European officials proposed Wednesday a new system of financial regulations that aims to keep bank failures from costing taxpayers billions and bankrupting governments.
Because many European governments are already overburdened with debts, rescuing their failed banks risks bankrupting some of them. Ireland has had to ask for an international bailout for that reason and investors fear Spain may be next.
The banks, in turn, own huge amounts of their governments' bonds, which drop in value when investors lose confidence in the country's financial future. The result is that any fall in confidence in either the banks or the government tends to create a downward spiral requiring foreign financial aid.
Under the European Commission's proposal, banks that posed no systemic risk to the stability of financial markets would simply be allowed to fail. Those whose failure did threaten to become unmanageable would be propped up in part by having unsecured creditors of the bank, such as bondholders and shareholders, take losses rather than having governments give them taxpayer money.
"We're going to break the link between banking crises and public budgets," said Michel Barnier, the European commissioner responsible for the internal market, as he outlined the measures in Brussels. "We don't want taxpayers to have to pay."
If he ever achieves that, however, it will be too late to alleviate the current banking crisis afflicting Europe and one of its biggest economies, Spain, where banks are sitting on huge losses that the government cannot afford to plug. The Spanish government's borrowing rates are at painfully high levels around 6.25 percent on fears it will go bankrupt saving the banks.
The Commission's complex proposal is not scheduled to take effect fully until 2018. In any event, it also needs the approval of the European Council, composed of the leaders of the 27 EU countries, and the European Parliament, and may be significantly altered in the process of gaining approval.
At the moment in Europe there is no central regulator with the power to step in and force weak banks to ask investors for more capital to strengthen finances, or to break them apart and restructure them. There is also no central deposit insurance backstop, making it more likely that a bank failure would exhaust one country's fund to compensate depositors.
In the United States, by contrast, state and federal banking regulators have the power to shut down failing banks. The Federal Deposit Insurance Corp. takes over the failed banks and sells their loans and deposits to stronger banks or private investor groups.
And unlike in Europe, the FDIC guarantees deposits up to $250,000 per account. That prevents bank runs because depositors are protected if a bank fails.
Barnier was at pains to emphasize that he had been working on the proposals for years, and they were not a response to the banking crisis in Spain or other recent bank bailouts.
While Barnier said the new rules are necessary because so many banks operate across borders, he did not propose setting up a powerful central banking authority, as the Commission had suggested a weak earlier.
Many analysts say Europe needs such a central banking authority, which would have the financial power to bail out banks anywhere in the eurozone, bypassing national governments that are often reluctant to admit the extent of problems in their domestic financial systems. It would also spread the cost of bailouts across multiple countries.
The importance of such a measure was made clear in the U.S. bank bailouts in recent years. Insurer AIG, for example, failed financially and had to be rescued. Although it was incorporated in Delaware and headquartered in New York, neither state had to go bankrupt paying for the rescue. The burden was shouldered by the U.S. Treasury.
Germany remains opposed to such a measure, however, fearing it will end up paying the bulk of bank rescues.
Barnier's proposal is more likely to be welcomed in Berlin. He said it would strengthen the ability of national authorities to — hopefully — head off bank failures before they happen and to deal with them decisively when they do.
"If we're going to avoid in the future banking crises, each member state has to be equipped with the appropriate tools to take action in time, not when it's too late," Barnier said.
All the national banking authorities would be operating with the same rules — rules that would enable them to intervene early, require banks to draw up recovery plans, and even to dismiss the bank's management.
If a bank was about to fail, national authorities would have the power to sell or merge the businesses, to create a temporary "bridge bank" to carry out essential functions, to separate good assets from bad ones, and to write down the bank's debts.
"The resolution tools will ensure that essential functions are preserved without the need to bail out the institution, and that shareholders and creditors bear an appropriate part of the losses," the commission said in an explanatory statement on the proposal.
This last part — having the bank's unsecured creditors take losses — is being termed a "bail-in" in contrast to a taxpayer-funded bailout.
Barnier acknowledged that the proposal would not have an immediate effect, but he said EU officials need to take both short-term and long-term actions to regain financial stability.
Other measures that senior European officials have floated recently include creating a central deposit insurance scheme to reassure savers across the continent that their money will not disappear in case a bank runs into trouble. A key worry is that rumors of a bank failure might trigger a bank run, fueling panic that could spread across countries.
Don Melvin can be reached at http://twitter.com/Don_Melvin