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Based on your readings, and at least one example, discuss the key factors that governments take into consideration when dealing with a failing bank. Discuss how European financial stability policy has evolved in this area.
Support your answer with reference to how various types of creditors get repaid when a bank is put into liquidation, as well as the range of policy measures available to regulators in the formation of `bank resolution’ policy.
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For as long as banks have existed there have been bank failures. They are a crucial part of the economy and failures are often left to up to individual governments to resolve. Failing banks are costly and careful consideration is needed for to the steps be taken to resolve the situation. Bank failure can quickly spread across the financial system and cause panic. Various methods are used by states to contain it including deposit guarantees and bailouts. Creditor repayments can have significant impact on the system and need to be managed. After the financial crisis of 2008, the EU has undertaken several steps to increase financial stability across the Eurozone, mainly in the form of setting up new funds to deal with future failures. Traditionally, creditors are repaid on a hierarchy with senior creditors pad first, followed by junior creditors, preferred shareholders, equity holders and finally depositors.
One of the first things for governments to consider when faced with a failing bank is the decision between corporate bankruptcy and keeping the bank afloat. While deliberately allowing a bank to go bust and the implications for the public may seem like poor government policy, there may be no other choice available. During the financial crisis, Iceland made the decision to allow their banks to more or less fail. The domestic portion of the banking system was bailed out with deposits given priority ahead of other unsecured claims. A debt moratorium was granted to the much larger international portion of the system and a resolution committee was selected to preserve the value of the assets (Hafliðason, Valgeirsson, and Marinósson 2009). Iceland suffered from ‘small country syndrome’ (Benediktsdottier, Danielsson, Zoega and Tile, 2011). In 2008, the Icelandic financial system was worth 900% of GDP. The government was simply be unable to finance a bailout for the entirety of the failing banks. A range of policy measures such as emergency resolution, capital controls, alleviation of balance of payments risks and preservation of financial stability were implemented in addition. In hindsight, the government’s response to the crisis seems to have worked well. (Benediksdottier, Eggertsson and Porarinsson, 2017).
The Icelandic banks were operating under EU passporting rules in order to carry out banking services across member states. Under this arrangement, non-EU credit institutions can establish an EU-based entity which is licensed to operate regulated services under EU law across the 28 countries provided home regulators are exercising adequate controls on the institutions. However, the failure of Icelandic banks left depositors across the Eurozone in danger of losing their deposits. They were under the belief that deposit insurance was in place for their deposits and the Icelandic institutions were in line with EU rules which was not the case. Iceland had undercut the supervisory standards of the other member states due to their own lax controls, which in turn weakened the entire system. The fragmented supervision left the entire financial system vulnerable due to too much faith being placed in national supervisors. The passport system had grown too fast and regulation was too slow to adapt. In 2016, this scheme was updated to increase the coordination between member states and reduce some of the weaknesses that existed with the intention of reducing instability.
If a government does take the decision to attempt to save the failing banks, it can have many non-monetary implications. Resolving a bank failure using public funds could reinforce future expectations of public support for distressed financial institutions. This could lead in the future to undermining market discipline and excessive risk-taking throughout the market and even possibly build the foundation for the next financial crisis. Moral hazard risks can be limited under the threat of temporary public ownership.
The area of controversy with financial support relates to who foots the bill. In New Zealand, all banks, even foreign owned, are structured in such a way that taxpayers do not have to pay for the failure of a bank. No deposit insurance exists in New Zealand, instead depositors are treated as junior creditors whose claims are written down in proportion along with others of the same class. All deposits are divided into a continuing portion that can be continued to be used in normal transactions and a frozen portion.
Many governments have no choice but to use taxpayer’s funds to finance a failing institution. The Irish government committed to a bank bailout after the property crash in 2008. Irish banks faced an imminent threat of collapse due to insolvency and were unable to bear the cost of such a bailout themselves. Taxpayers were left having to pay the price of the risky behaviour undertaken by the banking sector. Under the terms of the bank guarantee the government paid out €64 billion in bank bailouts. There is a fixed hierarchy setting out which creditors get repaid, based on seniority of their claim. Interestingly, the State was a junior creditor of the bank. The government had the decision to impose losses of €9 billion on senior debt holders. Financing should be arranged where possible so that taxpayers are beneficiaries from resolution measures that restore failing banks successfully. It is inappropriate for bank-owners to profit from such activities as it would be returns to resolved banks and those who caused the failing in the first place at the expense and risk of taxpayers. The ownership of the bank after government help is important. Will taxpayers ultimately own the bank, such as in the case of the nationalisation of Fannie Mae and Freddie Mac at a cost of $187 billion to taxpayers. Another option is a private entity taking control over the failing bank, similar to the case of Bear Stearns. JP Morgan acquired a loan from the Federal Reserve of $29 billion to finance the transaction.
One fund which attempts to place the cost of government aid for the financial system is the Single Resolution Fund (SRF) was set up by the EU in 2016. It collects contributions from credit institution and investment firms across 19 participating member states. Between 2016 and 2023, the fund will be gradually built up to reach the target level of at least 1% of total deposits of all credit institutions within the banking union. The aim of the fund is to provide a way for the financial industry to contribute to the stabilisation of the financial system. The SRF will be used only when necessary to ensure the effective application of resolution tools such as to make loans to or purchases on assets of the firm under resolution and to make contributions to a bridge institution. Funds will only be awarded on two condition – the SRF contribution does not exceed 5% of total liabilities and losses no less than 8% have been absorbed by creditors of the firm. The European Stability Mechanism (ESM) is a fund financed by taxpayers which replaces the European Financial Stability Facility and European Financial Stabilisation Mechanism. The ESM was set up after the crash of 2008 to act as a safeguard to the Eurozone by providing instant access to financial assistance for member states in financial difficulty. In 2012, Cyprus was able to use this fund to recapitalize its banks.
Today, due to globalisation, banks are linked to one another. While some banks can be considered ‘too big to fail’, the links with other banks is the financial system is of more concern. Governments must consider how ‘contagious’ a failing bank is. If a failing institution is in a network of banks who rely heavily on each other, failure could be contagious within the web. The larger and more complex this system, the greater the implications for the financial system as a whole. The collapse of Lehman Brothers turned a global financial distress into an international emergency due to the exposure of international firms. As the majority of banks are entwined in this network, liquidity for depositors is greatly reduced and a bank run can quickly occur. However, while early intervention can lower the cost of remedying bank failure, it may also prematurely interfere with the ownership, property, and rights of bank shareholders. There is a need to balance the advantages both to other bank creditors and to society as a whole, against the rights of bank owners.
In the Forgotten Panic of 1929, the intervention of the Federal Reserve highlights how banking runs can be limited and protect failing banks to allow them to continue operations. In 1929, revenues from fruit sales amounted to 51% of Florida’s revenue from crops. The discovery of fruit fly infestations resulted in the destruction of the majority of fruit crops in the state. With farmers taking a massive financial hit, there were worries about their ability to repay their loans. Panic spread quickly resulting in a run on the bank and subsequent bank failures across the state. In July of that year, 8% of the state’s banks closed their doors over the 48 hours following the failure of Citizen’s Bank which served as the financial centre for these citrus-growing areas (Carlson, Mitchener and Richardson, 2011). The response of a central bank to a bank’s failure demonstrates the larger role illiquidity plays (Summer, 2000). Worsening concerns over solvency increase the probability of a bank run, which was seen here. The Federal Reserve Bank of Atlanta took action to halt the panic by rushing currency to banks and publicly announced the guarantee of depositor’s currency. They provided targeted liquidity support helping to prevent a wave of further bank failures. Banks survived and creditors were repaid as operations returned to normal.
As economies become more globalised, banks become more interdependent and interconnected and requires cooperation between countries. This is especially true in the case of the European banking system. Many of the countries joining the EU have fundamental structural differences and the euro was introduced to help create the conditions necessary for further economic unity among the member states. One of the ways this was to be secured was through creating financial linkages across countries thus, making the economies more similar and subject to more common shocks over time (Frankel and Rose, 1998). Ultimately, this lead to country-specific shocks developing into systemic shocks. The financial crisis exposed important failures in the financial supervision of individual institutions, which proved unable to prevent, manage and resolve the crisis which evolved and revealed shortcomings in cooperation, coordination, consistency and trust that existed between national supervisors. In March 2009, the European Commission which set out to ensure the “long-term financial stability”. The Bank Recovery and Resolution Directive (BRRD) is a framework implemented in 2015 which set guidelines for the 28 member states on how to deal with failing banks at a national level and encourage cooperation agreements to tackle cross-county banking failures. It sets out guidelines as to how and when member states should intervene, encompassing precautionary, early intervention and measures designed to prevent bank failures. To promote financial stability, the aim is to shift the cost of failing banks to the shareholders and creditors of the bank and not taxpayers to avoid fiscal strain on governments. It is vital to have cooperation and coordination between all 28 countries to avoid moral hazard which hinders the process of restoring and maintaining confidence. Banks are no longer treated as purely national institutions, now risks are considered in the context of the negative repercussions for all euro area banks.
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When faced with bank failures, governments must first consider if supplying federal funds is economically feasible before taking into account the complexity and implications of the resolution. Many funds have been set up by the EU in the wake of the financial crisis to finance these issues. Governments must decide the best policy to suit the institution, whether it’s by guaranteeing bank deposits or nationalising banks, and must evaluate how creditors will be repaid.
(Frankel and Rose, 1998), Frankel J.A. and Rose A.K.: The Endogeneity of the Optimum Currency Area Criteria, NBER Working Paper, 1998.
Carlson, Mark, et al. “Arresting Banking Panics: Federal Reserve Liquidity Provision and the Forgotten Panic of 1929.” Journal of Political Economy, vol. 119, no. 5, 2011, pp. 889–924. JSTOR, JSTOR, www.jstor.org/stable/10.1086/662961.
(Hafliðason, Valgeirsson, and Marinósson 2009) https://www-jstor-org.ucc.idm.oclc.org/stable/90019458?Search=yes&resultItemClick=true&&searchUri=%2Ftopic%2Fbank-failures%2F%3Frefreqid%3Dsearch%253Ac9af7b70be74cb01a95bd878553eb613&seq=1#metadata_info_tab_contents
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