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The Safest Way to Let Banks Fail – Op-ed in Wall Street Journal

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The European crisis—and especially this spring’s events in Cyprus—has put the spotlight on a once-taboo question: Can a major bank be allowed to fail?

Looking back at recent financial history, it is quite difficult to find examples of full-fledged bank failures in which losses have been forced upon creditors. Instead there are manifold examples of banks being rescued, either with or without public support. Such rescues have led to the perception that certain institutions are “too big to fail” or “too interconnected to fail.”

These propositions alter the incentives of bank owners and lenders. Because creditors have very seldom faced losses in bank failures, moral hazard has become entrenched in the system.

Why have banks not been allowed to fail? One factor is path-dependence: By not letting banks fail in the past, policy makers face strong pressure not to let banks fail in the future. Time-inconsistency also plays a role: The rewards from letting banks fail—reduced moral hazard chief among them—lie in the future, whereas the costs—financial destabilization and voter outrage—are imminent.

But the biggest obstacle is simply that markets for now simply do not expect big banks to be allowed to fail. There is no concept more fundamental in economics and finance than expectations. When unexpected events occur, disorder can set in at an instant.

This is why the initial agreement to haircut Cypriot depositors caused such unrest. It was jarring enough that deposits—perceived as the safest of all forms of credit—would be hit under the plan. But to hit deposits below the insured level of €100,000 was seen as crossing a red line. Cyprus was,unfortunately to my mind, interpreted as the beginning of an unexpected regime change in how bank failures are dealt with in Europe.

Hence the importance of the European Commission’s Bank Recovery and Resolution Directive, which seeks to establish a pan-European framework to allow for orderly bank resolution. As the European Parliament’s lead negotiator on the directive, I have been studying the Cypriot and other cases of bank failures quite intensively. A few points seem fundamental to me:

First, bank failures must managed as predictably as possible. One cannot alter the rules of the game without adequate prior notice. Even the most well-considered line of action will have adverse consequences on market and depositor confidence if it is not carried out according to clear ex-ante principles. Formally secured investments such as insured deposits and covered bonds must be fully protected and exempt from the scope of any bail-in.

Second, the bail-in tool is complex to implement. It has many benefits, not least that bank creditors will be more certain of the riskiness of their investments. If the markets have been prepared for it, bailing in creditors will help resolve banks without the use of taxpayer money. But bailing in creditors in large volumes carries risks of contagion, especially when applied to banks whose creditors are to a large extent depositors.

Third and last, bail-in alone probably will not be sufficient in systemic crises. When the payment system—the most basic infrastructure of our modern economies—is in peril, government has a responsibility to act. Not because it is desirable, but because the alternative is far worse.

If our new bank-resolution rules do not allow for government intervention as a last resort, then future resolutions will be more or less solely dependent on bail-in. In the heat of a systemic crisis, this might cause more problems than it solves—thereby reducing the probability that bail-in is used at all.

Hence the best framework for dealing with a bank in severe stress should allow for both kinds of tools. When a bank is taken into temporary public ownership, for instance, moral hazard should simultaneously be addressed by wiping out previous shareholders and bailing in unsecured debt-holders to the largest feasible extent, with uninsured deposits being preferred in the hierarchy.

If markets know that government can intervene to contain chaos while also imposing losses on shareholders and creditors, then the application of bail-in will be more credible compared to a scenario in which bail-in alone is the only option.

Against this background, I am very satisfied that the European Parliament’s Economic and Monetary Affairs Committee backed my main proposals when we voted on the text of the directive last week. Once European finance ministers have reached a common agreement, we can initiate final negotiations on a joint legislative text that will enter into force on Jan. 1, 2015.

Done as outlined above, the forthcoming framework for bank resolution can both reduce moral hazard and enhance systemic stability.

Mr. Hökmark is a Swedish member of the European Parliament, vice president of the European People’s Party Group and rapporteur for the Bank Recovery and Resolution Directive.