How Europe can avoid costly taxpayer bank bailouts

November 21, 2013, 12:41 PM UTC

Europe is making real progress in unifying its banking system. In October the European Central Bank was granted new authority to supervise the eurozone’s large banks, which will enhance confidence and make supervisory standards more consistent. The EU has now turned to the second stage of banking union: creating a process to “resolve” banks when they fail. Called a Single Resolution Mechanism, the process is crucial to ending costly taxpayer bailouts. The EU must get it right.

A well-designed system to handle failing banks supports financial stability in two ways. First, in times of instability, it offers an efficient way of dealing with failing financial institutions with minimal disruptions to the economy. But even more important, a good resolution mechanism supports market discipline and prudent risk-management practices by providing a way to impose losses on shareholders and creditors without resorting to taxpayer bailouts.

As we saw in the last financial meltdown, generous taxpayer support of ailing financial institutions may help contain immediate risks to financial stability. But the price of such bailouts is steep: a further weakening of market discipline, paving the way to yet another costly episode of reckless risk taking.

Hence, government bailouts are not just morally wrong. They also entail long-term costs that may exceed any short-term gains. That is why a good resolution system should be hardwired against bailing out creditors.

In setting up its SRM, Europe would do well to look to America’s Federal Deposit Insurance Corp. as a model. The FDIC has decades of experience in dealing with troubled banks and since 2007 has handled more than 400 bank failures without resorting to taxpayer money.

When dealing with a failing bank, the FDIC enjoys strong independence from political pressure. The agency also has robust internal controls and external audit requirements. It can take over the bank, restructure or split it, write down its liabilities according to creditor hierarchy, and sell or liquidate it as a whole or in parts. At the same time, the FDIC’s flexibility to shield creditors from losses is strictly limited. The agency cannot support shareholders, and creditors must be treated in accordance with established claims priority.

The FDIC is also required to minimize costs when choosing the best strategy for handling a failing institution. The agency cannot bail out creditors based on some abstract notion of promoting “system stability.” It can alter the claims priority established by statute, but only if it can show that the cost of doing so is more than offset by increased revenues from the eventual sale of the bank. To minimize losses the FDIC can also pay employees to continue basic functions such as technology support.

In times of extreme financial stress, there may be reasons to provide broader support to bank creditors. But those are political decisions for democratically elected bodies. The FDIC, as an independent agency, is not burdened with such decisions.

Europe should pursue a similar framework. Its SRM should be bound by law to choose the strategy that minimizes costs to the EU’s Single Bank Resolution Fund. Such a legal obligation would protect the SRM’s operational independence and ensure that shareholders and creditors are always the first in line to bear losses.

Any decision to bail out creditors should require political authorization from democratically elected officials. One natural choice would be the EU’s Ecofin Council, where ministers of finance are accountable to their national parliaments.

To support long-term financial stability, the SRM must not become a mechanism for insulating investors from risk. We know from experience that, in times of perceived systemic fragility, there will be strong pressure to bail out creditors. The SRM needs protection against such pressure. Clear rules that impose losses where they belong — on shareholders and creditors — would go a long way in that direction.

Fortune contributor Sheila Bair is former chair of the FDIC. Jutta Urpilainen is Finland’s finance minister.

This story is from the December 09, 2013 issue of Fortune.