistics (Table II.1, March 2012):
  - Selected lines — Eligible deposits | Covered deposits | Coverage ratio | Country share in covered deposits:
    - AUT: 277 | 176 | 63.6 | 3.3
    - BEL: 364 | 255 | 70.2 | 4.8
    - CYP: 42 | 26 | 62.7 | 0.5
    - DEU: 2,157 | 1,609 | 74.6 | 30.5
    - ESP: 909 | 671 | 73.8 | 12.7
    - FIN: 104 | 85 | 82.0 | 1.6
    - FRA: 1,511 | 1,127 | 74.6 | 21.4
    - GRC: 153 | 106 | 69.5 | 2.0
    - IRL: 126 | 93 | 73.6 | 1.8
    - ITA: 675 | 460 | 68.2 | 8.7
    - NLD: 581 | 451 | 77.6 | 8.5
    - PRT: 165 | 112 | 68.3 | 2.1
    - EUROAREA: 7,205 | 5,279 | 73.3 | 100.0
  - Notes: eligible deposits = sum of MFI household and corporate deposits; covered deposits apply EC coverage ratio to eligible deposits.

### ESM direct recapitalization, AMCs, and recapitalization design
- Rationale and role:
  - Timely ESM direct recapitalization of domestically systemic banks can help break sovereign-bank vicious circle, repair monetary transmission, prepare for banking union, and complete EMU.
  - ESM as patient, deep-pocket investor maximizing financial stability benefits and long-run returns.
- Eligibility, valuation, and operations:
  - Instrument aimed at domestically systemic banks; AMCs and resolution corporations could be eligible.
  - Capital shortfall sequence: shareholders and creditors first, then national government, with remaining shortfall covered by ESM.
  - Valuation should not rely on depressed market prices; consider historical-cost or real long-term economic value approach; stress tests conservative and not balanced valuations.
  - Recapitalization via acquisition of ordinary shares—diluting existing shareholders; ESM should avoid arrangements that guarantee sovereign downside or hinder delinking.
  - ESM recapitalization requires unanimity in ESM Board of Governors and, in some jurisdictions, national parliamentary approval.
  - ESM needs capacity to manage equity stakes or a special vehicle; governance and transparency required.
- Asset Management Companies (AMCs):
  - AMCs used for asset segregation and workout; advantages: remove balance sheet uncertainty, consolidate workout skills, prevent fire sales.
  - Disadvantages: loss of borrower-specific information, political interference risk, asset warehousing risk.
  - Transfer price trade-off: lower transfer price increases bank losses and AMC upside; EC principle: transfers at "real (long-term) economic value."
  - Funding: government bonds, AMC bond issuance backed by government, possibility of private investor participation with risk sharing.
  - ECB potential roles: direct support limited by Treaty; indirect support via accepting government-guaranteed AMC bonds as collateral; legal and monetary financing constraints apply.
- Urgency:
  - Delays in ESM recapitalization increase crisis resolution costs; "The sooner the ESM can move, the sooner current market dislocations ... can be resolved."

### LOLR centralization, collateral policy, and transitional issues
- Current system:
  - OMO and Standing Facility provide liquidity; ELA by NCBs; ELA losses borne by NCBs, reinforcing sovereign links.
- Centralization case:
  - Banking union implies centralized LOLR; ELA lending should transfer from NCBs to ECB when ECB assumes supervisory responsibility.
  - ECB ELA should be relatively short term (perhaps up to one year) and accompanied by supervisory intervention; could be rolled over for another up to one year in systemic crises.
  - ECB must accept wider collateral pool for ELA; options for covering potential ECB balance-sheet losses include recapitalization per capital keys or precommitted fiscal backstop.
- Transitional issues:
  - If large banks move to ECB supervision first, ECB could take over ELA responsibility solely for those banks; ELA limits for NCBs need adjustment; markets require clarity on which banks moved to ECB supervision.

### Practical governance, sequencing, and key recommendations
- Delegated system inevitability:
  - No single body can immediately supervise all euro area banks; delegated system required with clear chains of command and compatible incentives.
- Preconditions/prerequisites:
  - Clear financial stability framework with strong macroprudential oversight; crisis management and resolution frameworks; common safety net; operational independence; legal protection; sound governance; adequate resources.
- Sequencing recommendations:
  - Pragmatic sequencing: bring banks needing or nearly needing recapitalization by ESM and large/systemic banks under SSM first; progressively bring other banks under ECB supervision balancing risks of supervisory drift.
  - Parallel progress required toward single resolution authority, resolution fund, and common safety net with a clear, time-bound roadmap and key deliverables to minimize transitional risks.
- Accountability and resources:
  - Independence must be complemented with accountability to EU Parliament and eurogroup; supervisors need secure and adequate funding (industry levies and possible seigniorage), highly trained independent staff at center, and retained resources at national level.
- Risks to manage:
  - Stalled reforms, inadequate common backstops, lack of burden-sharing rules, governance conflicts between monetary policy/LOLR and supervision, and persistence of TBTF concerns.

*Source: SDN/13/01 – TECHNICAL BACKGROUND NOTES, INTERNATIONAL MONETARY FUND.*

### 1.      Supervision. Supervision aims to ensure bank soundness by verifying and enforcing

### _sdn1301technt - 1.      Supervision. Supervision aims to ensure bank soundness by verifying and enforcing

### Supervision: objectives and structures
- Supervision aims to ensure bank soundness by verifying and enforcing prudential rules and providing discretionary powers to control undue risk taking.
- National-based supervision:
  - Banking supervision in the EU is performed at the national level.
  - Minimum harmonization guided by the Basel Committee on Banking Supervision Core Principles for Effective Banking Supervision, implemented through EU Directives.
  - Supervisory handbooks and practices vary across euro area countries reflecting inter alia different market structures, underlying laws, taxes and accounting rules.
  - The draft Capital Requirements Regulation and Directive (CRR/CRD IV) will strengthen supervision (e.g., supervisory plans, onsite inspections, more robust and intrusive supervisory assessments) and harmonize sanctions.
  - The draft Directive on bank recovery and resolution aims at ensuring that national authorities have adequate preventative and harmonized tools and early intervention powers, including in relation to recovery planning.
- Cross-border cooperation:
  - Supervision of cross-border banks is coordinated within supervisory colleges.
  - Draft EU Directive on bank resolution and recovery clarifies home-host relations and responsibilities in EU colleges in a non-binding way, especially regarding intra-group liquidity provision.
  - Establishment of supervisory colleges is a major step forward, but national emphasis in supervision may distort incentives to share information and collaborate.
  - College participation can be cumbersome, particularly for small countries; smaller countries can be on the periphery of core colleges even if their local entity is systemic from a host country perspective.

### Regulation: prudential rules and the single rule book
- Purpose:
  - Prudential rules aim to ensure financial stability by promoting safety and soundness, limiting excessive risk taking, correcting informational imperfections, and building buffers to limit the frequency and costs of bank failures.
  - In the EU, prudential legislation is drafted by the EU Commission and decided upon by the Council and the European Parliament.
- Single rule book:
  - Starting with the CRR and CRD IV, the Commission aims to create a single set of harmonized prudential rules, a "single rule book," for all banks across the EU to ensure uniform application of Basel II and III by limiting national options and discretions.
  - The CRR tightens large exposure limits, liquidity ratios, and public disclosure requirements, and proposes an indicative leverage ratio.
- National flexibility:
  - The EU Council "Danish compromise" (approved in May 2012) acknowledges differing financial stability risks and provides national authorities flexibility to impose stricter standards to respond to macroprudential concerns.
  - The draft regulation allows member states to impose temporarily (for up to two years, but extendable) some stricter prudential requirements for domestically licensed financial institutions.
  - Drafts maintain national authorities’ capacity to require Pillar 2 capital add-ons for individual institutions based on their risk profile.
  - Specific numeric flexibilities in draft legislation include: Common Equity Tier 1 capital ratios can be increased by up to 3 percent (―systemic risk buffer‖) on all exposures or up to 5 percent on domestic or non-EU exposures without the Commission’s pre-approval; sectoral risk weights up to 25 percent beyond the common rulebook for real estate and financial sector exposures; stricter large exposure limits (up to 15 percent).

### Role of the EBA
- The European Banking Authority (EBA), established at the start of 2011, is a cooperative body for EU bank supervisors and contributes to regulatory and supervisory standard setting.
- Mandate and functions:
  - Issue technical standards in regulatory and supervisory areas (subject to fiscal safeguards).
  - Contribute to consistent application of EU legislation in regulation and supervision.
  - Organize and conduct peer review analyses of competent authorities, including issuing guidelines and recommendations and identifying best practices.
  - Promote supervisory convergence, address breaches of EU law, and coordinate EU-wide stress tests.
  - Ensure smooth functioning of supervisory colleges, including mediating disagreements.
  - Provide advice to EU institutions in areas of banking, payments and e-money regulation, corporate governance, auditing, and financial reporting.
  - Hold back-up enforcement authority in specific cases under strict conditions and safeguards.

### Macroprudential oversight
- National authorities are responsible for macroprudential oversight, but adequate frameworks are lacking in several euro area countries.
- Where frameworks exist (e.g., Germany and France), institutional frameworks are not necessarily consistent across countries.
- Coordination and internalization of cross-border spillovers is achieved at the EU level by the European Systemic Risk Board (ESRB) through a (non-binding) "comply or explain" mechanism.
- In December 2011, the ESRB issued recommendations on macroprudential mandates of national authorities; guidance for establishing common macroprudential toolkits is being developed.

### EU Commission proposal and EU Council agreement: timeline and roadmap
- Initial proposal (EC draft Regulation published September 12, 2012):
  - Confers supervisory tasks on the ECB as part of a roadmap toward establishing a Banking Union.
  - Based on Article 127(6) of the ESCB/ECB Statute; provides a mandate and broad powers to the ECB to perform supervision of all euro area banks starting January 2013.
  - Proposal sequence: banks receiving or requesting public financial assistance targeted first; systemically important banks subject to ECB supervisory activities from July 2013; from January 2014 all other credit institutions. (These dates have subsequently been pushed back.)
- Roadmap and legislative sequencing:
  - Commission announced draft legislations contributing to the single rule book (CRR/CRD IV) and on harmonizing and strengthening national resolution regimes and deposit guarantee schemes should be adopted by the end of 2012.
  - Commission announced plans for a single resolution mechanism (plans adopted by the EU Council on December 14, 2012).
  - Commission did not specify steps to establish common safety nets and backstops for deposit insurance and resolution funding.
  - The December 14, 2012 EU Council conclusions postponed adoption timelines for the draft Directive for bank recovery and resolution and for harmonization of deposit guarantee schemes (DGS) to June 2013.
  - Adoption of the CRR/CRD IV was noted to be "of the utmost priority so as to develop a single rule book."
  - Council conclusions called for an operational framework before June 2013 to allow the ESM to have the possibility to directly recapitalize banks when an effective SSM is established.
  - Note: a draft of the regulation agreed by EU leaders on December 13, 2012 calls for entry into force of the SSM regulation on March 1, 2013; Council conclusions postpone adoption of other draft legislations.

### Main elements of the SSM in the Council agreement
- Risk-based approach:
  - Transition is rapid and sequenced, focusing first on banks requiring public support, then systemic banks.
  - Council agreed the SSM would come into operation in March 2014, or one year after the legislation enters into force, whichever is later.
  - When the ESM requests the ECB to take over direct supervision of a credit institution as precondition for direct recapitalization, the ECB may immediately assume supervisory duties regardless of SSM start date.
- Coverage:
  - SSM would cover all credit institutions established in participating countries.
  - Most tasks related to "less significant" institutions would normally be carried out by national authorities.
  - Criteria for direct ECB supervision include size, importance for the economy of the EU or of a member state, and significance of cross-border activities.
  - Under Art 5(4) of the Council agreement, banks accounting for about 80 percent of euro area banking assets would be under direct ECB supervision.
  - Specific criteria for ECB direct supervision: (i) assets exceed €30 billion, (ii) the ratio of total assets to GDP of the home member state exceeds 20 percent, and (iii) national competent authorities consider the institution to be significant. A bank may also be designated significant by the ECB if it has significant cross-border assets or liabilities, relies upon ESM financial assistance, or is among the three largest institutions in the home member state.
- Mandate:
  - ECB is provided with a clear mandate for bank safety and soundness and financial stability.
- Tasks and powers:
  - ECB is provided broad investigatory and supervisory powers available to competent supervisory authorities under EU legislation, including:
    - Enforcing compliance with prudential norms regarding own funds, large exposure limits, liquidity requirements, leverage, disclosure requirements.
    - Licensing and withdrawal of authorization, assessing mergers and acquisitions, performing on-site inspections, requesting necessary information.
    - Carrying out stress tests and assessments for public recapitalization, imposing macroprudential (capital and liquidity) buffers, conducting consolidated supervision and supervision of financial holding companies.
    - Carrying out early intervention tasks in relation to listed prudential requirements, and assessing governance and internal capital adequacy processes.
  - Operational arrangements must ensure adequate division of labor between national authorities and the ECB, compatible incentives, and appropriate information sharing within the SSM.
  - ECB to adopt a detailed framework for practical modalities of supervisory cooperation within the SSM by mid-2013.
- Participation of other EU countries:
  - Non-participating member states may enter into close cooperation with the ECB if the national authority abides by ECB guidelines and requests and provides necessary information.
  - ECB tasked to coordinate and express a common position of euro area national supervisors at the Board of Supervisors and at Management of the EBA for issues relating to ECB-conferred supervisory tasks.
- Governance:
  - A supervisory board (aided by a Steering Committee) will be created to facilitate timely supervisory decision making under the oversight and responsibility of the Governing Council.
  - Council agreement strengthened governance to address separation between monetary policy and supervision and to ensure non-euro area countries have a voice in the SSM.
  - Draft decisions of the supervisory board will follow a "silent procedure": deemed adopted unless the Governing Council objects within 10 days in normal times, and 2 days in stressful times.
  - A mediation panel and a Steering Committee are to be created to help resolve disagreements and aid decisions.
- Accountability:
  - The Governing Council, and in particular the Chair of the supervisory board, is accountable to the Eurogroup and the EU Parliament through mechanisms including an annual report on the execution of the ECB’s supervisory tasks and transparency of its supervisory budget.
  - The ECB is subject to internal and external audits, including by the EU Court of Auditors, and judicial scrutiny by the EU Court of Justice.
  - Both the ECB and national authorities are responsible for banks under their direct supervision; the ECB is responsible for effective and consistent functioning of the SSM.
- Role of national authorities under the SSM:
  - National authorities will prepare and implement ECB acts under ECB oversight, perform day-to-day supervision activities, and directly supervise banks not classified as "significant."
  - National authorities remain exclusively responsible for consumer protection and AML tasks, receiving notifications related to the right of establishment, supervising activities of third countries' credit institution branches, and supervising payment services.
- Macroprudential policies under the SSM:
  - ECB will be able to impose capital buffers, such as a countercyclical capital buffer, in addition to capital requirements and any other measures aimed at addressing systemic or macroprudential risks as specified in EU acts such as the CRR/CRD IV package.
  - Council agreement provided both national authorities and the ECB with powers to use macroprudential instruments, in close collaboration, with specific reporting to national parliaments to strengthen accountability.
  - Either party taking a macroprudential step needs to inform and hear the other party ahead of time.
- Resources:
  - Supervision could be financed partly by risk-based levies on credit institutions.

### Assessment of the proposal and agreement
- Positive aspects:
  - Inclusion of elements necessary to make the Banking Union effective, including ability for the ESM to request the ECB to take over direct supervision of a credit institution as a precondition for direct recapitalization, regardless of SSM starting date.
  - Direct bank recapitalization by the ESM viewed as critical for near-term stabilization.
  - Proposal specifies a clear mandate and accountability of the ECB and confers broad investigatory and supervisory powers.
  - Fast adoption of draft Directives on regulation, DGS, and Bank Recovery and Resolution is welcomed.
  - Call for a single resolution mechanism and need for appropriate and explicit backstops is welcomed.
- Requirements for effectiveness:
  - Ambitious, though risk-based, approach will require rapid establishment of resources and frameworks.
  - Need for operational arrangements to ensure adequate division of labor, compatible incentives, and appropriate information sharing within the SSM.
- Areas needing further clarity:
  - How delegation of supervisory tasks and associated control will be realized.
  - Macroprudential oversight arrangements.
  - Powers to assume national discretion as defined in the CRR/CRD IV.
  - Allocation of powers to intervene, enforce administrative sanctions, and trigger resolution (alongside a single resolution authority to be established).
  - Home-host supervisory arrangements for non-EU banks and interaction with the EBA.
  - While Article 127(6) ESCB/ECB Statute allows conferral of some supervisory tasks on the ECB, strengthening the legal basis of the framework over time may require Treaty change to minimize litigation risk.

*Prepared by Thierry Tressel, Pelin Berkmen (European Department), Fabiana Melo, Katharine Seal (Monetary and Capital Markets Department), and Wouter Bossu, Atilla Arda, Alessandro Gullo and Nikita Aggarwal (Legal Department).*

### 10.      Risks. The EC proposal and agreement carries risks of an incomplete framework. While it

### _sdn1301technt - 10.      Risks. The EC proposal and agreement carries risks of an incomplete framework. While it

### Risks and overall assessment
- The EC proposal and EU Council agreement sketch a swift implementation of a single supervisory mechanism (SSM) but lack a roadmap toward a common safety net, which is essential for depositor confidence and to weaken sovereign-bank links.
- Greater clarity is needed on how and when a single resolution authority can be established; the Commission and EU Presidency proposals are conditional on prior agreement on draft Directives on deposit guarantee schemes and bank recovery and resolution.
- Clarification is needed on whether implementation of an SSM would require changes to national legislations.
- The legality of the legal instrument establishing the SSM and its decisions could be challenged before the EU Court of Justice by EU Institutions (including the EU Parliament), member states, and any private person or entity affected by SSM decisions.

### Table I.1 — Key elements and IMF assessment
- Supervision: Single supervisory mechanism centered at the ECB
  - Starting March 01, 2013; and full effect by March 01, 2014 (or 1 year after the legislation enters into force, whichever is later).
  - The ECB is provided with broadly adequate governance, powers, and accountability to perform supervisory tasks.
  - Areas requiring more progress/clarity:
    - allocation of powers to intervene and enforce administrative sanctions and trigger resolution;
    - adequate degree of delegation to national authorities (though the Council agreement includes some clarifications on allocation of banks and some tasks);
    - home-host supervision with non-EU countries;
    - macroprudential oversight (agreement gives both ECB and national authorities some powers).
  - Governance agreements (for SSM and EBA) are complex; timely and effective decision making must be promoted in practice.

- Regulation:
  - As soon as possible: adopt a "single rule book" while providing some flexibility to national authorities.
  - Role of the EBA as standard-setter for the EU is confirmed.
  - Fast adoption is necessary, aligned with Basel III requirements.
  - Areas lacking clarity:
    - ECB’s power to assume national regulatory discretion;
    - EBA’s role in supervisory/resolution colleges.

- Resolution:
  - By June 2013: adopt EU directive harmonizing and strengthening national resolution regimes.
  - Announce steps toward a single euro area resolution authority when agreement on the Directive is achieved in the course of 2013.
  - Fast adoption of the resolution directive is welcome.
  - A single resolution authority, with adequate backstops, is necessary and urgent.
  - Transposition deadlines noted: 01/2015, and 01/2018 for bail-ins — transposition should be accelerated relative to current deadlines.

- Safety net:
  - By mid-2013: adopt EU directive harmonizing national deposit guarantee schemes.
  - The proposal lacks a roadmap toward common safety nets.
  - Common deposit insurance and backstops are crucial to restore confidence and weaken links between banks and sovereigns.

- Other EU countries:
  - Close cooperation as non-voting member of the SSM;
  - Abide by ECB guidelines and requests, subject to safeguards;
  - EBA confirmed in its current role, but further reforms postponed to 2014 review of the ESFS.
  - Non euro area EU countries that wish to opt in may require strong governance safeguards but should not be allowed to opt out too easily after they join.
  - Countries that peg to the euro or have large FX liabilities (or euro area bank presence) may have relatively larger benefits from opting in than others.
  - To improve home/host supervision with other EU countries, the EBA should be provided with stronger powers in colleges.

- ESM recapitalization:
  - Agreement on operational framework, including the definition of legacy assets, by June 2013.
  - Framework must be in place to ensure that the ESM will have the possibility to swiftly directly recapitalize banks.

### Design of the Single Supervisory Mechanism — lessons and standards
- Lessons from federations (United States, Canada):
  - Supervision, safety nets and resolution can be established at the federal/central level.
  - Different organizational models exist (delegation vs full centralization).
  - Benefits of mechanisms ensuring effective coordination and information flows among sister agencies, including overlaps to avoid gaps, strong corrective action mechanisms, early intervention, and horizontal checks and balances.

- International standards:
  - The "Core Principles for Effective Supervision" or Basel Core Principles (BCPs) issued by the Basel Committee on Banking Supervision are the accepted minimum standards for prudential regulation and supervision and provide guidance for designing and assessing the SSM.

### Considerations specific to the euro area SSM design
- The ECB will be formally accountable for supervision but will rely on national-level competencies and resources due to:
  - resource constraints in the near term;
  - differences in legal, accounting and tax frameworks;
  - differing local language, business and supervisory cultures;
  - local knowledge and relationships important for assessing bank activities.
- The center will need to delegate supervisory operations but also monitor them to contain reputational risks.
- The allocation of powers and the delegation/decentralization design will be crucial to effective supervision.

### Preconditions and prerequisites
- Preconditions (BCPs): a number of preconditions for sound banking supervision must be met in the longer term, including:
  - a clear framework for financial stability policy providing strong macroprudential oversight;
  - crisis management and resolution frameworks to deal effectively with bank failure and minimize disruptions;
  - an appropriate common safety net to deal with risks to confidence and contagion while minimizing distortions.
- Many preconditions are beyond supervisors’ jurisdiction and are not yet in place at the euro area level; resolution regimes and safety nets remain nationally based and, in most countries, need strengthening to align with FSB Key Attributes for Effective Resolution.

- Prerequisites for the SSM:
  - Operational independence consistent with statutory responsibilities, legal protection of supervisors, transparent processes, sound governance, adequate resources, and accountability.
  - Specific considerations:
    - Objectives and mandates:
      - As supervisor, the ECB should ensure safety and soundness of credit institutions and adopt a systemic approach contributing to preserving the integrity of the Single Market for financial services.
      - Under the EU Treaty, the primary objective of the ECB is price stability; its secondary objective is to support general economic policy objectives of the EU (e.g., a high level of employment and sustainable and non-inflationary growth).
      - Involving the ECB in supervision gives it access to supervisory information supporting its monetary policy and lender of last resort (LOLR) functions and helps separate illiquid from insolvent banks.
      - A revision of ECB objectives through Treaty changes may be warranted to clarify the interaction between monetary mandate and supervisory mandate and to explicitly specify that the ECB’s supervisory mandate includes financial stability and macroprudential oversight.
    - Operational independence and legal protection:
      - Operational independence regarding the ECB’s supervisory mandate derives legally from the ECB/ESCB statutes.
      - Bringing supervision under the ECB introduces risks for its independence and reputation due to potential political interference; Treaty modifications should be considered to safeguard independence and strengthen legal protection for supervisors.
    - Governance:
      - The Governing Council is the ECB decision-making body and is responsible for supervisory tasks per Article 127(6) of the Treaty.
      - Sound governance is crucial for early risk identification and timely, effective decision making in the interest of the whole banking union.
      - Decision-making arrangements and voting:
        - Options include one-member-one-vote to account for regional interests, or voting rights based on economic size, or a balance (uniform basic votes combined with votes relative to economic size).
        - Consideration for providing non-euro area members that join with voting rights.
      - Firewalls:
        - Robust firewalls between monetary policy and supervision would protect independence and credibility of each ECB function, ensure confidentiality of supervisory information, and limit conflicts of interest while exploiting synergies.
      - Institutional design options:
        - Establish a Supervisory Board within the ECB, assisted by a Steering Committee and Supervisory Department, to perform supervisory tasks and related decisions (under the EC proposal), with supervisory and monetary decisions reconciled at the Governing Council.
        - Alternatively, create a separate body from the Governing Council to provide stronger firewalls — this could complicate coordination, be legally complex, and require Treaty change.
      - Delegation and chains of command:
        - Need clear chains of command and adequate incentives when delegating supervisory tasks to national authorities.
    - Accountability:
      - Independence must be complemented with accountability to European citizens.
      - Under the Treaty, ECB monetary policy reporting is addressed to the European Parliament, EU Council, Commission, and European Council.
      - Given fiscal implications of supervision, stronger (e.g., more frequent) reporting to the EU Parliament and the euro group could be envisaged for the supervisory function.
    - Resources:
      - Supervisors need secure and adequate funding.
      - Pragmatism should govern funding and implementation decisions, but resources should allow the ECB to build adequate capacity while protecting it from influence by national authorities or the industry.
      - The ECB will need highly trained and independent staff at the center (including, but not only from, national authorities) to directly supervise a subset of banks (including globally systemic banks); this will take time.
      - National supervisors must retain sufficient resources to perform their tasks.
      - Funding models could consider combinations of industry levies (based on the size and the risk profile of supervised banks) and central bank support (seigniorage), provided transfers from the ECB’s monetary policy leg (seigniorage income) to its supervisory leg do not hamper the execution of its monetary mandate.

### Bank coverage, sovereign-bank links, and transition
- Steady state:
  - The SSM should eventually cover all of the roughly 6000 credit institutions licensed in the eurozone.
- Sovereign-bank links:
  - The Banking Union aims to weaken or sever sovereign-bank links and limit buildup of systemic risk.
  - Large and cross-border banks should be included; small banks with correlated risks can represent major fiscal and systemic risks.
  - Covering only "systemic" banks would only partially address these risks.
- Competitive distortions:
  - A Banking Union covering only a subset of euro area banks would affect the level playing field and could encourage regulatory arbitrage between centrally and nationally supervised banks.
- Uneven distribution of costs and benefits:
  - Because banking size and activities differ across countries, a partial Banking Union would benefit some countries more than others and affect distribution of costs and benefits.
- Transition considerations:
  - Positives of swift transition:
    - Reduce risks of regulatory forbearance between announcement and transfer of responsibilities.
    - Enable possibility of direct ESM recapitalization of banks.
  - Risks of rapid transition:
    - If supervisory capacity at the center is not built quickly and incentives are misaligned, risks include information losses, supervisory drift, and regulatory forbearance.
    - Building effective capacity at the center is challenging and requires urgent planning under a realistic but ambitious timeline.
  - Sequencing recommendation:
    - Pragmatic approach: bring banks needing—or nearly needing—recapitalization by the ESM or other public funds, and large and systemic banks, under the SSM first; progressively bring other banks under ECB supervision at a pace that balances risks of supervisory drift.

### Tasks and powers to be conferred on the ECB
- Principles:
  - Supervisors should have clear responsibilities and objectives for each authority involved (BCP 1).
  - As a supervisor in its own right, the ECB must comply with the Basel Core Principles.
  - Assessment of the SSM’s effectiveness will depend on functions delegated, capacity constraints, and accountability and control mechanisms.
- Tasks the ECB should be responsible for across the life cycle of banks:
  - Authorizing banks;
  - Assessing and authorizing mergers and acquisitions;
  - Ensuring compliance with prudential requirements;
  - Imposing additional buffers (including countercyclical and systemic buffers);
  - Applying requirements regarding internal governance and processes of banks;
  - Imposing measures necessary to address early unsafe and unsound practices by banks;
  - Carrying out stress tests;
  - Conducting consolidated supervision;
  - Taking on tasks related to home-host arrangements for cross-border banks.
- The EC proposal broadly confers these tasks on the ECB.

*Source: SDN/13/01 – TECHNICAL BACKGROUND NOTES, INTERNATIONAL MONETARY FUND*

### 20.      Powers. To carry out its tasks effectively, including potentially solo supervision of a set of

### _sdn1301technt - 20.      Powers. To carry out its tasks effectively, including potentially solo supervision of a set of

### Powers required for the ECB to supervise banks (paragraph 20)
- Enforce minimum prudential standards and any restrictions prescribed by the supervisory review, including increasing prudential requirements for individual banks and banking groups based on their risk profile and systemic importance (BCP 1 and 16).
- Request information and have full access to banks’ boards, management and staff records, and perform general investigations and onsite inspections (BCP 1 and 10).
- Require all necessary early corrective actions to address unsafe and unsound practices or activities that could pose risks to banks or to the banking system, and prevent banks from breaching standards (BCP 11).
- Ring-fencing of the bank from the actions of parent companies, subsidiaries, parallel-owned banking structures and other related entities in matters that could impair the safety and soundness of the bank or the banking system (BCP 11).
- Take measures and sanctions in line with the gravity of the situation, including revoking the license (BCP 11).
- Determine supervisory plans (BCP 8).
- Review, reject, and impose conditions on transfers of ownership and major acquisitions (BCP 7).
- Perform consolidated supervision, including application of prudential standards for the entire group (BCP 12).
- Withdraw licenses, and collaborate with relevant authorities in deciding when and how to effect orderly resolution (BCP 11).
- Identify and assess the build-up of risks, trends and concentrations within and across the system, in coordination with other relevant authorities, and address proactively any serious threat to the stability of the banking system (BCP 8 and 9).
- Note: See below on macroprudential responsibilities.

### Formal versus real powers and ensuring real powers (paragraphs 21–22)
- Distinction: formal powers must be conferred on the ECB, but “real powers” require adequate resources and monitoring during transition when real powers may partly remain with national authorities.
- Risk: the ECB should not merely validate and assume responsibility for national authorities’ decisions.
- Mechanisms to ensure real powers could include:
  - Immediate authority to conduct peer reviews and joint inspections with cross-country teams including lead supervisors from other countries or the ECB.
  - Use of a range of metrics, solvency, and liquidity stress tests to determine which banks require ECB attention or review.

### Design of a delegated supervisory mechanism (paragraphs 23–30)
- “Hub and Spokes” model:
  - All banks included in the single supervisory mechanism (SSM); division of labor between center (ECB) and national authorities necessary.
  - Full centralization and full decentralization are both undesirable.
  - Conferring formal responsibilities without enforcement power risks weak supervision and damage to ECB reputation.
- Common risk-based supervision:
  - Agree and apply a common analytical, risk-based framework across the SSM.
  - Attribute a risk classification to each banking organization; ECB develops a protocol specifying frequency, level, and type of supervisory action.
  - Centralization level, intrusiveness, and multinational team composition proportionate to supervisory risk assessment.
  - Define a non-rigid perimeter for institutions subject to supplementary scrutiny.
- Principles to guide delegation:
  - (i) systemic dimension: center advantage in systemic, cross-border externalities and supervision of SIFIs;
  - (ii) local knowledge and know-how;
  - (iii) risks of regulatory capture at national level;
  - (iv) delegation degree decreases with task discretion;
  - (v) consistency of delegation among national authorities and with the center.
- Grouping banks (paragraph 26):
  - Group I: global SIFIs (G-SIFIs), banks determined to be systemic for the euro area, and banks requiring (or nearly requiring) direct recapitalization by the ESM.
  - Group II: banks of intermediate size, simple but potentially systemic for their sovereign (individually or as a group).
  - Group III: very small banks unlikely to be systemic or to require access to a common backstop.
- Delegation by group (paragraph 27):
  - Group I: direct and intrusive ECB supervision, onsite presence, international supervisors in teams led by an ECB supervisor.
  - Group II: mainly supervised by national authorities with onsite presence; mixed-nationality teams appointed and compensated by home countries; offsite monitoring by ECB and local supervisor.
  - Group III: day-to-day supervision fully delegated to national authority; ECB entitled to request participation equivalent to other groups at any time.
  - For all groups: offsite monitoring by ECB and local supervisor.
- Delegation by task (paragraph 28):
  - Tasks harder to standardize, more intrusive, discretionary, or critical to the system are less conducive to delegation.
  - National authorities could carry out day-to-day assessments and some examinations under ECB guidance.
  - ECB or mixed teams should handle supervisory reviews, licensing, corrective actions, inspections, imposition of higher individual or macroprudential buffers, sanctioning, initiating resolution, approval for advanced approaches and certain capital instruments, model validation, and thematic/horizontal inspections.
  - ECB should be closely involved in stress tests, intrusive examinations, M&A approvals, and initiation of early corrective actions.
- Escalation of decision making (paragraph 29):
  - Preliminary recommendations left behind by inspection teams regardless of risk level.
  - For higher risk banks (Groups I and II), center review required.
  - For less-systemic banks, national level implements corrective action and escalates to center if unresolved.
  - Inspection reports could be peer-reviewed as first escalation step.
- Two-dimensional delegation (paragraph 30):
  - Flexible approach combining delegation by bank category and by task, with escalation as institutions become more systemic and tasks more critical.

### Transition steps to the steady state supervisory mechanism (paragraph 31)
- First phase (urgent):
  - Provide ECB with full legal powers and protections to perform supervisory tasks, including powers to impose corrective actions and initiate resolution.
  - Create embryo off-site supervisory structure and decision-making body at the ECB.
  - Develop standardized templates for information and share supervisory data.
  - Centralized analysis to create thresholds for centralized supervisory actions and classify banks.
  - Consider a solvency and liquidity stress test of the most important euro area banks.
- Second stage:
  - Develop consistent risk-based supervision protocols specifying frequency, level, type of supervisory action, centralization, intrusiveness, and multinational team mix.
  - Front-load development of common corrective action protocols, common timeframes to address deficiencies, and common escalation settings for corrective actions and sanctions.
- Third stage:
  - Bring systemically important banks (SIBs) and higher-risk banks under direct ECB supervision and finalize common protocols and delegation design.
  - When ECB starts supervising SIBs, international teams perform risk assessments and develop supervisory plans, identify areas needing mixed-nationality teams, and estimate workforce and skill needs at headquarters and national level.
  - ECB to decide on need for permanent presence in some banks, intensive diagnostic onsite inspections, or use of mixed teams for supervisory review and advanced approach authorizations.
- Note: Draft regulation allows ECB to start directly supervising a bank if the ESM unanimously requests ECB to take over direct supervision (Art 27(3)). (footnote 13)

### Risks associated with establishing an SSM (paragraphs 32–37)
- Categories of risks: insufficient resources, skewed incentives, powers not commensurate with responsibility, governance conflicts, and incomplete reforms.
- Inadequacy of resources, skewed national incentives, and lack of real power (paragraph 32):
  - ECB must be properly resourced and able to perform key tasks itself and resolve disagreements with national authorities, especially when ESM recapitalization is in place.
  - Overdependence on national authorities risks national favoritism and unclear accountabilities.
  - Delegation to national supervisors useful during transition but risks locking in imperfect delegation practices.
- Governance conflicts of interest (paragraph 33):
  - Need robust governance to ensure monetary policy and LOLR functions and ECB reputation are not compromised.
  - Conflicts may arise when monetary policy decisions impact solvency or when LOLR lending risks supporting insolvent banks.
  - As creditor, ECB may face conflicts when supervisory actions (e.g., license withdrawal) trigger resolution and losses to claimants.
- Incomplete framework (paragraphs 34–35):
  - Single supervisory mechanism requires a single resolution authority and adequate common safety net.
  - Without centralized resolution, coordinating corrective actions and initiating resolution across national authorities is difficult; least cost resolution hard to achieve; conflicts over loss distribution may arise.
  - Without adequate common fiscal backstop and funding for resolution, political buy-in may be jeopardized and incentives within delegated supervision harmed if fiscal costs remain national.
  - Urgent need for a plan for a more complete Banking Union; steps toward single resolution authority and resolution fund should be taken as soon as possible and ideally in parallel with the shift to the single supervisory regime.
- Single market risks (paragraph 36):
  - Member states remaining outside Banking Union create “variable geometry” risks for the single market.
  - Efficient framework needed to ensure collaboration between SSM and non-participating countries; the EBA could develop a single supervisory handbook.
- Other risks (paragraph 37):
  - Banking Union will not by itself solve TBTF; some G-SIBs may continue to grow, including beyond the euro area.
  - Common fiscal backstops and a single resolution authority aligned with FSB Key Attributes would support stability; SSM could contain incentives to grow excessively (e.g., capital surcharges for SIFIs).
  - Changes in finance structure could create new, unanticipated risks via new interconnections, mergers, and facilitation of larger external macroeconomic imbalances.

### Further considerations — Macroprudential oversight (paragraph 38)
- Case for centralization:
  - ECB should act as macroprudential oversight institution for euro area countries, with binding powers to use macroprudential instruments if necessary.
  - High financial integration calls for coherent macroprudential policies that internalize cross-border externalities and address home-host coordination problems.
  - Centralization does not imply policy homogeneity; policies must be flexibly adapted to country- or market-specific macrofinancial developments and apply to all financial institutions active in those countries or markets.
- Costs and limitations:
  - Building capacity for country-specific macroprudential policies has costs, but given ECB expertise in financial stability, these costs may not be high.
  - Potential overlap with ESRB role requires coordination.
  - Risk that ECB macroprudential responsibilities expose it to political pressures or disagreements with national authorities, adding rigidities.
  - ECB mandate excludes insurance firms and securities markets; collaboration with competent authorities needed when such institutions are involved.
- Mixed model:
  - A pragmatic mixed model could involve both ECB and national authorities as implied in the legislative proposal for the SSM.
  - ECB might be conferred power to impose systemic or countercyclical capital buffers if national authorities do not act, countering lack of “will to act.”
  - Additional tools (e.g., limits on debt-to-income and loan-to-value ratios) not in CRR/CRD IV may be provided to the ECB when a common macroprudential toolkit exists.
  - Alternatively, if national authorities retain macroprudential policies, use of tools may need coordination and validation by the ECB and mechanisms to resolve conflicts of interest.

*SDN/13/01 – TECHNICAL BACKGROUND NOTES, INTERNATIONAL MONETARY FUND*

### 39.      ESRB. The ESRB should remain the EU macroprudential oversight body, and closely

### ESRB. The ESRB should remain the EU macroprudential oversight body, and closely cooperate with the ECB

### ESRB role and interaction with ECB
- Under the current framework, the ECB provides resources to the ESRB and is represented at the ESRB General Board by the President (who chairs the ESRB Board), the Vice President and the Governors of the NCBs.
- The ESRB should interact with the ECB on macroprudential toolkits when the ECB takes on macroprudential responsibilities.
- Going forward, considerations may be given to strengthening the ESRB powers and resources.

### Implications for other EU countries — concerns
- Some non-euro area EU countries have questioned whether uneven access to safety nets and backstops or policies implemented to the benefit of the euro area could adversely impact the single market.
- Concerns include whether their interests would be taken into account by a powerful single supervisory mechanism if they:
  - choose to either opt out and are impacted by the decisions of the single mechanism; or
  - opt in but not have a vote in the Governing Council.
- Some have voiced hope that the opt-in could be made more attractive, e.g., through access to backstops.

### Implications for other EU countries — benefits
- A Banking Union would contribute to greater stability in the euro area and enhance the functioning of the EU single market for financial services, generating positive cross-border spillovers to other EU countries.
- A single euro area supervisory mechanism should simplify the supervision of cross-border banks.
- Within supervisory colleges, non-Member States would coordinate home-host supervision with the ECB instead of interacting with multiple individual euro area supervisors.

### EU Commission/Council proposal and governance
- Flexible supervisory arrangements, such as close cooperation of the ECB with supervisors in non-euro area Member States as envisaged by the Commission and the Council agreement, may suffice to achieve effective supervisory convergence under the current Treaty.
- Housing supervision within the ECB necessitates consideration to provide non-euro area countries with a say within the single supervisory mechanism, through a robust governance mechanism as envisaged in the draft legislation by the Council of the EU.

### Opt-ins — motivations and trade-offs
- Other EU countries may want to join the Banking Union, especially if they:
  - are pegged to the euro;
  - sustain high levels of foreign currency liabilities; or
  - have a significant presence of euro area banks in their domestic financial system.
- In the steady state, a common safety net would:
  - strengthen insurance mechanisms and depositor confidence for all;
  - provide a stronger basis to ensure private sector participation in bank resolution;
  - improve supervisory quality (in particular, in small countries where resources are scarce);
  - help internalize cross-border effects; and
  - solve coordination problems arising in supervision or resolution.
- Joining requires shifting control to the center.

### The role of the EBA
- To ensure balance of power at the EBA, voting procedures are to be modified for decisions requiring qualified majority.
- Double majority voting, as envisaged by the EU Council agreement, would balance the interests of the “outs.”
- Reforms of the EBA should go beyond the proposal:
  - The EBA role in supervisory and resolution colleges should be strengthened, together with the SSM, to reinforce coordination and cooperation in home-host issues for cross-border banks operating outside the single supervisory mechanism.

### F. Summary — benefits of a single supervisory mechanism
- A single supervisory mechanism is an essential step toward a Banking Union covering all banks in the euro area.
- It is part of a comprehensive response to the crisis—a pre-condition to direct recapitalization of banks by the ESM.
- In the longer term, it should:
  - provide the momentum and the vehicle to deliver consistently higher standards of supervision;
  - remove national distortions;
  - internalize cross-border effects; and
  - deliver more uniform enforcement of regulations across the region.
- Higher standards of supervision in place before the crisis may have led to swifter identification of unsustainable build-ups of risk (for example, in Ireland or Spain) and more timely and effective interventions (for example, through applying higher capital buffers or restricting excessive concentrations).
- Benefits over a nationally-based setup depend on alignment with international best practices, including:
  - clear statutory responsibilities and objectives for the ECB;
  - strong legal powers to carry out supervisory tasks;
  - operational independence;
  - legal protection;
  - sound governance; and
  - adequate resources.

### Practical issues and governance considerations
- No new single body can effectively supervise all euro area banks; a delegated system must be implemented.
- Local information and know-how argue for delegating responsibilities to national authorities.
- Systemic perspective, prospect of local regulatory capture, greater standardization of tasks, and need for public recapitalization argue for giving the ECB conduct of certain tasks and final responsibility for banking supervision.
- Real power must be aligned with responsibility; granting responsibility to the center without power risks distorting incentives.
- Strong governance is important to contain conflicts of interest that may arise between monetary policy and LOLR functions and supervisory functions.

### Essential package and sequencing
- Speed and sequencing of implementation need to be chosen carefully to minimize disruptions during transition.
- In parallel, progress is needed toward:
  - a single resolution authority;
  - a resolution fund; and
  - an adequate common safety net.
- Their absence could:
  - strain incentives (e.g., regarding the distribution of losses in resolution);
  - expose the ECB to political pressures; and
  - compromise the effectiveness of supervision.
- Full commitment and a clear and time-bound roadmap with key deliverables toward establishing a single resolution authority and safety net would minimize such risks.

### The “outs.”
- Establishing a single supervisory mechanism will benefit other EU countries through:
  - more effective interactions in cross-border colleges; and
  - a more stable monetary union.
- Other EU countries may want to join the Banking Union to benefit from more uniform and higher supervisory quality and stronger safety nets, although these economies and those that choose to opt-out would require stronger governance safeguards.

### Annex I.1 — Selected international comparisons (high-level findings)
- United States:
  - Banking regulation has traditionally been fragmented with multiple regulators.
  - Dodd-Frank consolidated supervision in fewer agencies, created the Financial Stability Oversight Council (FSOC), assigned oversight authority over institutions designated by the FSOC to the Federal Reserve, and gave resolution authority over such institutions to the FDIC.
  - The FDIC manages the federal deposit insurance fund (DIF), which is funded by risk-based levies and backed by the Treasury; the deposit insurance ceiling was raised to US$250,000 during the 2008 financial crisis.
  - As part of Dodd-Frank, the FDIC has authority to establish a widely-available program to guarantee liabilities of solvent insured institutions under certain conditions during severe economic distress.
  - The FDIC has powers to examine institutions, issue regulations, initiate early intervention, require corrective actions, manage receiverships, and liquidate systemically important financial institutions.
  - The Fed’s scope includes bank holding companies, U.S. branches of foreign banks, state-chartered banks that are Federal Reserve members, and firms designated by the FSOC as systemically important.
  - The Dodd-Frank Act brought firms with assets of US$50 billion or more (or designated by the FSOC) under FDIC/Fed resolution and review of “living wills.”
- Canada:
  - Regulatory and supervisory framework spans federal and provincial levels.
  - Department of Finance (DOF) is responsible for overall stability and legislation; Bank of Canada (BOC) assesses risks to financial system stability; Office of the Superintendent of Financial Institutions (OSFI) is the prudential regulator and supervisor of federally regulated financial institutions.
  - Canada Deposit Insurance Corporation (CDIC) insures deposits and is the Canadian bank resolution authority.
  - Provincial authorities regulate most credit unions and provincial deposit insurers back those schemes.
  - Coordination mechanisms include the Financial Institutions Supervisory Committee (FISC), the Senior Advisory Committee, and the Heads of Agencies committee.
  - There is no single formal entity for macroprudential oversight; in practice, BOC monitors systemic risks and DOF is responsible for macroprudential issues.

*Source: SDN/13/01 – TECHNICAL BACKGROUND NOTES, INTERNATIONAL MONETARY FUND*

### 67.      Resolution. The bank intervention framework in Canada is based upon inter-agency

### _sdn1301technt - 67.      Resolution. The bank intervention framework in Canada is based upon inter-agency

### Canada — Bank intervention and resolution responsibilities
- Prudential supervision of individual financial institutions is discussed at the FISC.
- Bank resolution responsibility:
  - Is the responsibility of the CDIC, which is subject to a least-cost resolution requirement.
  - CDIC Board includes the BOC Governor, OSFI Superintendent, FCAC Commissioner and the Deputy Minister of Finance, as built-in consultation mechanisms and checks.
  - CDIC can terminate an institution’s deposit insurance, which would mean closing the institution, unless objected by the Minister of Finance for exceptional circumstances.
- OSFI roles and tools:
  - OSFI’s legislated early intervention mandate complements the intervention regime and provides a framework for accountability.
  - OSFI’s Guide to Intervention provides a transparent framework for intervening.
  - OSFI’s Advisory for Non-Viability Contingent Capital provides defined triggers for non-viability situations for federally-regulated institutions.

### Euro Area — Purpose of the paper
- The paper elaborates on the design of a single resolution framework and a common safety net with backstops for the Euro Area.
- Section A describes the current national-based setup of resolution and safety nets in the Euro Area and discusses drawbacks versus an integrated prudential system.

### Bank resolution framework — Current national regimes and reforms
- National regimes:
  - Many EU countries rely on general corporate insolvency proceedings for bank failures, which can be complex, lengthy, costly, and inefficient.
  - Several countries (e.g., Germany, the U.K., and Ireland) strengthened bank resolution frameworks to align with international best practices such as the FSB Key Attributes of Effective Resolution Regimes for Financial Institutions.
  - Germany’s new resolution framework provides broad early intervention powers and resolution tools, including the possibility to “bail-in” senior unsecured creditors and creation of a resolution fund partially prefunded by levies on the industry.
  - U.K. proposals (Vickers) include creation of a resolution fund and power to bail-in creditors, complementing the U.K.’s special resolution regime for banks.
- EU proposals and legislative steps:
  - June 2012: EC issued a draft directive for harmonized crisis management and resolution framework across EU countries (expected adoption by EU Parliament in early 2013).
  - New national regimes would be consistent with FSB Key Attributes and endow EU countries with strong early intervention powers (e.g., capital raising/conservation measures, restrictions on activities, recovery plan implementation) and resolution tools (e.g., bridge banks, asset separations, override shareholders rights, replace management, divest non-essential businesses, trigger debt write-down or bail-in).
  - EC blueprint of November 27, 2012 stated a proposal for a Single Resolution Mechanism would follow adoption of the Single Supervisory Mechanism.
  - December EU Council agreement reaffirmed need for a single resolution mechanism with adequate powers and tools; mechanism to be based on financial sector contributions and backstop arrangements to recoup taxpayer support over the medium term; EC to make a proposal in 2013.
- First steps for cross-border resolution:
  - EC envisaged mechanisms for cross-border banks, including the EU Directive on bank recovery and resolution which:
    - Offers principles for early intervention and resolution of cross-border banks (e.g., liquidity provision within cross-border groups).
    - Establishes resolution colleges to develop non-binding mechanisms for crisis planning and resolution (with EBA mediating).
  - Absence of binding ex ante burden-sharing agreements leaves key coordination problems unsolved (e.g., Fortis, Dexia), potentially undermining least-cost resolution.
  - Fast national implementation of the Directive is highly desirable and could lead to further legislation or Treaty change toward a centralized European Resolution Authority.

### Safety nets — Deposit insurance, backstops, and LOLR
- Deposit insurance schemes:
  - Schemes are national and diverse across EU countries.
  - Key differences:
    - Coverage, mandate, payout, and funding arrangements vary; some mandatory schemes are supplemented by voluntary schemes.
    - Example: Germany’s complex voluntary DGS insures accounts up to 30 percent of bank capital per depositor (in practice offering a blanket guarantee); includes mutualization of liabilities among participating banks.
    - Resources from private DGSs and mutual protection schemes could finance restructuring of banks on a going-concern basis, but coordination mechanisms between funds are unclear.
  - Funding:
    - Many national DGS have limited prefunding and rely on ex post funding.
    - In 22 Member States, contributions to DGS include a regular prefunding mechanism, but ratios of prefunding to eligible deposits remain very low.
    - Example: Funds available for payouts of the French Fonds de Garantie des Depots reached about €2 billion at the end of 2010, about 0.1 percent of insured deposits.
    - Some countries (e.g., Austria and the Netherlands) rely exclusively on ex post funding.
  - Harmonization:
    - Post-2008 crisis, the EU harmonized deposit insurance limit to €100,000 per depositor and bank.
    - Harmonization was not accompanied by clarification on how new liabilities would be covered, which could hamper implementation.
  - Proposals:
    - 2010 draft EU legislation proposed harmonization steps including shorter payout periods (limited to seven working days) and funding arrangements.
    - Draft DGS Directive of July 2010 proposed a target pre-funding level of 1.5 percent of eligible deposits and possibility of mutual borrowing.
    - June 2012 Directive on bank resolution establishes “financing arrangements” for bank resolution and payouts of deposit insurance, requiring a target pre-funding of one percent of the total liabilities, excluding own funds, within 10 years.
    - The June 2012 Directive characterizes borrowing arrangements between resolution funds across countries but includes safeguards that constrain ability to delink sovereigns from bank health.
    - It provides the possibility of borrowing from the central bank for the purpose of resolution funding.
    - Commission expected the Directive to be adopted by end 2012 under the banking union roadmap.
- Backstops:
  - Fiscal backstops and guarantees remain nationally-based.
  - Since 2008 many European countries used recapitalization programs and guarantees of bank liabilities or assets (e.g., blanket guarantees, guarantees of unsecured or secured debt, on bond issuance).
  - Such guarantees stabilized markets but created large contingent liabilities, reinforced adverse sovereign-bank links, raised questions on burden sharing fairness/effectiveness, and worsened moral hazard.
  - Article 97(2) (as quoted): “national financing arrangements shall not be obliged to lend to another national financing arrangement in those circumstances when the resolution authority of the Member State of the financing arrangement considers that it would not have sufficient funds to finance any foreseeable resolution in the near future. In any case they should not be obliged to lend more than half of the funds that the national financing arrangement has available at the moment when the borrowing request is formalized.”
- Lender of last resort (LOLR):
  - In the Eurosystem, LOLR responsibilities are well defined but stratified by collateral quality.
  - Banks can refinance eligible assets with the ECB or, for a wider class of collateral, with their national central banks (NCBs).
  - If collateral constraints bind, banks can resort to costly emergency liquidity assistance (ELA) from their NCBs.
  - This setup tends to reinforce sovereign links to weak or failed banks through the NCB balance sheet: losses from bank failures associated with ELA remain the responsibility of the sovereign (weak banks cannot access ECB refinancing).

### Design of the Single Resolution Authority — Objectives, powers, and considerations
- Objective and standards:
  - Powers should align with FSB Key Attributes of Effective Resolution Regimes for Financial Institutions.
  - Objective: make resolution feasible without severe systemic disruption while minimizing costs to taxpayers.
  - Burden sharing should ensure shareholders and unsecured/uninsured creditors absorb losses consistent with liquidation claim hierarchy where possible.
  - Authority should comply with FSB preconditions/prerequisites for effective resolution.
- Specific considerations for multicountry setting:
  - A single, fully centralized, supranational resolution authority would:
    - Set correct incentives, correct externalities and coordination issues, provide swift decision-making, and avoid national duplication.
    - Ensure countries are not forced to internalize all resolution costs and spillovers (e.g., Ireland experience).
  - Issues to address: burden sharing, governance, accountability, interaction with SSM, legal difficulties (e.g., possible need for Treaty change and an insolvency regime superseding national regimes).
  - In steady state centralization is easier than for supervision; short-run delegation to national authorities may be necessary, raising monitoring and SSM interaction issues.
  - Common backstop is essential for effective resolution, particularly in systemic crises.

### Preconditions and prerequisites for an effective single resolution authority
- Preconditions (emerging best practices):
  - (i) well established framework for financial stability, surveillance and policy formulation;
  - (ii) effective system of supervision, regulation and oversight of financial institutions;
  - (iii) effective protection schemes for depositors, insurance policy holders and other customers;
  - (iv) robust accounting, auditing and disclosure regime;
  - (v) well developed legal framework and judicial system.
  - In Banking Union context, these imply implications for EU legal regimes and the existence of an effective credible single supervisory mechanism and deposit insurance scheme for all banks.
- Prerequisites for the resolution authority:
  - Operational independence consistent with statutory responsibilities; transparent processes; legal protection; sound governance; adequate resources; rigorous evaluation and accountability.
  - Objectives and mandate:
    - Maximize recovery value in resolution and minimize overall cost of resolution and losses to creditors.
    - Pursue financial stability and continuity of systemically important financial services/functions while protecting depositors and other insured claimants.
  - Operational independence and legal protection:
    - Treaty changes establishing the authority should provide appropriate operational autonomy and legal protection for officials’ actions/decisions.
  - Accountability:
    - Independence must be complemented with accountability due to intrusive nature and fiscal implications of resolution.
    - Transparency, strong accountability and reporting to eurozone finance ministers (Eurogroup/EU Council) and EU citizens (EU Parliament) are essential.
    - If national authorities retain prime responsibility for some banks, a two-level accountability mechanism (national and supranational) will be required.
  - Sound governance:
    - Governance must prevent conflicts of interest, undue political interference, and long negotiations that can delay resolution.
    - Possible two-tier governance model:
      - Executive Board to make decisions affecting specific financial institutions in the interest of the Banking Union.
      - Resolution Council with national representatives to oversee Executive Board decisions and settle broader policy matters (e.g., burden-sharing, fiscal backstops).
    - Voting mechanisms should prevent blocking of resolution decisions and guarantee the “will to act.”
    - Cooperation and information exchange with the single supervisory mechanism and checks and balances are necessary.
  - Resources and competencies:
    - Central resolution authority needs sufficient resources to build capacity, be insulated from undue national or industry influence, and hire independent staff with expertise to implement preventative, early intervention and resolution measures for large/complex institutions.
    - Interim pragmatism: rely on national resources/expertise, but swift centralization of resources/expertise is essential to avoid duplication and build capacity.
  - Funding:
    - Effective central resolution authority requires access to common funding and a fiscal backstop.

*Source: SDN/13/01 – TECHNICAL BACKGROUND NOTES (excerpt).*

### 11.      Coverage. Consistent with the scope of the SSM, the common resolution mechanism should

### 11.      Coverage. Consistent with the scope of the SSM, the common resolution mechanism should

### Coverage
- Eventually include all the banks licensed in the eurozone.
- No bank should remain under non-bank national insolvency proceedings.
- Consideration should be given to extending the scope of the resolution authority to other financial institutions such as:
  - holding companies,
  - non-regulated operational entities within a financial group or conglomerate,
  - branches of foreign (other EU, and non-EU) banks.
- Rationale: Covering these institutions is important insofar as they can be systemic and therefore would need to be dealt with adequate tools when they fail.
- Extending the coverage of the SSM to these institutions (if this turns out to be possible) would ensure consistency and help contain risks of failure.

### Powers and tools (sections 12–14)
- 12. Preparation and prevention: the central resolution authority should be able to ensure preparation and prevention, in close cooperation with the SSM, and should have powers to:
  - Review and validate recovery plans of systemic banks (to be performed in close cooperation with the SSM).
  - Prepare resolution plans for systemic banks, including details on application of resolution tools and ways to ensure continuity of critical functions, with close involvement of the ECB as the center of the SSM.
  - Take investigatory actions to ensure preparedness, including requests for information and on-site inspections.
  - Require actions to remove impediments to resolvability (e.g., changes to a firm’s business practices, structure or organization) to avoid compromising critical functions, threatening financial stability, or involving undue costs to taxpayers.
  - Be involved in decisions related to intra-group support agreements, alongside the ECB.
- 13. Early intervention: the resolution authority should be able, alongside the SSM, to:
  - Require capital conservation measures.
  - Impose restrictions on activities, including implementation of measures set out in the recovery plan.
  - Trigger resolution.
- 14. Resolution powers and tools, including taking control of failed institutions:
  - Take over control of the firm, including by nominating a special manager and remove the senior management and directors.
  - Transfer assets and liabilities (“P&A”) to a sound acquirer.
  - Set up a bridge bank taking over good assets or services to ensure continuity of essential services.
  - Separate bad assets by setting up an asset management vehicle (a “bad bank”), in conjunction with other measures.
  - Apply a “bail-in tool,” involving the SSM, used to recapitalize or wind-down the bank with shareholders wiped out or diluted, and creditors having their claims reduced, wiped out, or converted to shares.
  - Override shareholders’ rights regarding any decision needed in resolution, subject to the condition that shareholders should not be worse off than under liquidation of the firm.

### Coordination with the SSM (section 15)
- Decisions to trigger early intervention or resolution are highly sensitive and have distributional consequences that may bring conflicting interests among member states to the fore.
- Overlapping powers between the resolution authority and the SSM may contribute to a strong and robust financial stability framework for the euro area.
- The resolution authority would have investigatory powers, be able to trigger early intervention, require prompt corrective actions and be able to initiate resolution (e.g., by withdrawing deposit insurance).

### Central resolution authority and institutional issues (sections 16–19)
- 16. Central resolution authority: a fully-centralized euro area resolution authority should be able, in the steady state, to handle the resolution of failed euro area banks with possible delegation of some tasks to internal offices located across member states; it should have powers and tools, mandates, independence, governance, and accountability aligned with international best practices and the EU Directive on bank recovery and resolution, but with reinforced mechanisms for multi-country effectiveness.
  - Positives:
    - Internalizes cross-border effects and solves coordination failures.
    - Builds solid resolution expertise for systemic institutions.
    - Provides flexibility to intervene and allocate resources where needed and avoid national duplications.
    - Ensures the ECB interacts at par with a strong supra-national institution that complements its functions and mandates.
    - A strong resolution authority would contribute to effective supervision, provided clear coordination and information sharing; strong supervision reinforces credibility of resolution authority.
    - Would provide mechanisms for clear ex ante burden sharing arrangements, provided an adequate fiscal backstop is also in place.
  - Obstacles:
    - Credibility requires agreement on common resolution funding and fiscal backstops (including loss sharing involving taxpayers).
    - Any Treaty change to create a strong supranational resolution authority would require time.
    - Such authority should be able to apply a single resolution regime, overriding national insolvency laws.
- 17. Burden sharing:
  - Clear and workable burden-sharing arrangements, including between participating member states and the common backstop, are essential.
  - The euro area resolution authority would have power to override shareholders’ rights and impose losses according to clear ex ante rankings of claimants respecting the hierarchy of claims with some flexibility to depart from the pari passu principle.
  - A bail-in mechanism for haircutting or converting senior unsecured creditors provides a tool toward burden sharing.
  - Depositor preference should be included to further protect depositors and the funding provided by the deposit insurance scheme.
  - Pooled contributions from the euro area industry would be needed to finance costs of normal resolution.
  - Pooled contributions from euro area taxpayers (following specific ex ante rules) would be needed only insofar as private sector contributions and allocation of losses among uninsured claimants are insufficient to cover costs of resolution, subject to a systemic exemption.
  - The single resolution authority should be provided with a clear mechanism for decision making and ex ante burden sharing rules across member states (which could be based on capital keys similar to capital contributions at the ECB).
- 18. Funding:
  - A euro-area resolution fund would finance costs associated with bank resolution.
  - The fund would build resources from risk-based contributions levied on all euro area countries.
  - Contribution base would ideally include not only total deposits but other liabilities, possibly adjusting for risk taking and externalities.
  - A good benchmark: build a fund targeted to cover the net fiscal costs of up to a large or a few medium-sized bank failures.
  - Adequate common fiscal backstops are crucial for systemic events.
  - A transition period would reduce the immediate impact on banks; other costs could be recouped ex post from banks, although this may create moral hazard.
- 19. Institutional considerations:
  - An independent body should be established to operate alongside the ECB supervisor.
  - To ensure effectiveness, the resolution authority should be an EU institution established on par with the ECB, though a transitional arrangement (e.g., a temporary EU agency) could have merit.
  - Governance arrangements must ensure close cooperation with the SSM, complemented by joint technical committees and working groups.

### Transition (sections 20–21)
- 20. Scope: possible approach to bring all euro-area banks under a central resolution authority as soon as possible after they are brought under ECB supervision.
  - Positives:
    - Ensures more consistent treatment of resolution in the euro area.
    - Simplifies operational complexity of supervisory tasks for the ECB.
    - Especially relevant for banks being restructured and in need of, or nearly in need of, public support.
  - Temporary body:
    - Merit to establishing a temporary body or creating an EU agency to coordinate bank crisis management and resolution among national authorities and the ECB; could be linked to the ESM, with accountability to the Eurogroup.
    - Examples: Swedish Bank Authority of the 1990s and U.S. Treasury unit set up to restructure AIG.
  - Risks:
    - Time needed to build resources and capacity at the center.
    - Delayed transition would require the ECB to supervise systemic banks while interacting with multiple competent national authorities, complicating early intervention and corrective actions.
    - Delayed transition risks inefficiency, duplication of tasks, and potential weakening of political support leading to an incomplete framework.
- 21. Speed: two main strategies.
  - “Big-bang” approach:
    - Rapid move toward establishment of a central resolution authority and supra-national insolvency regime—preferred but constrained by political and practical considerations.
    - Pros: smooth transition to SSM by moving supervision and resolution in tandem; temporary body could be stepping-stone; builds cross-border expertise.
    - Cons: securing a Treaty change could be daunting; requires pan-euro area insolvency laws and involvement of courts (European Court of Justice) to supersede national regimes; temporary body or EU agency may require its own Treaty or could be established under Article 352 of the TFEU.
  - Gradual approach:
    - Three steps: harmonize/strengthen national regimes per EU Directive; set up harmonized national resolution funds with cross-border borrowing; establish an EU body by Regulation to coordinate resolution, then long-term supranational authority.
    - Pros: avoids disruptions during transition; guarantees compatibility across national regimes and between “ins” and “outs”; avoids changes in national laws beyond transposition needs.
    - Cons: SSM would interact with multiple national authorities (unwieldy); may create incentive problems within the SSM as national authorities could withhold information; national resolution funding achieves little risk diversification compared with centralized funding; long transition risks a stalled or incomplete process and harmonization via transposition could take time.

### Risks to the Single Resolution Mechanism (sections 22–25)
- 22. Stalled reforms:
  - Main transitional risk in a gradual approach is a stalled reform process.
  - Mitigation: a clear, time-bound roadmap indicating main steps and key deliverables including toward a common safety net.
  - Harmonization stage risks:
    - Creation of incentives to shift costs of resolution to the euro-area taxpayer.
    - An unwieldy system where SSM interacts with many national authorities.
    - Little weakening of sovereign-bank funding link.
    - Transposition of the EU Directive may leave room for divergent interpretations and practices.
  - Centralization stage risks:
    - A federal agency lacking adequate binding powers could be constrained by fiscal safeguards and sovereignty concerns, impeding effectiveness.
  - Need for burden sharing and adequate fiscal backstop: essential for an effective single resolution authority and swift decision making.
- 23. Precedent:
  - How legacy is addressed during the crisis creates precedents.
  - Costs of existing bad bank debt should be left as much as possible to those primarily responsible (creditors and national supervisors).
  - If government solvency is endangered, direct recapitalization by the ESM becomes necessary.
  - Possible incomplete solutions and consequences:
    - ESM direct recapitalization but no central resolution could incentivize national resolution authorities to shift costs to euro area taxpayers.
    - Central resolution but no adequate common fiscal backstop would leave fiscal consequences on national taxpayers, generating political risks and jeopardizing credibility and effectiveness of a single resolution authority.
- 24. TBTF (too-big-to-fail):
  - Complexity, cross-border dimensions, and systemic roles of G-SIBs argue for quickly establishing a robust supranational resolution authority with powers and tools aligned with the FSB Key Attributes and with adequate common fiscal backstops.
  - National approaches and fiscal resources would be inadequate to resolve a systemic institution.
  - Benefit of pooling scarce resources and building shared knowledge and capacity at the center; resolution authority should require steps to remove impediments to resolvability of systemic institutions.
- 25. Legal considerations:
  - A Treaty change would be necessary to establish a strong and autonomous resolution authority.
  - A supranational insolvency regime would have to override national insolvency laws.
  - Interim: a temporary resolution authority could coordinate bank restructuring in the euro area.

### Common Safety Nets and Backstops (sections 26 and following)
- 26. Essentials:
  - Backstops and common insurance mechanisms are essential to the Banking Union; absent them, the Banking Union would be unable to delink, or weaken, sovereigns and banks, potentially unstable and risking the credibility of the ECB.
  - To be set up, backstops require transfer of control to the center and must follow only after some preconditions are met.
  - Common fiscal backstops:
    - Essential to deal with systemic crises as pre-funding by DGS and/or resolution funds would likely not suffice for gross fiscal costs of a crisis.
    - Common backstops are needed to create a robust framework that breaks sovereign-bank links in tail events.
    - During transition, direct recapitalization by the ESM will allow breaking the link between banks and sovereigns when solvency concerns about the latter arise.
    - As DGS and resolution funds accumulate contributions, agreements on fiscal backstops and burden sharing may be even more important during the transitional phase.
  - Deposit insurance:
    - Common deposit insurance is needed for stability reasons.
    - A pooled mechanism would be more effective in protecting confidence (subject to an adequate fiscal backstop) and in diversifying risks across large numbers of banks.
    - The need for a common DGS follows logically once a single supervisory mechanism and a single resolution authority are in place.
    - To the extent a resolution authority would require common funding from the industry, postponing centralization of DGS makes little sense.
    - Additional national DGS could be allowed to complement the euro area DGS.

*SDN/13/01 – TECHNICAL BACKGROUND NOTES; INTERNATIONAL MONETARY FUND*

### 27.      EU Commission proposal. The EU Commission aims at a swift adoption of its DGS Directive

### 27. EU Commission proposal. The EU Commission aims at a swift adoption of its DGS Directive and Bank Resolution Directive

### Deposit insurance: harmonization under the DGS Directive
- Key harmonization elements:
  - 75 percent share of ex ante financing and a target coverage ratio of 1.5 percent of eligible deposits after 10 years.
  - Permits ex post financing of up to 0.5 percent of covered deposits.
  - Borrowing arrangements across national schemes permitted up to 0.5 percent of eligible deposits of the borrower; must be repaid within five years; claim ranks first in liquidation proceedings.
  - After 10 years, fund size recalibrated on the basis of covered deposits (instead of eligible deposits).
  - Bank contributions reflect risk, based on core indicators such as capital adequacy, asset quality, profitability and liquidity.
  - DGS can be used for resolution funding provided primary DGS function is not impeded.
- Funding and target size:
  - DGS should be significantly prefunded through ex ante risk-based premiums levied on the industry; complemented, if needed, by ex post levies.
  - Tax base: total eligible deposits.
  - Prefunded element steady-state target: ratio of about 1.5 percent of total eligible deposits (hence, total fund size of about €100 billion).
  - Coverage limit per account holder and per bank could remain at €100,000.
- National schemes:
  - Specific national schemes could continue in addition to a pan euro area deposit insurance, provided alignment with EU Directives.

### Resolution funding: national arrangements and possible use of DGS resources
- Required national-level arrangements:
  - Financing arrangements funded with contributions from banks and investment firms in proportion to their liabilities, risk profile and systemic importance.
  - Contributions raised from banks (on total liabilities, excluding own funds) at least annually to reach a target funding level of at least one percent of covered deposits after 10 years.
  - If ex ante funds insufficient, further contributions will be raised (ex post).
  - Mutual borrowing across schemes allowed subject to safeguards protecting creditor resolution funds.
- Interaction with DGS:
  - Funding already available in DGS could be used for resolution; in that case contributions for resolution would be based on total liabilities, excluding own funds and insured deposits.
  - DGS would rank pari passu with unsecured creditors in insolvency proceedings for the amount of covered deposits.
- Alternative funding means:
  - Alternative funding means (such as borrowing from the central bank) should be enabled.

### Pan-euro area alternatives and a single integrated fund
- Alternative preferred (potentially long-term) approach:
  - Create a pan euro area deposit guarantee scheme and resolution fund.
- Scope considerations:
  - All euro area banks should be covered by the resolution fund and by the deposit insurance scheme for consistency with the single supervisory mechanism and the single resolution authority.
  - Covering only a subset could induce deposit reallocations and distort competition; additional top-up schemes could be allowed.
  - Coverage would be skewed towards largest financial systems in the core of the euro area.
- Funding design for a euro-area resolution fund:
  - Pre-funded through ex ante risk-based premiums (reflecting capitalization, profitability, liquidity and asset quality) adjusted for systemic importance.
  - Complemented by arrangements to recoup losses through ex post levies; share of ex post levies should be limited to avoid procyclicality and moral hazard.
  - Resolution fund should have access to common backstops, particularly important during transition and systemic events.
  - Tax base should include all liabilities (including wholesale funds) excluding capital.
  - Tax rate chosen to smooth cyclical burdens while building a target prefunding ratio within 10 years.
- Merging DGS and resolution fund:
  - Single integrated fund could yield synergies and economies of scale; objectives differ (DGS: reimburse eligible depositors up to coverage limit; resolution fund: wind up failed banks and cover resolution costs while minimizing losses and contagion).
  - Separation does not preclude fiscal fungibility during crises.

### Mixed model and sizing
- Mixed model:
  - Common resolution fund administered by single resolution authority; harmonized national DGS remain at national level.
  - Advantages: common financing for resolution, enhanced SSM effectiveness.
  - Disadvantages: limited impact without common backstops; less efficient risk pooling; complexities in cross-border cost allocation; duplication of costs.
- Desired fund sizes:
  - Typical target size could range from about 1–2 percent of insured deposits in large systems to 4–5 percent in smaller systems (aiming to cover 2–5 mid-size banks or 4–6 small bank failures).
  - Part of gross outlays recouped from asset sales and ex post industry contributions.

### Legal and governance concerns
- Legal constraints:
  - A single resolution fund requires a supranational resolution framework; may require a Treaty change if the fund is "joint and several" due to Article 125 no bail-out clause.
  - Voluntary loans to member states or multiple several guarantees would not appear to contradict the current Treaty.
- Decision making and governance:
  - Clear rules for prompt resolution decisions; ex ante agreed burden sharing rules; clear hierarchy of claims including bail-ins of unsecured senior creditors.
  - Governance should allow discretion for swift decisions (e.g., “over a weekend”).
  - Least cost resolution and allocation of losses should weigh stability concerns.

### Pecking order for burden sharing in crises
- Suggested hierarchy of loss allocation (subject to systemic exemption):
  1. Haircutting shareholders.
  2. Junior creditors.
  3. Bailing-in senior unsecured creditors.
  4. Bailing-in resolution and deposit insurance funds.
  5. Taxpayer contributions.
- Insured depositors:
  - Insured depositors should come last in ordering of losses and there should be depositor preference (deposit insurance fund senior to other claimants).
- Historical scale:
  - Since 2008, according to the EC, over €4.5 trillion has been used to rescue banks in the EU (including liquidity provision measures and asset guarantees by governments).

### Layers of common backstops to handle tail events
- Proposed layered scheme:
  - Common resolution fund: first buffer; covers a proportion of banking crisis depending on prefunding; ex-post levies may help reduce fiscal needs.
  - ESM direct recapitalization: if all ESM resources used for direct recapitalization, eventual size would be able to cover crises requiring up to about 5 percent of euro area GDP of fiscal outlays.
  - Earmarked contingent euro-area taxation: grant a eurozone institution limited taxing power to back blanket guarantees during systemic events.
  - ECB line of credit: temporary ECB lines of credit to the resolution authority, guaranteed by the common fiscal backstop, contingent on the backstop covering eventual net fiscal costs.
- Historical examples:
  - U.S.: Fed financed asset management company dealing with AIG’s and Bear Sterns’ toxic assets.
  - Switzerland: SNB funded the Swiss Stabilization Fund for UBS legacy assets.
- Table II.2: Financial Sector Support, 2008–11 (percent of 2011 GDP)
  - Belgium 7.0
  - Ireland 41.2
  - Germany 12.2
  - Greece 6.1
  - Netherlands 14.1
  - Spain 19.5
  - United Kingdom 6.8
  - United States 5.3

### Co-financing by national sovereigns and burden-sharing options
- Risks of common backstop:
  - Could create incentive problems, regulatory forbearance, and shift costs to euro area taxpayers.
- Options to involve national taxpayers:
  - Fixed amount of loss to national taxpayer: allocate losses up to an ex ante defined maximum (could be expressed in percent of GDP); above threshold, losses go to common backstop.
  - Co-financing starting with the first euro: national taxpayers contribute a minimum ex ante agreed share of gross fiscal costs of each bank failure.
  - Liquidity backstops: national authorities bear resolution risks but are eligible for ESM loans (may only marginally weaken bank-sovereign link).
- Issues raised:
  - Co-financing raises questions about dilution of sovereign equity after recapitalization and the effectiveness of delinking banks and sovereigns.

### Transition considerations
- EU Commission approach as stepping stone:
  - Harmonized national DGS and resolution funds could be interim steps toward a single pan-euro area scheme, but will achieve little risk diversification initially and would not delink banks from sovereigns.
- Phasing issues:
  - Slow transition by gradually extending coverage could create liquidity pressures in countries with weak sovereigns and raise cyclical concerns about bank levies.
  - Rapid phasing could raise concerns about cyclical effects if levies are too large during transition.
- Euro-area reinsurance scheme:
  - A reinsurance scheme for national DGS funded at euro area level through industry levies and/or annual member state contributions could be created.
  - Ex ante agreement on degree of national vs supranational funding in depositor payouts would be needed to prevent moral hazard.
  - Over time, a reinsurance fund could build capacity and be a step toward a permanent euro area DGS and resolution fund.

### Key statistics from Table II.1 (Euro Area: Deposit Insurance—Eligible and Covered Deposits, March 2012)
- Selected country lines (Eligible deposits | Covered deposits | Coverage ratio | Country share in covered deposits):
  - AUT: 277 | 176 | 63.6 | 3.3
  - BEL: 364 | 255 | 70.2 | 4.8
  - CYP: 42 | 26 | 62.7 | 0.5
  - DEU: 2,157 | 1,609 | 74.6 | 30.5
  - ESP: 909 | 671 | 73.8 | 12.7
  - FIN: 104 | 85 | 82.0 | 1.6
  - FRA: 1,511 | 1,127 | 74.6 | 21.4
  - GRC: 153 | 106 | 69.5 | 2.0
  - IRL: 126 | 93 | 73.6 | 1.8
  - ITA: 675 | 460 | 68.2 | 8.7
  - NLD: 581 | 451 | 77.6 | 8.5
  - PRT: 165 | 112 | 68.3 | 2.1
  - EUROAREA: 7,205 | 5,279 | 73.3 | 100.0
- Notes:
  - Eligible deposits = sum of MFI household and corporate deposits.
  - Covered deposits apply the EC coverage ratio to eligible deposits.
  - * DGS or desk info end-2011, ** Banking associations top up the mandatory scheme, hence coverage ratio is lower bound.

_Italic: Source: SDN/13/01 – TECHNICAL BACKGROUND NOTES, INTERNATIONAL MONETARY FUND._

### 39.      Fiscal backing. As noted, resolution funds and DGS require explicit fiscal backing,

### _sdn1301technt - 39.      Fiscal backing. As noted, resolution funds and DGS require explicit fiscal backing,

### Fiscal backing (overview)
- Resolution funds and DGS require explicit fiscal backing, complemented at times by liquidity lines from the central bank, to cover the gross costs of systemic crises.
- Agreement on backstops is required to transition to a euro-area resolution fund.

### E. Lender of Last Resort (LOLR) — current system and rationale for centralization
- Current system:
  - The Eurosystem (via the ECB and NCBs) provides reserve money (liquidity) to euro area commercial banks against acceptable collateral via Open Market Operations (OMO) and the credit Standing Facility (SF).
  - OMO currently uses a full-allotment procedure; banks lacking eligible collateral may borrow from their NCB under Emergency Liquidity Assistance (ELA), subject to the NCB’s overall ELA limit and ECB approval if lending exceeds certain levels.
  - Participation in OMO or access to SF requires a bank to be ―financially sound‖; ELA requires the bank to be judged solvent.
  - The Eurosystem sets interest rates applicable to SF transactions and currently fixes rates on OMO. ELA loans are subject to a minimum interest rate set by the Eurosystem and in practice most loans are harmonized around this level.
- Credit risk:
  - Potential ELA losses would in principle be borne by the NCB in question, though the Eurosystem may need to share costs.
  - Monetary policy (OMO and SF) and ELA lending are associated with TARGET2 positions; weaker countries’ NCBs have liability positions with the ECB.
  - If ELA-borrowing bank failures cause substantial losses and the relevant government cannot recapitalize the NCB, the Eurosystem could be required to cover those losses—strengthening the argument for ECB taking full ELA powers.

### Centralization of LOLR at the ECB (case and implementation)
- Argument:
  - Banking union implies centralized LOLR responsibilities; ELA lending should transfer from NCBs to the ECB when the ECB assumes supervisory responsibility for euro area commercial banks, delinking sovereigns from potential ELA-related losses.
- Operational changes:
  - NCBs would lose the ability to extend ELA; ELA would be at the ECB’s discretion.
  - The ECB may set a higher bar for ELA than NCBs; decisions to provide ELA should be case-by-case, reflecting solvency and systemic importance.
  - Determination of ―systemic importance‖ can be difficult—an institution may be systemically important nationally or regionally but not for the euro area as a whole.
  - Banks refused ELA would presumably be handed to the resolution authority (national or euro-zone level).

### Duration and supervisory preconditions for ECB ELA
- ECB ELA should be relatively short term, perhaps up to one year, and accompanied by supervisory intervention.
- In systemic liquidity crises, emergency lending could be rolled over for another period of up to one year, subject to even stricter supervisory oversight.
- Recipient banks should provide a funding plan and undergo thorough supervisory examination and possibly sanctions (e.g., dividend bans, operational constraints) to avoid ‘‘gambling for resurrection.’’
- Note: the ECB’s two 3-year LTROs have provided longer-term finance but are exceptional thus far.

### Collateral policy under ECB-provided ELA
- ECB would need to accept a wider pool of collateral for ELA, because banks needing ELA typically cannot access OMO or SF due to collateral constraints.
- Possible approach: broad guidelines for likely acceptable collateral for ELA circumstances, with scope for case-by-case judgments.
- In case of substantial losses on the ECB balance sheet, options include:
  - Recapitalization in line with current capital keys following a Governing Council decision; or
  - Seeking an additional, precommitted fiscal backstop for losses related to such lending—however, this could be difficult and raise questions about ECB independence.

### Transitional issues for shifting ELA responsibility
- If large banks move to ECB supervision first, the ECB could take over ELA responsibility solely for those banks.
- ELA limits for NCBs (covering banks remaining under national supervision) would need adjustment.
- Markets would need clarity on which banks have moved from NCBs to ECB supervision.

### F. Relations with other EU members — coordination and opt-ins
- Coordination:
  - Burden-sharing arrangements and coordination with other EU countries are crucial given integration with non-euro area countries and the U.K.’s role as a financial center.
  - The EU Directive should be implemented promptly to ensure robust resolution regimes and harmonized DGS across EU members.
  - Burden-sharing arrangements (especially for banks operating in the U.K.) may need to be established case-by-case.
  - The mediation role of the EBA envisaged under the EU Directive may need strengthening and governance changes.
- Opt-ins:
  - Non-euro area countries may wish to join the Banking Union and access common safety nets; treaty change may be needed to create a common backstop open to non-euro area EU countries.
  - During transition, ESM direct recapitalization remains accessible only to euro area members under current rules.

### G. Summary — burden sharing, backstops, transition, and risks
- Burden sharing and backstops:
  - A strong, autonomous resolution authority is key to enhance the single supervisory mechanism’s effectiveness.
  - Centralized resolution authority requires clear rules for burden sharing and adequate common backstops to break sovereign-bank links.
  - A pan-euro area resolution fund should be built over time from risk-based industry contributions, complemented by a fiscal backstop (ESM or earmarked pan-euro area taxes in the longer term) and a liquidity line from the ECB.
  - Establishing the single resolution authority may require a treaty change.
  - Centralizing DGS would enhance credibility and risk diversification; in the long term a single deposit insurance and resolution fund could be created by merging the resolution fund and national DGS.
- Transition:
  - Addressing transitional risks is key; an embryonic resolution authority (temporary body or EU agency) could assist with failed bank resolution.
  - Designing appropriate cofinancing arrangements (clear ex ante burden-sharing with room for discretion) could align national incentives with the common good, subject to consideration of sovereign-bank link impacts.
- Risks:
  - A stalled reform process is a key risk.
  - An SSM without a single resolution authority would weaken the SSM’s effectiveness.
  - Centralized resolution without agreed burden-sharing rules and adequate fiscal backstops would be ineffective and non-credible.
  - To address transitional risks, a clear, time-bound roadmap with strict deadlines and key deliverables should be announced.

### Annex II.1. Bank Resolution and Deposit Insurance in Germany — key findings
- Bank resolution framework:
  - New bank restructuring law (2011) introduces broad powers and instruments for resolving systemic banks: transfer of banking business, remedial powers, reorganization involving courts, appointment of special administrators, measures to improve own funds adequacy and liquidity.
  - The law provides the basis for a restructuring fund administered by the Federal Agency for Financial Market Stabilization (FMSA).
  - No specific legal requirement for resolution plans (―living wills‖) under the law.
  - BaFin leads resolution strategy formulation; FMSA administers the restructuring fund; Bundesbank assesses financial stability implications; BMF has a central role in systemic cases and is represented on FMSA’s steering committee.
  - Crisis management coordination will be a task of the Financial Stability Committee to be established under macroprudential oversight.
- Restructuring fund:
  - Target size: €70 billion.
  - Administered by FMSA under BMF oversight.
  - Tools: bridge banks, guarantees (up to €100 billion or 20 times the size of the restructuring fund), capital injections, other support measures.
  - Financing: ex ante bank levy; expected receipts in the range of €650 million to €1.3 billion per year are low relative to the target size and potential failure costs.
  - With limited resources built up, contingency funding arrangements remain important.
- Bank levy structure:
  - Levy higher for banks engaging in activities creating systemic risk (size and interconnectedness).
  - Levy collected in addition to contributions to deposit insurance schemes; calculated according to government regulations and subject to an overall ceiling linked to a bank’s annual profit (over a multi-year period).
  - Levy rates:
    - 2 bps of bank liabilities (excluding deposits and capital) up to €10 billion,
    - 3 bps from €10 billion up to €100 billion,
    - 4 bps from €100 billion up to €200 billion,
    - 5 bps from €200 billion up to €300 billion,
    - 4–6 bps in excess of €300 billion.
  - An additional levy element based on nominal value of off balance sheet derivatives covers interconnectedness.

### Deposit insurance in Germany — structure, reforms, and issues
- Fragmentation and transparency:
  - The deposit insurance regime is fragmented, prefunding limited, and features lack transparency and legal certainty.
- Crisis-era measures:
  - Minimum coverage level under statutory schemes increased to €100,000 in 2011 from €20,000 before the crisis; coinsurance eliminated in 2009.
  - Current coverage level is estimated to cover more than 90 percent of retail deposit accounts at commercial banks (ratio higher when including savings banks and cooperative banks under mutual protection schemes).
- Resource use and coordination:
  - Private deposit insurance schemes and mutual protection schemes may finance restructuring on a going-concern basis instead of reimbursing depositors.
  - No clear interaction and coordination mechanism exists between the restructuring fund and private/mutual protection schemes for systemic bank restructurings.

### Box II.1. Deposit Insurance Schemes in Germany — salient features and numeric details
- Commercial banks: statutory scheme
  - Coverage: €100,000.
  - Reimbursement initiated by BaFin declaration and should be completed within 20 business days (extension of 10 business days possible).
  - Banks’ contribution rates recently doubled to 0.016 percent of the banks’ balance sheet item ―liabilities to customers.‖
- Commercial banks: private scheme (Bankers’ Association)
  - Additional coverage: 30 percent of the bank’s capital per depositor (reduced over time to 8.75 percent by 2025), constituting a de facto full compensation scheme.
  - For new member banks, limits of €250,000 per depositor are in place for the first three years.
  - Claims are not legally enforceable by depositors (confirmed by a 2010 Berlin district court ruling).
  - The scheme was under pressure in 2008 during failures; FMSA provided support for Lehman Brothers Bankhaus in the form of a €6.7 billion guarantee.
  - Contribution rates recently doubled to 0.06 percent of banks’ liabilities to customers.
  - Parameters for ex post burden-sharing among banks under stress are not clear and require ad hoc solutions.
- Savings banks (Sparkassen) and Landesbanken
  - Partial ex ante funding (risk-based) under regional arrangements, coupled with ex post burden-sharing provisions and potential contributions from local authorities (sponsors/owners).
  - Inter-regional arrangement among 11 regional arrangements and a master arrangement offers further support (without legal obligation).
  - Voluntary nature of arrangements limited resources in 2009 for a large Landesbank case.
- Public banks (other than savings banks and Landesbanken)
  - Own statutory and private schemes administered by the Association of German Public Sector Banks.
- Cooperative banks (Volks- und Raiffeisenbanken)
  - National Association of German Cooperative Banks protection scheme intended to protect cooperative banks in their entirety (mutual protection scheme).
  - Ex ante risk-based funding complemented by limited guarantees; no legal obligation to provide assistance when called upon.
  - Association leads resolution of failed member banks (purchase-and-assumption, mergers) and operates a dedicated ―bad bank.‖

### III. Bank recapitalization
- This paper elaborates on issues relevant to bank recapitalization and repair of balance sheets to break vicious loops between sovereign and bank funding costs.

*International Monetary Fund — SDN/13/01 – TECHNICAL BACKGROUND NOTES*

### 1. A potential turning point. On June 29, 2012, euro area leaders correctly identified the

### _sdn1301technt - 1. A potential turning point. On June 29, 2012, euro area leaders correctly identified the

### A. A potential turning point
- On June 29, 2012, euro area leaders identified the vicious circle between banks and sovereigns as a core problem with the monetary union and called for the establishment of an effective single supervisory mechanism and common backstop for bank capital.
- Mobilizing the ESM direct bank recapitalization tool in a timely manner is critical to developing a path out of the current crisis.
- It is of critical importance that ESM direct recapitalization of banks, including migration to ESM of existing public support to banks, is not subjected to overly burdensome preconditions.
- ESM investment decisions should take a long-term perspective, cognizant that gross upfront crisis outlays tend to dwarf ultimate costs net of recoveries and capital gains and, in many instances, generate positive financial returns.

### B. Designing an Effective Solution
- Role and rationale
  - Timely and effective direct recapitalization by the ESM of domestically systemic banks in the euro area can help break the sovereign-bank vicious circle, repair monetary transmission, prepare for banking union, and help complete the economic and monetary union.
  - As a patient, deep-pocket investor, the ESM can maximize financial stability benefits and long-run returns on its investment.
  - Conditional on standing ready to take material losses in a downside scenario, the ESM would be unlikely to actually incur those losses because the investment would improve banks’ funding environment and minimize the risk of the adverse scenario occurring.
- Purpose and mandate
  - The ESM Board of Governors would appear to be authorized to develop a direct bank recapitalization instrument consistent with the ESM purpose: “to mobilize funding and provide stability support under strict conditionality, appropriate to the financial assistance instrument chosen, to the benefit of ESM Members which are experiencing, or are threatened by, severe financing problems, if indispensable to safeguard the financial stability of the euro area as a whole and of its Member States.”
  - The current Treaty may leave sufficient flexibility to accommodate related financial operations such as ESM participation in or ownership of an asset management company (AMC).
  - ESM recapitalization of banks would in any case require unanimity in the ESM Board of Governors and approval by national parliaments in some jurisdictions (e.g., Germany).
- Inter-related goals
  - Ensure systemic banks have adequate capital.
  - Sever the link so banks are no longer a source of contingent fiscal liabilities.
- Confidence and limits
  - Achieving these goals will enhance market confidence in the credit standing of both the sovereign and the banks.
  - The ESM recapitalization tool is not a panacea: failing non-systemic banks should be resolved at least cost to national deposit insurance funds and taxpayers.
  - Systemic banks benefiting from ESM support will need effective supervision and sustained reform to be fully returned to private ownership, with state aid rules mandating formal restructuring plans, and the sovereign itself will need an adjustment program.
- Considerations on ESM ownership of banks
  - Source of strength: ESM capital support would reassure creditors that potential future capital needs can be met; this could lower funding costs, restore profitability, and build capital over time.
  - A large equity participation by the ESM in a bank is distinct from a market share transaction, as it changes prospects for banks and for the economy.
  - The ESM should avoid restricting investments to sanitized banks at depressed market prices; a balanced approach internalizing benefits of ESM capital support over a sufficiently long horizon is needed.
- Eligibility, scope, and valuation
  - Which countries should be eligible? Instrument should only be applied where there is a paucity of private capital—including capital from burden sharing with creditors as appropriate—and where use of national taxpayer capital would threaten sovereign market access or significantly undermine the terms on which the sovereign has such access.
  - What types of institutions should qualify? Instrument appears limited to domestically systemic banks; in principle AMCs and resolution corporations used to restructure such banks by warehousing certain segregated assets should also be eligible.
  - What extent of capital shortfall should be covered? ESM bank capital holdings should eventually be marketable. Capital needed to bring a systemic bank out of insolvency would first be provided by shareholders and creditors, then by the national government, with any remaining shortfall covered by the ESM. In principle, advantages exist if a central fiscal authority ultimately provides all capital needed to ensure a systemic bank is adequately capitalized.
  - How should bank equity be valued? Current depressed market valuations would not be appropriate. Consider historical-cost approach where analysis is coordinated with European authorities. Stress tests are conservative and not balanced valuations; assessment should internalize benefits of the investment and factor in reasonable baseline projections, using for instance a real long-term economic value approach.
- Balance sheet restructuring and risk sharing
  - Should banks first have a balance sheet restructuring? Flexible approach: where banks can manage distressed assets in-house, they should retain them at valuations making prudent allowance for lifetime credit losses in a baseline scenario; separate legal vehicles may offer advantages for certain asset classes and, ideally, such vehicles should fall under ESM ownership.
  - What types of risk-sharing arrangements are appropriate? To minimize contingent fiscal liabilities, a clean break would usually be best, with the sovereign providing no downside risk protection and receiving no claim on future upside, except if it retains a minority equity stake. Simple option structures can facilitate transactions where there are large valuation uncertainties.

### C. Implementation Issues
- Elements required for ESM direct recapitalization
  - Mandate: The ESM can directly recapitalize banks, based on diagnostics performed by (or under the leadership of) the ECB-led SSM. Such recapitalization would require a “regular decision,” unanimity in the ESM Board of Governors, and, in some jurisdictions, national parliamentary approval.
  - Transparency, governance and accountability: A transparent investment strategy and governance mechanism and an incentive structure in which the public sector shares any upside are important to ensure investor understanding, acceptance, and public buy-in.
  - Principles for access: Modalities should incentivize banks to seek private capital first, in particular by diluting existing shareholders. National authorities are expected to cover, at least, any negative equity that might remain, subject to ensuring sustainable public debt dynamics and an exit from the crisis.
  - Role of Bail-in: Holders of capital instruments (such as subordinated debt and preferred shares) should be subject to burden sharing. For banks undergoing resolution, losses could be imposed on remaining creditors in line with seniority of claims, including senior unsecured bond holders, if systemic consequences can be contained. Insured depositors, which in most of Europe rank pari passu with senior creditors, would need protection to avoid contagion.
  - Operations: The ESM will need capacity to manage equity stakes, including exercise of ownership rights, or establish a special vehicle to manage investments at arm’s length. Management should be at arm’s length from the political process and follow strictly commercial principles. The ESM could forgo annual dividend income on its holdings to help reduce funding costs of banks and increase prospects of returning to profitability. Beneficiary economies must not implement policies that harm profitability or viability of recipient banks (e.g., onerous taxes or ex post resolution levies).
  - Design of instruments: Recapitalizations should be effected via acquisition of ordinary shares—diluting existing shareholders. Any “first loss” arrangements with the sovereign would hamper efforts to weaken sovereign-bank links. For nationalized banks, debt-equity swaps with member states transferring equity stakes to the ESM and a corresponding reduction in their debt should be considered.
  - Adequate resources: Direct equity injections could absorb significant amounts of ESM capital. It is important the ESM has adequate capital to allay investor concerns about ESM credit quality and play its role as a common backstop for bank recapitalization.
- Supporting workout of impaired assets
  - Clean up: Resolving impaired assets is a necessary supplement to banking union. Segregation between impaired and performing assets would remove doubts about balance sheet quality and contribute to restoring confidence.
  - AMCs: AMCs have been used in past systemic crises as part of measures to resolve insolvent and nonviable institutions, restructure distressed but viable institutions, and privatize government-owned banks. Examples cited include the U.S. Resolution Trust Corporation, Thai Financial Sector Restructuring Agency, U.S. Maiden Lane LLCs (Bear Stearns and AIG), Sweden’s Securum, Korea Asset Management Institution, Malaysian Danaharta, and the French Consortium de Realization. Centralized AMCs were used in central and eastern Europe during the 1990s.
  - Advantages and disadvantages of centralized AMCs:
    - Advantages: remove balance sheet uncertainty; consolidate workout skills; securitization benefits; greater leverage over debtors if granted special power; prevent fire sales and destabilizing spillovers; allow cleaned-up banks to focus on core business.
    - Disadvantages: loss of banks’ borrower-specific information; limited AMC ability to provide additional financing; risk of deterioration in asset values if not actively managed; difficulty insulating AMCs from political interference; risk of asset warehousing and open-ended transfer arrangements undermining credit discipline.
  - Lessons and prerequisites for AMC success:
    - Prerequisites: insolvency framework supporting rehabilitation of viable firms and liquidation of nonviable firms; neutral tax framework; robust financial regulation, supervision, and bank resolution framework.
    - Design features: strong leadership and operational independence; accountability, transparency and governance; adequate funding; strong legal basis; appropriately structured incentives (including forms enabling AMC owners to benefit from future increases in asset values); commercial orientation.
  - Transfer price considerations:
    - Assets transferred to AMCs should be priced as close to fair market value as possible based on expected recovery, cash flow projections, and collateral appraisal.
    - Pricing nonperforming and illiquid assets can be difficult and subjective in a crisis; an initial price with a final price established later is a possible approach.
    - Profit-sharing arrangements may be used but should not remove full upside for the government sponsoring the AMC.
    - Example: The Malaysian Danaharta purchased impaired loans at an average discount of 55 percent, while banks that sold assets retained the right to receive 80 percent of any recoveries in excess of acquisition costs that the AMC realized.
- Box III.1. Key Considerations for Asset Management Companies
  - Transfer price effects:
    - The lower the transfer price, the larger the losses imposed on restructured banks; low transfer prices increase need for capital injections.
    - Low transfer prices limit the size and capital/funding requirements of the AMC, limiting fiscal costs and possibly providing upside as assets are liquidated, and can spur private equity interest.
    - Trade-off exists between crystallizing large capital needs and setting up a large AMC requiring capitalization.
    - The EC typically applies the principle that transfers should take place at the “real (long-term) economic value” which for impaired assets would typically be closer to market value than historical value.
  - Funding and eligibility issues:
    - Long-term funding of asset run-off vehicles is critical to avoid fire-sales.
    - If the AMC has a banking license, it could in principle access Eurosystem refinancing directly, but bad assets are unlikely to be eligible collateral under ECB operations, and ELA is not appropriate for long-term refinancing.
    - Even if the AMC is capitalized with government bonds, the ECB may challenge eligibility of the entity as a monetary policy counterparty or the appropriateness of Eurosystem refinancing on monetary financing prohibition grounds.
    - There are precedents for central bank funding of AMCs, often involving protection of central banks’ balance sheets by a fiscal guarantee (for instance, from the ESM), which may require amendments to the ESM Treaty.
    - A non-bank AMC can be funded by issuance of government guaranteed bonds that can be placed in the market or with restructured banks as payment for transferred assets; it is critical such securities be eligible for Eurosystem refinancing (e.g., as per the Spanish MoU).
    - Private investors should be invited into AMCs with proper risk sharing arrangements to maximize recovery values.

*Prepared by Craig Beaumont, Ashok Bhatia and James Daniel (European Department), and Marina Moretti, Michaela Erbenova, Michael Moore, and Constant Verkoren (Monetary and Capital Markets Department).*

### 20. Competition policies. EU competition policies complicate asset pricing in the European

### 20. Competition policies. EU competition policies complicate asset pricing in the European context.

### EU valuation requirements and experience
- The EC requires a clear ex ante identification of the magnitude of a bank’s asset-related problems and a viability review, with assets valued at market prices whenever possible.
- The EC’s approach allows for a transfer value reflecting a "long-term economic value" of the assets, on the basis of underlying cash flows and broader time horizons.
- Experience with Ireland’s National Asset Management Agency (NAMA) in late 2009:
  - Lack of a universally accepted methodology for valuation led to a protracted process whereby bank book values were repeatedly discounted, prolonging uncertainty and delaying normalization of bank funding.
  - NAMA had acquired assets at an average discount of over 50 percent.
  - The process lasted for over a year and required detailed asset-by-asset valuation.
- Spain’s process was more rapid, with transfer prices set conservatively, based on haircuts in line with the adverse stress test scenario.
- The EC Communication allows alternative approaches where valuation appears particularly complex, including creation of a "good bank" whereby the state purchases good rather than the bad assets. Nationalization combined with creation of a "good bank" was used in Latvia for resolving Parex bank in 2008-2010.

### AMC funding
- Key design feature: the AMC must have sufficient funds to perform its intended functions, with the operating budget separate from funding for asset takeover.
- Past crises funding sources:
  - Proceeds of government bond issues.
  - AMC’s own bond issuance backed by the government, with losses absorbed by the budget as private investor participation is unlikely in the early stages.
- Example: In Ireland, banks received government-guaranteed securities in return for assets transferred to the Irish NAMA.
- Advantage of using a company without a banking license (an AMC) instead of a "bad bank":
  - AMCs do not need to meet regulatory capital and liquidity requirements, thereby reducing their overall costs.

### Sovereign-bank loops and alternative backstops
- In the euro area context, government funding of AMCs reinforces sovereign-bank links and complicates AMC design.
- If AMC debt funding bears on public debt, there is an incentive to minimize the size of these vehicles and the scope of assets segregated.
- Raises questions on alternative sources of equity and liquidity for AMCs, and specifically potential roles of the ECB and ESM.

### Potential role of ECB
- Direct support:
  - The ESCB Statute limits credit operations counterparties to "credit institutions and other market participants, with lending based on adequate collateral." This may provide leeway to fund non-banks.
  - Funding acquisition of bad assets, or resolution of bad banks, remains a fiscal responsibility. If the ECB were to provide such funding, its balance sheet risks should be protected by a guarantee from euro area member states, such as could potentially be extended by the ESM.
- Indirect support (subject to prohibition of monetary financing):
  - The ECB could accept government-guaranteed AMC bonds issued to banks in exchange for their assets as collateral for Eurosystem financing operations, with safeguards such as observer status in AMC governing committee(s) and special access to AMC internal information.
  - Bond characteristics important for ECB repo collateral acceptance: interest rate, maturity, and marketability.
  - Central banks accept collateral of a high credit quality and liquefiable in secondary markets; they also typically accept government and quasi-government securities as collateral, subject to not being a direct party to monetary financing of the fiscal deficit.
  - Central banks would not typically accept non-marketable securities (for example, special purpose government bonds that may not be on-sold in the market).
  - Open market purchases of bonds or general acceptance of a class of securities as collateral from all counterparties are acceptable ways for central banks to acquire government securities.
  - A side deal where the central bank agrees to purchase or accept a particular class of non marketable securities issued to just a few banks would not generally be acceptable practice.
- ECB legal opinions:
  - The ECB indicated in CON/2010/2 that "the prohibition of monetary financing prohibits the direct purchase of public sector debt, but such purchases in the secondary market are allowed, in principle, as long as such secondary market purchases are not used to circumvent the objective of Article 123 of the Treaty."

### Central bank precedents for funding AMCs (Box III.2)
- United States:
  - The "bad bank" of Continental Illinois was owned by the former shareholders of the bank and funded with liabilities to the Federal Reserve, fully guaranteed by the FDIC (which owned the good bank).
- Central and Eastern European transition economies:
  - A number of central banks were engaged in funding AMCs or bad banks; the losses incurred were covered by the national budget or, over time, via seigniorage.
- Switzerland (2008):
  - The Swiss National Bank (SNB) supported transfer of illiquid securities and other troubled assets of UBS to a special purpose vehicle—the Swiss Stabilization Fund—controlled and mainly funded by the SNB.
  - Assets were transferred to the fund at market prices and thus, on average, with a discount to notional value.
  - Asset transfer from UBS was financed by a 90 percent loan from SNB, backed by a security interest in all the fund’s assets, and 10 percent financing contribution from UBS.
  - Management of assets was outsourced to UBS and UBS was given an option to repurchase the fund.
  - Protection to the SNB took the form of loan overcollateralization and warrants for UBS shares, to cover any losses on liquidation of assets.
  - Broad recovery of secondary market asset valuations in 2010 allowed the fund to dispose of assets with sales mostly above their intrinsic values.

### Potential role of ESM
- Broadened mandate:
  - Consideration could be given to broadening the ESM mandate, allowing it to own, or lend support to, AMCs.
  - Argument: the risk of losses on impaired assets for creditor Member States (via the ESM) is likely to be much lower because of the retention of the long-term value of assets transferred to the AMC.
  - Transfer of conservatively valued assets from banks’ balance sheets to an ESM-owned AMC would be beneficial for all banking union participants, although it would also increase the capitalization needs of banks.
- Governance and accountability:
  - Potential conflicts of interest between capacities in which the ESM might operate (for example, acting as (co-)owner of banks following an equity injection and as purchaser through an AMC).
  - Suggested safeguards:
    - Clear and transparent evaluation criteria (guided by the ECB’s diagnostics) on asset prices.
    - Clear rules on the interaction with the ECB in its capacity as single supervisor, as well as with resolution authorities.
    - If needed, a potential revision of ESM governance and decision-making arrangements (which would require modifying the ESM Treaty).

### Conclusions
- Effectiveness:
  - Banks benefiting from ESM participation will need time to reorder their operations and restructure their distressed loans.
  - With moral hazard addressed through appropriate burden sharing, conditionality, and supervision, the ESM can act as the quintessential patient investor, taking a forward-looking approach to its equity holdings and internalizing the benefits of its ownership for the medium- to long-term outlook.
  - Such an approach to ESM direct bank recapitalization would maximize effectiveness in breaking the vicious circle between banks and sovereigns and safeguard the financial stability of the euro area as a whole.
- Urgency:
  - Large international experience shows that delays almost always ramp crisis resolution costs upward.
  - Some euro area member states continue to face severe stresses in both sovereign and bank funding markets, with broad ramifications for the currency union.
  - Others may be poised at a decision point between durably restored market access and potentially prolonged dependence on official financing.
  - Delay in applying the ESM direct bank recapitalization instrument would not improve ultimate outcomes; "The sooner the ESM can move, the sooner current market dislocations in both the periphery and the core can be resolved, for the benefit of all."

*Source: SDN/13/01 – TECHNICAL BACKGROUND NOTES (excerpt).*

---


_Source: https://www.imf.org/-/media/websites/imf/imported-publications/external/pubs/ft/sdn/2013/_sdn1301technt.pdf_