Unlike the failure of non-financial firms, which typically affects a limited group (such as shareholders, creditors, and employees), the failure of a bank can have far-reaching consequences for the broader financial system and the real economy. These risks multiply when several banks are at risk of collapsing simultaneously. In such scenarios, the question of how to effectively manage and resolve failing banks becomes crucial, especially in regions where banking systems remain fragile and resolution frameworks are still developing.
This is precisely the focus of the Widening Project on Bank Resolution Frameworks in Systemic Crises (BRSC). Using data from 22 Financial Stability Board member countries, the team of investigators, including Thorsten Beck (Director of the Florence School of Banking and Finance at the EUI’s Robert Schuman Centre) and Deyan Radev (Sofia University St. Kliment Ohridski), evaluate the effectiveness of bank resolution frameworks in addressing systemic banking crises.
Even when the failure of a single bank is not part of a widespread crisis, how can it impact the broader financial system? Should this be a cause for concern?
Thorsten Beck: There are bank failures that are so idiosyncratic that they will not affect other banks. However, in many cases, even if there is only one bank failing, it can have repercussions far beyond the bank in question. First, depositors and investors might get nervous about banks with similar business models and balance sheet structures. Second, there might be spillover effects if other banks are connected to the failing through interbank loans or by holding similar assets. Third, the failure of one bank might result in a general loss of trust in the banking system and bank supervisors. These different spillover effects underline the importance that bank resolution regimes look beyond the bank in question to broader financial stability concerns, unlike in the case of non-financial corporate failures.
Over the past years, the institutional and regulatory frameworks for dealing with failing banks have been reformed significantly. For better or for worse?
Thorsten Beck: Many countries, including in Europe, have made it easier to intervene a failing bank early on, by establishing procedures that do not rely on (typically slow) court procedures but rather on swift actions by authorities that protect the interests of depositors (especially insured depositors) and allow quick intervention before the bank’s situation deteriorates further. In several cases, where banks failed for individual reasons, these procedures have proven to work relatively well, limiting damage for the banks’ stakeholders, including depositors and borrowers, and limiting contagion effects. Our empirical work, however, casts doubts on whether such procedures would be helpful in situations where distress in the banking sector is more widespread. Specifically, we find that having strict rules that might limit flexible actions by authorities might make the situation worse rather than better.
What alternative procedures or rules would be needed instead?
Deyan Radev: The focus of the bank resolution legislation in the past two decades has been to prevent future bank bailouts. However, the regulatory actions during recent banking crises, such as the failure of Silicon Valley Bank and First Republic Bank, confirm the conclusions from our analysis that bailouts may be unavoidable if an individual bank’s failure threatens to turn into a systemic crisis. We believe that there is no single blueprint to handle bank failures and therefore resolution authorities should maintain a wide set of crisis-handling tools, which include access to a higher fiscal capacity to potentially perform bank bailouts if necessary. Authorities should keep their eye on the main goal: to localise and contain the impact of bank failure to protect and maintain the critical functioning of the remainder of the banking system, in order to avoid contagion to the real economy.
This fiscal capacity is related to the ability of governments to maintain access to financial markets, which has been a recurrent problem in the past decades, especially in the euro area. The improvements in fiscal discipline since the sovereign debt crisis have been tremendous, but took a step back after the outbreak of the COVID-19 pandemic and the start of the War in Ukraine. We believe that efforts in that direction should be resumed and accelerated to face the future global challenges to the functioning of the financial system.
What data and methodology did you use to come to these conclusions?
Thorsten Beck: As we do not observe systemic banking distress regularly, we used certain shocks, such as events during the Global Financial and Eurodebt crises, to see how a measure of banks’ systemic risk contribution reacts to these events and explore whether this reaction varies with the structure of countries’ bank resolution frameworks. We find that certain dimensions of bank resolution, such as bail-in of certain debtholders, might exacerbate the situation rather than help mitigate it. In establishing these findings, we use bank-level data on systemic risk contribution with hand-collected data on bank resolution frameworks across 22 countries.
In your view, what are the biggest challenges for Widening Countries in managing bank failures effectively, given the current stage of their banking systems?
Deyan Radev: The Widening Countries have experienced a number of banking crises in the past three decades, including the Bulgarian banking crisis of the 1990s, the Baltic Financial Crisis following the Global Financial Crisis of 2008-2009, and the Greek (and euro area) sovereign debt crisis of the 2010s. The problem of dealing with failing banks is exacerbated in that region by the fact that the national banking systems are primarily foreign-owned. The main issue we see is that any bank failure in that context requires significant cross-border coordination of the relevant authorities of the countries of operation of the failing multinational bank.
The goal is to avoid “importing” foreign financial distress into the local banking system that could potentially negatively affect the domestic and regional real economy. This leads to the next big challenge: educating and preparing local regulators and authorities to manage effectively the risks within their respective banking systems and, when need be, to deal with banking crises swiftly and efficiently.
In this context, we should point out the role of the European University Institute and the Florence School of Finance and Banking in educating EU- and national-level bank resolution authorities, as well as the local efforts of higher education institutions like Sofia University with their international banking programmes to build and improve the crisis management capacity of local regulators.
The EUI Widening Europe Programme, supported by contributions from the European Union and EUI Contracting States, is designed to strengthen internationalisation, competitiveness, and quality in research in targeted Widening countries.