The common backstop – a welcome step forward

The Eurogroup’s agreement to introduce the common backstop to the Single Resolution Fund (SRF) early is something we very much welcome at the SRB. This is an important step towards completing the Banking Union, and will enhance confidence in the bank resolution framework.

In the context of the Covid-19 crisis, the backstop will strengthen the SRB’s capacity should any issues arise. We have previously noted that market confidence in a time of crisis is key[1] for effective bank resolution. The common backstop is crucial for the SRFs credibility, and further strengthens market participants’ confidence by increasing the funds available to the SRB to manage a crisis.

At the same time, we will continue to press ahead with our work to make banks resolvable. The backstop does not cancel the need for effective resolution planning and crisis management. Now, more than ever, we need to continue to build on our progress, and make our financial system stronger and more stable.

What is the Common Backstop?

Following the financial crisis, the SRF was created to ensure the effective application of resolution actions by the SRB, where necessary and subject to strict criteria. The banking sector funds the SRF through annual contributions, ensuring that the cost of failures will be borne by shareholders and creditors of the banks, rather than the taxpayer. The SRF now holds approximately €42 billion and it is being built up over a period of eight years – ending in 2024 - to reach at least 1% of covered deposits of the institutions authorised in the Banking Union.

However, there could be a situation where the SRF would not have sufficient funds, for example if it had to be used to support the resolution of multiple large banks. That’s why the creation of a common backstop was agreed in 2013. The idea was that the SRB would have access to this by the end of the transitional period (2016-2023). In effect, the common backstop is intended to ensure that the SRB would have sufficient firepower to address even a severe systemic crisis.

The European Stability Mechanism will provide the common backstop, and its size will be aligned to the size of the SRF, up to a nominal cap of €68bn[2]. It will take the form of a revolving credit line, which will only be available subject to funds in the SRF being exhausted, and the conditions for its use being met. The backstop will not be a burden on the public purse, because in the medium term the banking sector will cover the cost of any use of it, via contributions collected afterwards.

The common backstop will be introduced by 2022. This means that it will be introduced during the transition phase, i.e. before the fund has been fully built up. During this phase, the common backstop will be equivalent to the actual size of the SRF[3]. With consideration of the expected contributions, and without including the possible use of such funds in bank resolution, the SRB will have access already in 2022 to combined funds of over €100 billion from the SRF and the common backstop, in case of need.

Why has the backstop been introduced early?

The early introduction of the common backstop was conditional on sufficient progress in risk reduction having been made. To support this assessment, the European institutions (the European Commission, the European Central Bank and the SRB) prepared an extended Risk Reduction Report.

In contributing to this report, the SRB focused on developments relating to the build-up of loss-absorption capacity in the banking sector i.e. MREL. In particular, it was highlighted that:

• The gradual build-up of MREL-eligible instruments by the sector is confirmed, leading to a significant improvement in MREL compliance as of Q4 2019 when compared with Q4 2018. The average MREL shortfall declined to 1.0% total risk exposure amount (TREA) in Q4 2019 from 1.8% TREA in Q4 2018.
• Due to the Covid-19 crisis, the average aggregate MREL shortfalls increased between Q4 2019 and Q2 2020.
• Although market access conditions continued to improve at the end of Q2 (as well as in Q3) 2020, enabling most banks to resume issuances, the precise impact of these factors cannot yet be quantified.
• The SRB continues to work with banks to ensure they meet their MREL targets in line with the timelines set out in legislation.

Progress on risk reduction strengthens the ability of the SRB to manage bank failures. While the progress made was the basis for ministers deciding to early introduction, it should also reduce the possible need for the common backstop by ensuring that private sector funds are available to use before the SRF and common backstop.

Completing the Banking Union

In the current economic context, this important step shows that the Banking Union will have the funds needed to manage bank failures, bringing further confidence to the system.

However, we should not lose sight of the remaining work to complete the Banking Union. Agreement of the European Deposit Insurance Scheme remains a priority, as is the harmonisation of insolvency regimes, or at least a bank liquidation framework.

We have come a long way since the great financial crash, and the backstop is the latest important milestone on the road to promoting financial stability and protecting the taxpayer.