A bank restructuring agency for the Eurozone – cleaning up the legacy losses

Thorsten Beck, Christoph Trebesch 18 November 2013



At the core of the Eurozone crisis is the deadly embrace between banks and governments. Sovereign fragility has led to pressure on banks’ balance sheets. The weak fiscal position of governments in many periphery countries, on the other hand, has led to delays in recognising bank problems and addressing them (Acharya et al., 2012). The situation, however, also has a political dimension, as regulators in many European countries have become too close to the regulated entities. The combination of regulatory capture and incentives to forebear, exacerbated by easy access to ECB liquidity, has led to further delays in addressing bank fragility.

What to do? The problem of legacy assets cannot – and should not – be addressed as part of the intended framework of a Eurozone banking union. A full mutualisation of banking risks is also not possible and not desirable for political reasons. Currently, there appears to be deadlock between policymakers favoring a centralised solution to the Eurozone banking crisis, and those favoring a country by country approach. Last week’s ECOFIN statement still puts a heavy emphasis on national solutions (ECOFIN 2013a).

As an alternative, we propose a unified Eurozone approach to speed up the long-delayed crisis resolution, by combining elements of centralised control with elements of decentralised implementation. Specifically, following Beck, Gros and Schoenmaker (2012) we suggest the establishment of a central and independent Eurozone Restructuring Agency (ERA) that is in charge of coordinating the restructuring and recapitalisation of viable and liquidating non-viable banks throughout the Eurozone. The agency should be a temporary vehicle, with a clear sun-set clause, so that it ends its duty after the banking union will be completed.

Due to its temporary nature, our proposal differs importantly from previously discussed schemes. The institution should be solely concerned to deal with legacy problems of the past crisis and is not intended to address any future bank failures within the banking union. This is crucially different from the current discussion on a Eurozone public backstop for troubled banks, which continues to mix the resolution of legacy problems with guarantees for future losses.

For example, the banking union’s Single Resolution Mechanism (SRM), as currently discussed, will be responsible of dealing with past and future banking losses. Legacy problems would be solved over time, with the risk of further costly delay. In addition, it is uncertain when the SRM will be up and running and whether the current funding proposals will suffice to deal with unviable banks and toxic assets from the past. In light of this situation, we believe that a bridge solution that exclusively aims at cleaning up legacy losses is a quicker and more transparent way to resolve the ongoing bank distress in the Eurozone. It would also facilitate the banking union to go ahead in a forward looking way.

Building on a successful model

Bad banks, or asset management companies (AMCs) have become a popular tool to resolve national banking crises and clean up bank balance sheets. As discussed by Klingebiel (2000), Calomiris (2003), and Schäfer and Zimmermann (2009), several countries have resolved a large stock of non-performing assets successfully with centralised asset-management companies. These experiences were especially favorable in countries with a strong legal framework and for agencies with a narrowly defined mandate, namely that of cleaning up unviable banks and selling off their assets. This is what we have in mind here.1

A Eurozone restructuring agency (ERA)

We propose that by mid-2014, at the end of the process of the asset quality review (AQR) and stress tests, weak banks be referred to a temporary Eurozone Restructuring Agency for restructuring and resolution purposes.

  • In the first phase of its existence, the resolution agency would have to separate weak banks into viable and unviable financial institutions, based on the results of AQR and stress tests.

Unviable banks would be liquidated while viable weak banks would be restructured, preferably in the form of a separation of good and bad banks. This phase should also involve a partial or full bail-in of junior (and maybe senior) creditors of unviable banks. Liquidating unviable banks should thus involve minimal public funding, with losses borne mostly by non-insured creditors and equity holders.

  • In the second phase, the ERA would gain responsibility with regard to both the good and the bad banks that emerged from phase one.

Once the bail-in of bank creditors is completed, the ERA would inject capital in the good banks, but in return receive equity claims in them (as currently envisioned in the case of direct ESM bank recapitalisation, see ECOFIN, 2013b). One arm of the ERA would thus partially or fully own and manage the good banks, and sell them at the best achievable price after the restructuring is finalised. The second arm of the ERA would be responsible for liquidating the assets of the bad banks, and these assets would also be partially or fully owned by the agency.

The ERA would be jointly owned by the 17 Eurozone members, in the same proportion as their shares in the European Stability Mechanism (ESM). All liabilities, but also assets and equity stakes in the good banks, would thus indirectly be owned by European taxpayers. As a result, any returns from the asset liquidations or bank sales would be disbursed to the ERA shareholders and, thus back to the Eurozone governments.

Financing and control

In essence, the ERA scheme amounts to an exchange of bailout money (from creditor countries) against management control over weak and failing banks and their assets (in debtor countries). It is obvious that a lot of capital will be needed for the scheme to work.

The initial funding for the ERA could come from the ESM, in a way that preserves the ESM’s AAA creditor status. This could require paying in additional ESM capital or additional loan guarantees by Eurozone governments, including from creditor countries like Germany. Early on, the ERA should also seek market funding for additional equity stakes in individual banks. In addition, the ERA itself could be given the ability to issue bonds on the market.

With its capital the ERA would provide loans and/or capital to AMCs and bad banks across Eurozone countries, including to those entities that have already been created (e.g. FROB in Spain or NAMA in Ireland). The ERA would also replace the current ESM scheme of recapitalising banks by lending to the sovereigns or via direct recapitalisation.

At the end of the process, the ERA will thus become a mother entity with decision and delegation power over national resolution schemes. This means that a country like Spain would have to give up sovereignty in deciding how its unviable banks will be restructured and how its assets will be liquidated.

Convincing the north and the south

How can creditor and debtor countries be convinced to agree to such a scheme? We propose the following ideas:

  • Asymmetric return pay-offs
    While ESM loans to the sovereigns only involve down-side risk, our scheme has the advantage that positive returns (upside risks)