The ECB is considering setting up an emergency credit line for banks – a bail-in scenario is becoming more likely

The ECB is considering setting up a new emergency credit line for banks (Eurosystem Resolution Liquidity, ERL). The idea is that such a credit line would enable the ECB to provide liquidity to viable parts being spun out of a failing financial institution into a „good bank.“ The document in question argues that there are a number of scenarios in the context of bank resolution in which currently no additional liquidity can be provided by Eurosystem central banks. It continues: „A permanent framework to provide liquidity in resolution would send a strong signal related to banking union and improve overall confidence in the functioning of the euro-area resolution framework“. In this context, loans are to be backed up by European guarantees (ESM or SRB/European banking restructure fund) because the requirements for the collateral that banks provide would be weaker than for the ECB’s „normal“ operations. Indeed, the requirement that banks put up collateral – beyond the euro-area guarantee – could, under certain circumstances, be dropped entirely. The document points out that both US authorities and the Bank of England already have similar instruments available.

It is unclear, though, whether such an emergency credit line will ultimately materialise. Such an instrument conflicts in particular with legal stipulations because the central bank is effectively banned by law from financing actions normally undertaken by public authorities, in this case bank resolution. What is more, it is not very probable that countries like Germany would be willing to assume a pan-European guarantee for (unsecured or under-secured) liquidity assistance to troubled banks. Such a development would run clearly counter to the intention of such countries not to mutualise risks across Europe, even if it was ultimately only the „good“ recapitalised part of a bank which was being refinanced.

The ECB’s reflections do, however, show clearly that the pan-European bank recovery and resolution architecture still lacks an important component part needed to render it fully operational. The case of Banco Popular has eloquently demonstrated how quickly liquidity gets withdrawn from banks which are conjectured to be in distress. In the case of an announced bank resolution, including the use of the bail-in principle regarding equity and subordinated senior debt, it is to be assumed that access to short-term and long-term capital-market refinancing would be blocked. In addition, negative media reports and rating downgrades would probably prompt private and institutional customers to take their deposits  elsewhere, which would aggravate the liquidity crisis, even though the financial institution – or at least its viable „good“ part – was being recapitalised (presumably to a level in excess of the market average) by the bail-in measures.In any event, some weeks or months would be likely to elapse until the bank regained access to the capital market. During the intervening period, some injection of liquidity would be necessary to keep the bank concerned above water. Otherwise, the bail-in instrument would be no better than a blunt sword – making use of it would be meaningless because the bank would, at the end of the day, fail not due to a lack of equity but rather as a result of liquidity problems.

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