Document Type

Article

Publication Date

2015

Center/Program

Center for Law and Economic Studies

Center/Program

Ira M. Millstein Center for Global Markets and Corporate Ownership

Abstract

The project of creating a Banking Union is designed to overcome the fatal link between sovereigns and their banks in the Eurozone. As part of this project, political agreement for a common supervision framework and a common resolution scheme has been reached with difficulty. However, the resolution framework is weak, underfunded and exhibits some serious flaws. Further, Member States' disagreements appear to rule out a federalized deposit insurance scheme, commonly regarded as the necessary third pillar of a successful Banking Union. This paper argues for an organizational and capital structure substitute for these two shortcomings that can minimize the systemic distress costs of the failure of a large financial institution. We borrow from the approach the Federal Deposit Insurance Corporation (FDIC) has devised in the implementation of the "Orderly Liquidation Authority" under the Dodd-Frank Act. The FDIC's experience teaches us three important lessons: First, systemically important financial institutions need to have in their liability structure sufficient unsecured (or otherwise subordinated) term debt so that in the event of bank failure, the conversion of debt into equity will be sufficient to absorb asset losses without impairing deposits and other short term credit; second, the organizational structure of the financial institution needs to permit such a debt conversion without putting core financial constituents through a bankruptcy or other resolution process; and third, a federal funding mechanism deployable at the discretion of the resolution authority must be available to supply liquidity to a reorganizing bank. On these conditions, a viable and realistic Banking Union would be within reach-and the resolution of global financial institutions would be greatly facilitated, not least in a transatlantic perspective.

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