SAFE Finance Blog
22 Jun 2017

Banking Failures: Consolidation is Better than Rescue

Jan Pieter Krahnen: Bailing out ailing banks distorts competition

The exit of the ailing Banco Popular from the Spanish banking market – as a consequence of the takeover by Banco Santander – is a success for the young EU banking resolution regime (BRRD). It could be considered as a partial victory on the path to a new European financial architecture were it not for the recapitalization of the Italian bank Monte dei Paschi di Siena (MPS) and the planned rescue of the two banks from Venice, Banca Popolare di Vicenza and Veneto Banca.

Bailing out verifiably mismanaged banks is economically not reasonable. It gives wrong incentives, by rewarding the willingness to take excessive risks, and causes distortions in favor of market participants who have proven to be incapable of surviving. Supporting troubled financial institutions prevents market consolidation and deprives other banks of new market opportunities. Both effects will decrease social welfare and financial stability over the medium term.

Instead of intentionally preventing a consolidation of the banking market, a strong competitor could be put in a position, via a “reversed bailout policy”, to take over the bank in trouble, or at least parts of its assets or business units. This would be in accordance with the initial intention of the Single Resolution Mechanism (SRM), which allows for the exit of weak banks without burdening savers and small investors.

Clearly, the provision of fresh capital to one or more “strong” banks would have to be conditional on e.g. the obligation to only use it as intended and during a specific period of time. The financing of the “reversed bailout policy” could be provided by the national bank rescue fund to which all banks contribute. This way, the danger that a banking crisis causes contagion effects may be contained without undermining competition.

Resolution authorities should not only consider national banks as possible “saviors”. Also pan-European financial institutions could play an important role. However, for a “reversed bailout policy” the current regulation would have to be amended. Currently, there is only little political and regulatory support for the evolution of pan-European banks, although this would be desirable. The rescue of a small foreign bank could provide a good opportunity for the entrance in a new market. A manageable size of well diversified pan-European banks would, in turn, contribute considerably to a balancing of risks in Europe.

Jan Pieter Krahnen is Director of the Research Center SAFE and Professor of Finance at Goethe University Frankfurt.