EU Bank Recovery and Resolution Directive Just as the banking crisis led to Norway’s Bank Guarantee Schemes Act, the financial crisis gave rise to a new EU framework for crisis resolution. In January 2015, the Bank Recovery and Resolution Directive entered into force. 10 The aim of the directive is to enable insolvent banks to be resolved in a manner that ensures continuity of their critical functions, but without banks necessarily receiving public funds. The authorities are empowered to take control of a bank that is insolvent, or is at risk of becoming insolvent, and ensure that critical functions continue without bailing out shareholders and creditors. A new tool will make this possible. Beginning in 2016, national authorities in Europe will be able to write down and convert liabilities to equity while a troubled bank is kept open. The value of the bank’s assets is to be calculated and losses apportioned in accordance with the order of priority of claims. If the bank does not have sufficient equity, liabilities will be converted to share capital. This tool is called bail-in. 11 [Bail-in requires that creditors, and not the authorities, initially cover losses in excess of equity. Creditor claims are converted into equity to ensure continued operation. Short-term liabilities and secured deposits are exempted. It is primarily long-term liabilities not backed by certain assets or guarantee arrangements that will be eligible for bail-in. 12 Long-term creditors will then have to take account in advance of the real risk inherent in the bank they fund.
BIS central bankers’ speeches  3  When the government assumes a substantial portion of bank risk in this way, a problem arises that we economists refer to as moral hazard: If there is a widespread perception that the authorities in reality stand behind banks, banks may take insufficient account of the risk of losses when making decisions. In particular, the risk that things can go horribly wrong may be underestimated, because banks do not have to bear the consequences of a crisis. By bailing out banks, we in turn reduce the motivation of banks’ owners and creditors to take full account of the risk associated with their activities. The pricing of risk is easily set too low. Banks may therefore end up taking excessive risk. Now, the authorities that bail out banks will often require that the former owners forfeit their equity. This means that bank owners should, at the outset, have incentives to hedge against the risk of large losses. But owners’ risk is limited. It does not cover losses beyond paid-in capital. Owners’ motivation to avoid risk may therefore be weakened at a bank with little equity. The lower the equity capital is, the more serious the problem of moral hazard becomes. An interesting feature of the financial crisis was precisely banks’ low pre-crisis equity ratios. Many large international banks operated with equity of around three percent of their total portfolios. 8 This means that for every dollar or euro the banks owned they invested thirty.