Banking union’s success depends on further integration

28.01.2015
The Eurozone’s sovereign-debt crisis both reflected and reinforced the banking crisis. Instituting a common regulatory framework in a form of a Eurozone-wide banking union is aimed to sever the link between public debt and banks' solvency. But it is still not enough to bring long-term financial stability to the EU and euro area.

Protecting the single European market requires minimizing the number and scale of systemic financial shocks which the economy may be exposed to, because the financial instability results in reduction of potential production and initiates corrective actions by public and private sector. Systemic events may have source outside the European Union, within it, regionally, and locally. Risks arising at each of these levels may contribute to weakening of the single market. The recent crisis has reduced the level of financial integration of markets – both globally and within the European Union. It also highlighted structural weaknesses in the EU’s institutional framework for financial stability.

Sovereign crisis complicated conducting of fiscal policy and threatened the stability of financial sector. Destabilization of the market for treasury securities in some euro area countries exposed European financial institutions to losses as they were forced to seek for new sources of capital or reduce balance sheets. As a result, increase in credit risk restricted funding opportunities for the real economy, contributing to the deepening of the recession caused by the necessary fiscal consolidation (especially in Southern Europe).

Rebuilding confidence in the quality of financial services’ regulation and supervision is essential to maintain the free movement of financial services within the EU’s single market. Banking union is a vital condition for survival of a monetary union that is unable to implement a strict no-bailout policy for member countries. Such a union should be understood as a centralized bank supervisor, resolution authority, and deposit guarantee fund, at least for systemically important and cross-border institutions, as well as a unified rule book for prudential supervision.

Moving supervision to the European Central Bank could improve overall supervisory quality, limit the scope for regulatory arbitrage, reduce compliance costs for cross-border banks, eliminate host-home coordination issues and increase the consistency between the market for financial services and the underlying prudential framework. A single resolution authority and shared safety net, with backstops, would provide further benefits in terms of risk sharing, when these are in place.

What we have now

While the banking union already exists partially, it has some flaws. Establishing a supervision agency with a truly European perspective and bringing convergence of supervisory practices, seems to be challenging. There are some hindrances to that in the general legal framework, like many national options in CRD IV. ECB is to supervise only the Eurozone’s 130 or so biggest banks. That will leave the smaller banks in the hands of local financial supervisor. The argument that smaller lenders are not a systemic threat is phony: consider Spain’s cajas. The governance structure of the Single Supervisory Mechanism (SSM) is rather not simple so a lot of time and effort will be required to make this mechanism work efficiently and smoothly.

What is more, the resolution part of banking union is complicated. Although the Bank Recovery and Resolution Directive (BRRD) provides general resolution framework in the EU, separate legal act – regulation establishing a Single Resolution Mechanism (SRM) – has been agreed. It was considered that for member states who share the common currency and have a single supervisor, resolution based on a network of national authorities and resolution funds would not be sufficient as it may create conflicts between the European supervisor and national resolution authorities. It would also not allow to break the negative feedback loop between banks and their sovereigns. Banking union is to weaken to a large degree the toxic link between banks and sovereigns, but it will not break it up completely. The ECB as a supervisor promises to lower protection that contributed to banks’ dominant position in the Europe’s financial system; it may also bring a lower home bias in sovereign debt portfolios.

The governance of the resolution part of banking union is intricate, too. In particular, the decision-making process might be prolonged as it involves numerous institutions – the Single Resolution Board (SRB), national resolution authorities, the European Commission and the EU Council. It is difficult to foresee how exactly this process will look like in practice and what effect it will have on the crisis management. Another example of that limited predictability may be the case of the BRRD weakening the very important communication that there is no bail-out for banks any longer. The directive allows for that in some cases.

The financing arrangements of the SRM are its another shortcoming. The size of Single Resolution Fund (SRF) seems to be very confined. Moreover, SRF will be subject to gradual mutualisation in the transition period of 8 years. The efficacy of the mechanism will also depend on the backstop arrangements which are currently missing. The European Stability Mechanism (ESM) is sometimes indicated as a possible backstop but it should be remarked that the funds accumulated within the ESM would not be available for non-euro area countries that would join the banking union.

In brief, we have supervision integrated within the ECB, considerable progress in the area of centralized resolution and the single rulebook, though with some loopholes and weaknesses left, and not much advancement in the single deposit guarantee scheme. Presumably this is more than half of the banking union for more than half of the EU counties – a real structure, but not an entire success.

What is needed (ideally)

In a globalized financial system, striking the right balance between home and host country jurisdiction, and between national and supranational oversight, is all-important. The EU’s current model – the ‘single passport’ with home-country regulation of financial institutions – has fallen short of expectations. The most stark example is the impact of the crisis on the Central, Eastern and Southeastern Europe’s economies, countries hosting Western banking subsidiaries and branches.

What is at stake now is decades of future financial integration in Europe. It is not possible to simultaneously have integrated financial market, national supervision and financial stability. This impossible trinity could be overcome in one of two ways: either one returns to a world of segmented, national financial markets and relinquishes the benefits of integration, or moves towards supranational structures for financial supervision and resolution. Ultimately, it is too late now to untangle the tightly bound threads of economic interdependence.

An ideal model for a banking union, which aims at maximizing welfare and financial stability in the EU and euro area, requires a further transfer of important competences towards federal European institutions. It also demands a common safety net with backstops and sufficient risk sharing, but ideally bank restructuring and optimizing the role of banks in financing the economy should prevent systemic problems erupt again.

Long-term financial stability of the EU relies on creating a complete European banking union which will be the biggest integration move and the most important shift of authority from national to the European level since the establishment of the euro.

The author holds a PhD in economics and works in the NBP’s Financial Stability Department. The views expressed are those of the author and do not reflect the official position of the National Bank of Poland.

 

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