Can the ESM as a common backstop to the SRF weaken the sovereign-bank link?

A deeper economic and monetary union will include a common backstop to the Single Resolution Fund provided by the European Stability Mechanism. This paper analyses the potential of the common backstop to weaken the vicious link between sovereigns and banks whose intertwined holdings can threaten each other’s financial health. First, we analyse the size of the common backstop against potential resolution needs. Second, we assess whether the repayment capacity of the Single Resolution Fund, which depends on banks’ ability to pay contributions, will be sufficient to repay the backstop. Under an adverse scenario using the past crisis data, we find that the Single Resolution Fund’s repayment capacity could, after full mutualisation, be sufficient to cover the required backstop lending. During the earlier transition period when banking sectors experiencing distress would bear a greater repayment share, however, a financing gap may emerge due to the restrained repayment capacity, limiting common backstop disbursements. These findings suggest that an accelerated mutualisation of the Single Resolution Fund would effectively weaken the sovereign-bank link and add to the robustness of the Banking Union, and thereby the euro area.