New Policies to Stabilize the Banking System

In a conceptual environment, where central banks were supposed to be independent and not to interfere with markets, their intervention processes as known for decades could no longer be unlimited when faced with huge monetary flows. Letting a systemically important bank fail, as in the Lehman Brothers case, is not acceptable when considering the consequences. The FSB answer was to call for banking resolution systems to be set (see Chapter 7). For Europe, a banking recovery and resolution directive (BRRD) for the banking industry is intended to anticipate the difficulties with a surveillance system and require banks to build up a plan in case such difficulties arise. In essence, what happens if a portfolio's value goes down or if deposits go away, or a crisis appears in a sector of the economy or with public debts. This is the purpose of stress testing, which banks are submitted to on both sides of the Atlantic. When these difficulties do appear, the resolution system will take over to impose either a recovery or a liquidation process without contagion effects. In essence, it gives power to the central banks to impose cross-nation or monetary zone solutions. With the aim of avoiding what happened with Lehman Brothers, the intention is to disconnect the bank from central bank money and taxpayer's money. Among the tools are the request for sufficient equity and limited leverage after the assets have been risk weight appraised. At that stage the central bank will require additional equity (if this is deemed to be insufficient) or, if the failure is obvious, impose an orderly process of partial or total liquidation with the maintenance of support functions. To insure the financing the authority will impose an equity and long-term non-claimable financing instrument haircut. This is called the “bail in”. If no sufficient resolution fund comes through the banking system from contributions over time, the sale of assets and/or a bridge bank might also be imposed before the central bank or a bail-out process intervenes.

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