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August 16, 2018

ESRB published a working paper examining bank resolution and public backstop in an asymmetric banking union. The authors analyze the optimal bank resolution decisions and the design of a fiscal backstop in a banking union. The findings highlight the importance of establishing country-specific resolution policies for heterogenous countries to benefit from a banking union.

EC recently issued a communication that identifies a last resort common fiscal backstop for the single resolution mechanism as a critical missing element to complete the banking union. The June 2018 Euro Summit agreed that by the end of the year the Eurogroup would have prepared the terms of reference for the use of the European Stability Mechanism as a common fiscal backstop. This raises several questions: How should a common fiscal backstop be articulated? How should bank resolution decisions be conducted? How much risk-sharing can countries achieve through a banking union? The authors address these questions in a model that takes into account two asymmetries that are prevalent in the Euro Area context.

The paper characterizes the optimal banking union with endogenous participation in a two-country economy, in which domestic bank failures may be contemporaneous to sovereign crises, giving rise to risk-sharing motives to mutualize the funding of bail-outs. It was found that raising public funds to conduct a bail-out entails the dead-weight loss of distortionary taxation. Bank bail-ins create disruption costs in the economy. When country asymmetry is large, resolution policies exhibit reduced contributions to the public backstop and forbearance in early bank intervention in the fiscally stronger country, facilitating bail-outs in this country. 

 

Related Link: Working Paper (PDF)

Keywords: Europe, Banking, Systemic Risk, Banking Union, Bank Resolution, Public Backstop, Bail-in, ESRB

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