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Completing a half full or a half empty Banking Union: the introduction of the common backstop

The road to reach an integrated European banking sector is long but the end is at sight.

Written by: Maria Ana Barata

‘Half full or half empty’, has become a consensual way to describe the progresses made in advancing banking market integration in Europe. The Banking Union (BU) is a three-pillar project: it comprises the Single Supervisory Mechanism, the Single Resolution Mechanism, and the European Deposit Insurance Scheme. The first pillar is fully operational since November 2014, the second pillar has been operating without an important piece of its puzzle, and the third one is (for now) facing an ongoing impasse at the political level. So, whether the glass is half full or half empty, largely depends on the optimism concerning the odds of soon completing the puzzle. Hopefully, and as planned, the glass will become fuller in the next months with the introduction of the common backstop. This missing piece of the puzzle is a significant milestone in the progression of banking market integration in Europe.

What is the Single Resolution Fund and why is it necessary?
In 2013, the European Union (EU) agreed to establish the Single Resolution Fund (SRF) to enable the Single Resolution Board (SRB) to better manage bank failures within the participating countries of the BU. The SRF is owned by the SRB, and it is part of its budget, which is independent of the EU budget. Since its establishment, the SRF has been principally funded by ex-ante annual contributions, raised at national level by the National Resolution Authorities (NRAs), from the banking sector. Contributions to the SRF are made by all credit institutions and certain investment firms operating in the BU. Yet, the obligation to contribute to the SRF has been challenged, both on substantive and procedural grounds, numerous times. Its desired target – by the end of 2023 – is to reach at least 1% of covered deposits of all the institutions of participating countries, including the latest joiners, Bulgaria and Croatia.
The stabilisation of the financial system is in the hands of the financial industry. Hence, the obligation to contribute to the SRF ensures the split of the costs of stabilising the financial system with the banking sector, which is comprised by small, medium size and large institutions. Additionally, as the improvement of risk indicators foresee a better management of bank failures, the existence of a SRF is closely linked with the need to reduce risks within the BU. Moreover, the existence of a European level fund enhances trust in the banking sector of the Euro area. Overall, the need for a SRF is also closely linked with market confidence, which is extremely important in crisis moments, as the one we are currently facing.

The establishment of a common backstop to the SRF and the need to plan ahead
For the possibility of the SRF not having sufficient funds to support the resolution of multiple large banks, in 2018 it was agreed to create a common backstop provided by the European Stability Mechanism (ESM). The common backstop to the SRF will provide loans as ‘a last resort’ support and will further enhance the capacity of the SRF. Until the SRF is fully funded, the size of common backstop will be equivalent to the size of the SRF.
Once operational, the backstop can be activated when, even after imposing losses on the banks’ shareholders and creditors, the SRF is temporarily short of resources to facilitate the resolution of a non-viable bank.
This means that if the SRF is depleted, as a last resort, the ESM can act as a backstop and lend the necessary funds to the SRF to finance a bank resolution, ensuring the efficient application of the resolution tools and the exercise of resolution powers. Acting as a last resort measure, the ESM will provide a revolving credit line, thanks to which the bank can be resolved without causing financial instability and without additional costs for taxpayers.
The ESM can lend to the SRF up to €68 billion, however the ESM can only intervene if the SRB is not able to raise sufficient contributions or borrow funds from other sources at acceptable rates to finance a bank resolution. If the credit line is used, the SRF will pay back the ESM loan with money from bank contributions within three years (or up to five years, if extended).

Background of the ESM Reform
In December 2013, the Eurogroup and ECOFIN Ministers stated that the SRF should be established to protect financial stability in the BU, and that the fund should be assisted by a common backstop that should be fully operational in the upcoming 10 years. Three years later, the Council presented the roadmap to complete the BU, and reemphasized the completion of the common backstop by the end of the transition period (i.e. 2024).
Only in June 2018, the Eurogroup revealed the consensus that the common backstop to the SRF was to be provided by the ESM, which made the need for a reform of the ESM Treaty foreseeable. The ESM reform was initially endorsed by the Heads of State or Government of Euro Area countries as part of a package of measures to strengthen the Economic and Monetary Union and to broaden the mandate of the ESM – as agreed in the Euro Summit of 14 December 2018.
It took one year for the Eurogroup to agree, subject to national procedures, on the elements related to the ESM Reform – on 4 December 2019. It took another year for the finance ministers of the Eurogroup to reach the political agreement on completing the ESM Treaty reform – on 30 November 2020. As mentioned above, the common backstop was initially planned to be introduced by 1 January 2024. However, the Eurogroup decision of 2020 resulted in an agreement to introduce the common backstop two years earlier than planned, i.e. by the beginning of 2022.
Finally, and to set up the backstop, on 27 January and 8 February 2021, the 19 ESM member countries signed the Agreement Amending the ESM Treaty. This Agreement provides a legal basis for a set of new tasks assigned to the ESM, but the reformed Treaty will come into force only when ratified by the parliaments of all ESM Members.

Toward topping the glass up
The new year has arrived, and the establishment of the common backstop is awaited with great enthusiasm. According to the 2022 SRB Work Priorities, this is one of its key targets.
In addition to effective resolution planning and crisis management, the common backstop is crucial for the SRF’s credibility. It also enhances the trust in the SRB managing future banking crisis without burdening national budgets. It ultimately contributes to top up the half full glass, a long-waited milestone in the history of the BU. Soon we are likely to be one step closer of achieving an integrated European banking sector.

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