This presentation by Sebastian Schich draws attention to a potentially fundamental flaw in the design of the European banking union, which is the incomplete harmonization of the underlying financial safety net. It abstracts somewhat from the specific institutional aspects that currently figure prominently in the European safety net discussion in the financial press. According to one popular view, the European safety net requires, in addition to a common lender of last resort, three pillars, that is first, a common regulatory framework and a single supervisor, second a single bank restructuring fund and third, harmonised or unified deposit insurance. This view implies that the current banking union agenda is incomplete as only the first of the three pillars is in place. While the presentation agrees with the basic assessment that the banking union agenda is still incomplete, the approach taken places a sharp focus on the safety net functions rather than the institutions providing these functions, acknowledging however that both aspects are important. In particular, it argues that the modern definition of the financial safety net includes a guarantor of last resort function. Moreover, as long as a common fiscal backstop for the European banking sector is missing, the guarantor-of-last-resort function remains a national issue. In fact, an analysis of data reveals that bank debt benefit from implicit guarantees and that the value of the guarantees reflect not only the weakness of the bank but also the strength of the sovereign perceived to be providing the guarantees. This observation is consistent with the view that the GOLR function is perceived as being provided by each sovereign to its domestic banks only. As a result, especially during periods of heightened market stress, banks in Europe face different funding conditions depending on where they are located. Read more about OECD work on financial sector guarantees http://www.oecd.org/daf/fin/financial-markets/financialsectorguarantees.htm

1. THE EUROPEAN FINANCIAL
SAFETY NET: CHALLENGES
RELATED TO ITS INCOMPLETE
HARMONISATION
Sebastian Schich
August 2014

2. Three observations from the global financial crisis
with relevance for design of the financial safety net
I. The traditional safety net functions -- such as regulation
and supervision, lender of last resort, deposit insurance
and other failure resolution -- are now complemented in
more explicit form by a new function, the government-
supported guarantor of last resort function (GLRF).
II. It is now widely recognised that (even in Europe)
government-supported guarantees for financial claims are
not risk-free.
III. The value of government guarantees for European bank
debt reflects the strength of the sovereign (seen as)
providing the guarantee.

3. Observation I:
Traditional safety net functions are now
complemented in more explicit form by a
new function, the government-supported
guarantor of last resort function (GLRF)

4. Looking back: Financial crisis policy response
• EU leaders at European Council meeting on 15-16 October, 2008
announced their intention “to take decisive action and use all
available tools to support systemically important financial
institutions and prevent their failure”.
• The announcement was consistent with subsequent actions. A
key element of these actions was the extension of existing and
introduction of new guarantees, including:
• Blanket guarantees for bank deposits.
• Government guarantees for other bank liabilities and
excess loss guarantees on bank assets.
• Central bank assurance that liquidity would always be
ample, thus essentially providing a guarantee for the
stability of this part of bank funding.

5. The traditional definition of the financial safety net
de facto has changed
The policy response to this global financial crisis, consisting of making available
the government-supported function of guarantor-of-last-resort in more explicit
form, has effectively changed the traditional definition of the financial safety
net:
Lender
of
last resort
Deposit
insurance
(and other
failure
resolution)
Lender
of
last resort
Regulatory
and
supervisory
framework
Deposit
insurance
(and other
failure
resolution)
Regulatory
and
supervisory
framework
Guarantor
of
last resort
Source: “The government as guarantor of last resort: benefits, costs and the case for premium charges”,
by S. Schich in: Managing Risk in the Financial System, edited by LaBrosse et. al., Edward Elgar, June 2011.

6. This policy response was helpful, but not without costs
• OECD’s Committee on Financial Markets (Schich, 2009):
– This policy response was helpful, but not without costs
(e.g. contingent liabilities, competitive distortions, moral hazard).
– The Committee wondered whether the guarantees could ever be
fully withdrawn under all circumstances.
• In fact, among other things, this policy response has
inadvertently further entrenched the perception that bank
debt benefits from an implicit guarantee.
• The costs and benefits of the addition of this new function
notwithstanding, it is now effectively part of the financial
safety net structure, at least as perceived by financial
market participants.

7. In Europe, while many safety net functions are provided in a
harmonised way, the guarantor-of-last-resort is a national issue
Lender
of
last resort
Guarantor
of
last resort
Deposit
insurance (and
other failure
resolution)
Regulatory and
supervisory
framework
Single or harmonised framework
being achieved or proposed
Single framework and institution
to provide that function available
No single or harmonised
framework envisaged for
now

8. Observation II:
Government-supported guarantees for
financial claims are not considered risk-free

9. An initial assumption was that the GLRF adds the same value,
regardless of which sovereign provides that function
• While emergency policy actions during the financial crisis
were taken at the national level, intense efforts were
made to achieve a considerable degree of international
cooperation and coordination, especially within Europe.
• Initial official recommendations regarding pricing of
government-provided guarantees to avoid distortions to
incentives assumed that all government guarantees add
the same value (ECB Governing Council, Oct 2008).
• Market pricing of government guaranteed bank debt
revealed, however, that the identity of the sovereign
matters for the value of guaranteed debt (Panetta et al.,
2009; Schich and Levy, 2010; Grande et al, 2013).

10. Just like any guarantee, a European government
guarantee is not considered risk-free
• More recently, official recommendations regarding the
pricing of government-supported guarantees recognise
that the strength of the government plays a role for the
value of the guarantee (EC Communication, 1.12.2011).
• In fact, as a result of the effects of the crisis and the actual
and contingent liabilities created by the policy response to
it, guarantees by European governments are now being
widely recognised as being risky.
• They are “vulnerable put options” (Johnson and Stulz,
1987).

11. Observation III:
The value of government guarantees for
European bank debt reflects the strength of
the sovereign (seen as) providing the
guarantee.

12. Current bank regulatory reform efforts effectively attempt
to withdraw the GLRF,…
• Strengthen the banks’ stand-alone creditworthiness, so
that the guarantee function is invoked more rarely (Basel
III, Capital Regulation Directive,etc.).
• Limit that function by strengthening the “capacity“ of
public authorities to withdraw it, e.g. by making banks
more resolvable (e.g. “key attributes”).
• Charge an implicit or explicit “user fee” in exchange for
the provision of the function, so as to incentivise banks to
limit their “use” of it (e.g. higher regulatory capital charge
buckets for banks considered systemically more
important).

13. …, but implicit bank debt guarantees persist,…
Notes: Average uplift due to regional and systemic support (hence abstracting from parental and co-operative
support) in ‘notches’ of credit rating categories. Sample consists of 122 largest banks rated by Moody’s in the
above countries (with size measured by total assets as of December 2010). Number of banks headquartered in
each country in parentheses.
Source: Update from Schich and Lindh (2012), “Implicit Guarantees for Bank Debt: Where do we Stand?”,
OECD Financial Market Trends, Vol. 2012/1, June;
http://www.oecd.org/finance/financial-markets/Implicit-Guarantees-for-bank-debt.pdf .
-4
-3
-2
-1
0
1
2
3
4
5
Average uplift July 2012
Average change in uplift December 2010 - July 2012

14. … and their values depend on where a bank is located.
• Using cross-sectional data for 122 European banks for two
different dates, Schich and Lindh (2012) show
• that a measure of the value of implicit guarantees for bank
debt is higher,
• the lower the bank’s stand-alone creditworthiness,
• the higher the sovereign’s creditworthiness, and
• that the decline during 2011/12 is explained to a large
extent by declining sovereign capacity to provide for the
guarantee.
• Using panel data for 184 large worldwide banks from 2007 to
2012, Schich (2013) confirms the significant role of bank’s
stand-alone creditworthiness and sovereign creditworthiness
for bank credit rating uplifts.

15. This situation is consistent with the view that the
guarantor-of-last-resort function is provided at a national level
• Contingent claims analysis shows that the value of an
implicit bank debt guarantee increases with the
“weakness” of a bank and the “strength” of its sovereign
guarantor (Estrella and Schich, 2011).
• The observation that implicit guarantees for bank debt
persist is consistent that market participants believe that
the GLRF continues to be provided as part of the
financial safety net.
• The observation that their value reflects the credit
strength of the domestic sovereign is consistent with the
view that the GLRF is provided separately by each
national sovereign to its domestic banks.

16. Concluding remarks
• The persistence of implicit bank debt guarantees that reflect
the credit strength of the domestic sovereign is consistent with
the view that the GLRF is provided separately by each
sovereign to its domestic banks.
• As long as market participants believe that the guarantor-of-
last-resort function is provided at a national level, funding
conditions during periods of heightened stress will differ for
otherwise identical banks depending on where a bank is
located.
• Unless the GLRF is effectively withdrawn everywhere, progress
towards banking union cannot be made in complete isolation
from progress towards (some form of effective) fiscal union.

17. Selected References:
Estrella, A. and S. Schich (2013), “ The impact of sovereign guarantees on the quality of bank
debt: Theory and evidence from Europe”, Financial Crisis Containment and
Government Guarantees, pp.156-173; Edward Elgar.
Grande, G., A. Levy, F. Panetta and A. Zaghini (2013), “Public guarantees on bank bonds:
Effectiveness and distortions”, Financial Crisis Containment and Government
Guarantees, pp.140-155; Edward Elgar.
Panetta F., T. Faeh, G. Grande, C. Ho, M. King, A. Levy, F. M. Signoretti, M. Taboga, and
A. Zaghini (2009), “An assessment of financial sector rescue programmes”, BIS Papers,
No.48; www.bis.org/publ/bppdf/bispap48.pdf
Schich, S. (2009), “Expanded guarantees for banks: Benefits, costs and exit issues”, OECD
Financial Market Trends, Vol. 2009/2, November,
www.oecd.org/finance/financialmarkets/44260489.pdf
Schich, S. (2013), “How to reduce implicit bank debt guarantees? – A framework for discussing
bank regulatory reform”, Journal of Financial Regulation and Compliance, Vol. 21, No. 4,
November www.emeraldinsight.com/journals.htm?articleid=17098675

18. Find out more about OECD work on financial
markets and financial sector guarantees
www.oecd.org/daf/fin/financial-markets/
Contact Sebastian Schich
sebastian.schich@oecd.org
This presentation was initially given under a slightly different title at the FSI-IADI
Seminar on Bank Resolution and Deposit Insurance, Basel, Switzerland, 27–29 August
2013, organised by the Financial Stability Institute (FSI) and the International
Association of Deposit Insurers (IADI). It draws on work by Sebastian Schich for the
OECD’s Committee on Financial Markets with Sofia Possne from the Swedish Riksbank
as well as on work with Arturo Estrella from Rensselaer Polytechnic Institute. The
arguments do not necessarily reflect those of the OECD or any of its member countries.