Europe is making a new mistake on failing banks

Three years since their banking union began to take shape, European Union regulators are seeking fresh powers to deal with lenders in trouble. Their plan would let them stop withdrawals from a failing bank for a few days while they address the problem, with the aim of preventing a run. But this approach could easily have the opposite effect, spreading panic to the whole financial system. There’s a better way.
Instead of freezing bank accounts, EU governments should enable regulators to keep a bank going while they restructure it and search for a new owner. This will require EU governments to commit additional resources for the task.
The European Central Bank and the euro zone’s Single Resolution Board have been calling for the power to freeze bank accounts—a so-called moratorium—since the swift resolution of Banco Popular in June. They succeeded in winding down the troubled Spanish lender by selling it to rival Banco Santander, but had to do it on a weekday night with a run on deposits in progress. The regulators say that next time it might be impossible to find a buyer overnight. A moratorium would relieve that pressure and perhaps allow them to sell the bank at a better price.
This approach would mirror an arrangement which is currently in place in Germany, and it’s superficially appealing: Closing a bank would certainly stop a run. But it could also have unintended consequences. Depositors may run from a bank in trouble sooner—fearing that if they wait too long they may not be able to withdraw their money. It could also lead depositors to empty their accounts as soon as the bank re-opens. Most dangerous of all, freezing accounts in one bank could spread panic to the rest of the system, as other depositors fear the same will happen to them.
The idea also puts international cooperation on bank resolution at risk. The EU regulators’ plan threatens to disrupt measures put in place after the bankruptcy of Lehman Brothers in 2008. Bank of England economists recently warned in a working paper that adopting the new moratorium might prompt banks to back out of the existing arrangements for handling financial emergencies.
Strengthening Europe’s Single Resolution Fund is the better approach. The fund’s planned capacity of 55 billion euros is too small, and even that amount won’t be fully available for years. The EU should agree to make it bigger, and quickly. An adequately financed SRF would give regulators the chance to resolve failing banks without putting the financial system at greater risk. If it helps to head off the next banking crisis, the additional upfront cost will be money well-spent.

—Bloomberg