Liquidity is central to successful crisis management. Banks depend on trust. If customers lack confidence that their funds will be available on demand, a spiraling liquidity crisis may develop. Such a crisis can potentially drive fire sales of assets to meet increasing liquidity demands, hampering the viability of the bank, the feasibility of resolution and possibly spreading panic across the banking sector and beyond.
The Single Resolution Board’s (SRB) resolution toolkit is strong but must be backed up by effective liquidity provisions to ensure the successful resolution of any crisis. While we have the tools necessary to restore a firm to viability, it may take time for market confidence to be restored. Without adequate liquidity support, the failure of a bank may become a self-fulfilling prophecy as market actors seek to ensure that they will not be left in a bank run. This is why in recent cases, the liquidity provisions have been of a dramatic scale relative to the size of the failing entity’s balance sheet.
In some cases, this support can be provided directly by the private sector. For example where a large, liquid bank takes over a smaller competitor, the buyer can meet the liquidity needs of the failed bank thus restoring confidence. However, for the very largest banks it seems likely that some form of public liquidity support would be needed.
Even in the acquisition of Credit Suisse by UBS we have now seen that public support was available to give markets the confidence that the transaction would be successful. Such a funding mechanism should also be in place in the EU. How should we structure this mechanism? We would need to align to the Financial Stability Board (FSB) Guidance while accounting for Banking Union specificities. The FSB set out that the backstop should be of adequate size and be capable of rapid use. Importantly, rapid use is dependent on a lean, quick and efficient decision making process when calling on the facility, ensuring enough flexibility to act in a crisis scenario. In addition, the duration of funding should be no longer than the time needed to achieve an orderly resolution, but sufficiently long that the bank in resolution has time to regain access to private sector funding. Putting these different elements together, in a way that preserves the flexibility of the authorities, will ensure the authorities can rapidly intervene with the funding needed in a crisis scenario.
Importantly, developing an effective liquidity in resolution facility should also support the bank’s return to market funding by restoring confidence in its finances and business. It is important to balance adequate incentives for the bank to return to the market without constraining too much the use of the liquidity tool. One thing important to underline is that the amount of support put in place to reassure the markets and customers is not necessarily drawn up by the bank in resolution. The liquidity really needed can be smaller and just for a short period of time, as a good resolution scheme will restore confidence in the bank.
Liquidity can come from several authorities in the Banking Union. The SRB has now built up the Single Resolution Fund, which stands at almost EUR 80 billion, and its firepower could almost double if the revised ESM Treaty is ratified. This is already an important step but the liquidity needs of a global bank could go well beyond this amount. As such, while we stand ready to play a role in providing liquidity, our role can only be limited. This is why we stand ready to work on developing an effective mechanism for liquidity in resolution in the Banking Union.
For these tail risk liquidity needs, the intervention of central banks is certainly needed. How the necessary protection to the central bank can be managed is clearly a topic of the utmost importance and further technical work is needed. Looking at other jurisdictions, it is clear that providing the support necessary for the central banks to act is key. In Switzerland, the US and the UK, we see that the possibility is in place for a public sector guarantee. This was a key part of making the Credit Suisse transaction credible, and of course we can see these facilities are in place in other jurisdictions such as the US or UK. Discussion is needed in the Banking Union on how we can develop such a facility within our own institutional context.
So the question is how can we make real progress on this thorny issue? While we can understand the concerns around committing to providing large amount of liquidity, failing to agree on an ex-ante facility may drive uncertainty that could lead to escalating liquidity needs. Given the nature and size of the facility, a clear political support is needed to make the technical work becoming a reality.
The SRB’s resolution toolkit is strong but must be backed by effective liquidity provisions.
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