Financial Stability | Crisis Management
The banking sector has a specific role in a country’s economy, as it performs functions essential for its economic activity, such as provision of payment services, saving, insurance, loans, risk hedging etc. Any disturbance in these functions tends to reflect negatively on financial system stability, while repercussions are also felt by the real economy and all citizens. The global financial crisis has proved that not even the most advanced economies had an appropriate legal framework for problem bank resolution which would ensure that bank bailout burden is borne primarily by its shareholders and creditors. Competent authorities and governments had to make a choice between a bankruptcy procedure bearing a high risk of potential systemic disturbances on the one hand and bank bailouts shouldered by budgetary or other public funds on the other. Endeavours to prevent bank insolvency and illiquidity and to preserve critical bank functions led to problem banks rescues at very high costs ultimately borne by taxpayers. However, despite the importance of bank functions, the issue of moral justifiability of government financial support has been raised, bearing in mind that these are, after all, profit-making institutions, generally privately owned, where owners of capital – bank shareholders generate and keep for themselves profit generated in times of market prosperity, while they resort to budgetary support in times of crisis and losses to the bank.
Thus during the global financial crisis, and also in the post-crisis period, in countries which managed to weather the crisis, the existing mechanisms proved inefficient and inadequate for addressing the problems of banks which faced serious difficulties in their operation. They allowed no possibility for sufficiently prompt and efficient intervention of competent authorities, and did not ensure all the conditions for preserving banks’ critical functions or for safeguarding financial stability of the financial system as a whole. All this has led to growing international awareness on the need to define clear rules and mechanisms for action in crisis situations. At the EU level this eventually led to the adoption of the Directive 2014/59/EU on establishing a framework for recovery and resolution of credit institutions and investment firms (hereinafter: Directive) in May 2014. The Directive became effective on 1 January 2015 in all EU member states.
In line with the strategic commitment of the Republic of Serbia toward EU accession, the NBS drafted the Law Amending the Law on Banks which was adopted by the Serbian Assembly in February 2015 and came into force on 1 April 2015. The law harmonised the legal framework in the area of bank resolution with the aforementioned Directive and the best international practices and regulatory trends.
These legal changes set up a comprehensive legal framework for bank resolution, the main goal of which is to minimise the use of budgetary and other public funds with a view to preserving financial stability. This was achieved by ensuring that losses incurred by a bank failure are to be borne firstly by bank shareholders and creditors, observing the prescribed limitations and protective mechanisms (the losses may not exceed the ones entailed by a bankruptcy procedure). Namely, while it is justifiable to use budgetary and other public funds to address a specific case of a troubled bank of systemic importance, it is unsustainable and contrary to the public interest to encourage moral hazard in banking by fuelling a belief that a bank can always be saved at the taxpayers’ expense, regardless of oversights in its operation and the resulting financial damage, i.e. regardless of the shareholder and management liability for such oversights. Quite the contrary – shareholders and creditors must be aware of the losses they have to shoulder in case of a bank failure, and adequately assess such risk, which would positively reflect on market discipline.
Following amendments to the set of financial laws in February 2015, the NBS was entrusted with a new role – that of a resolution authority (thus, among other things, the NBS establishes whether the conditions for resolution of a bank and/or members of a banking group are met and carries out the resolution procedure, making a decision on resolution tools and measures). In addition, the NBS, as a resolution authority, is equipped with a wide range of powers and a set of flexible measures and tools, allowing it to timely and efficiently respond to different stress situations in the banking sector, and to apply to a concrete case such resolution tool that most effectively meets the resolution objectives, bearing in mind the public interest. This laid down the groundwork for the NBS to be able to assess, in each individual case, whether the conditions for bank resolution are met or a regular bankruptcy procedure is required, how to maintain the critical functions of a bank under resolution as well as if it is possible to re-establish an adequate financial position and long-term sustainability of a bank, and to apply, consequently, a resolution tool that most effectively meets the bank resolution objectives stipulated by the law:
It is important to note that, according to the law, the resolution objectives are of equal importance and they are to be balanced in the resolution procedure as appropriate to the circumstances of each individual case.
As for the resolution tools, the NBS may apply such tools in the resolution procedure individually or in any combination that would best achieve the resolution objectives. The Law on Banks envisages the following resolution tools:
In order to further the resolution objectives, the law provides for enforcement of resolution tools without shareholder and creditor consent. On the other hand, the law also ensures measures and mechanisms for protection of shareholders, creditors and third parties which the NBS must adhere to in the resolution procedure.
In order to meet one of the key resolution objectives – protect budgetary funds and other public funds – it is necessary to have additional mechanisms in place which ensure that capital can absorb losses arising from a bank’s operation. It is therefore envisaged that the NBS may write down appropriate elements of a bank’s capital or convert them to shares or other equity instruments even before initiating the resolution process. The NBS may also carry out such write down and conversion upon initiating the resolution procedure, before the implementation of an appropriate tool. Ratio legis of such option is to create preconditions, prior to initiating the resolution procedure, for restoring an adequate financial position of a bank failing or likely to fail, i.e. to preclude the resolution, while if the resolution procedure has been launched, the purpose is to ensure that elements of the core and supplementary capital suffice to cover the bank’s losses at the moment of its insolvency, prior to implementing any resolution tool.
Furthermore, a new legal framework has also improved conditions for preventive action and adequate preparation of banks, the NBS and other competent institutions for responding to financial stresses, failure or likely failure of a bank. Preventive action and readiness of the banking sector is ensured by a requirement for banks to draft their recovery plans, within one year from the law’s effective date. Such plan provides for measures to be taken by a bank in order to restore its viable operation and adequate financial position following a significant deterioration of its financial condition. Preventive action and readiness are also ensured by the requirement imposed on the NBS to develop, by 31 March 2016 at the latest, a resolution plan for each bank, envisaging the application of appropriate resolution measures and tools and the exercise of powers by the NBS once the decision to initiate the resolution procedure is taken.
Bank resolution exercised in a single, clearly regulated procedure aims to enhance the functioning of the banking sector and to improve the conditions for safe and sound bank operations. Safe and sound functioning of the banking sector is of key importance for preserving and strengthening the stability of the financial system as a whole, bearing in mind the well-known bank-centeredness of the financial sector, and for the strengthening of institutions and participants in that system. This is also of utmost importance for promoting and preserving citizens’ confidence in banks and the banking sector which on its part safeguards and improves baking sector liquidity and ultimately boosts economic activity.