Banking Union: Meaning and implications for the future of banking

This article aims at providing an overview on the latest developments regarding the European Banking Union – in particular, what the meaning is of the achievements so far and what the implications are for the future of banking and the financial system in the Eurozone.

We start with briefly looking back at the rationale for Banking Union. This has been recently addressed in several speeches.¹ Keeping supervision at the national level in both creditor and debtor countries contributed to the large imbalances that built up before the crisis.² Contrary to the “it was mostly fiscal” view of the crisis, private financial sector developments, intermediated by banks, were at the heart of developments in peripheral countries. This is why Banking Union is the necessary institutional response.

Indeed, the current account deficits in most peripheral countries were, in fact, led by very large capital inflows coming from core countries with capital account surpluses. The exposures of banks from core to peripheral countries more than quintupled between 1999 and 2008. Competitiveness losses in the periphery were simply the mechanism that connected the capital account surplus and the current account deficit – that is, an appreciation of the real exchange rate caused by economic over-heating. As John Williamson explained, it is impossible to have “an immaculate transfer” from capital inflows to current account deficits.³

Without unified supervision, national supervisors found it impossible to contain these developments. They had to respect the single market rules and lacked the macro-prudential tools to offset the effects of large capital inflows. But, by introducing supervision at the European level, the Banking Union offers a possibility to better pre-empt such developments in the future – and therefore to better protect the real economy and financial stability in the whole area.

The article will concentrate on two more practical and immediate goals of the Banking Union: (i) to eliminate the bank-sovereign loop and thereby reduce financial fragmentation; (ii) to repair banks’ balance sheets, unclog the impaired credit channel and consolidate the on-going mild economic recovery. Lastly, the article will also reflect on some implications of the Banking Union for the future of the financial system and for the role of macro-prudential policies.

1

The bank-sovereign feed-back loop

What makes the link between sovereigns and banks important is the fact that, during the crisis, weak banks weakened the sovereign and vice-versa. Some governments had to support their national banks with negative consequences for their own debt. In other cases, it was the weakness of the sovereigns, which had low ratings and difficulty in accessing the financial markets, that enfeebled domestic banks, who saw their ratings tumble and their funding become more difficult. At the same time, as the sovereign debt crisis in 2010 deepened and triggered contagion effects across countries, banks’ holdings of domestic government debt rose, thereby increasing their dependence of the sovereign's fortunes.

These different forms of dependence created a negative feed-back loop that induced financial fragmentation among members of the euro area. It contributed to impairing the credit channel and the transmission of monetary policy. Monetary policy interest rates were not properly transmitted and deposit and credit rates became too divergent among countries. It was as though interest rates were not related to the same currency and that banks were not operating in a monetary union.

The ECB did its utmost to repair the transmission of monetary policy and restore the credit channel. The OMT initiative proved effective in reducing fragmentation. More recently, world market developments, combined with the perception that the tail risk of euro redenomination has been overcome, have contributed to an inflow of capital into European periphery assets, further mitigating fragmentation of financial markets in the euro area.

Severing this bank-sovereign nexus and reducing fragmentation was also the initial trigger for establishing the Banking Union. The idea of launching the Single Supervisory Mechanism (SSM) was born during the June 2012 European Council meeting. It was a consequence of the decision that the ESM could directly recapitalise weak banks, thus taking some fiscal pressure off sovereigns. But if at a European level were to assume liability for European banks, it also had to assume control: hence the need for a European supervisor. It was only later, through the Van Rompuy Report, that the concept of a fully-fledged Banking Union appeared, which would contain a Single Resolution Mechanism (SRM) and a future possible Deposit Guarantee Scheme as well. Thus, out of a desire to sever the bank-sovereign nexus, we achieved what can be seen as the biggest institutional reform since the inception of the euro, with implications that go well beyond the problem of the bank-sovereign loop.

Somewhat ironically, however, this widening of the focus caused the initial objective to become obscured. The question of European direct recapitalisation – for which a framework has still not yet been decided – ceased to be the main focus of attention. In the view of many commentators, the SRM became the expected instrument to achieve the separation between banks and sovereigns. But this is a somewhat misleading view.

Both components of the Banking Union, the SSM and the SRM, contribute to reducing the negative feed-back loop between banks and sovereigns. The SSM is the first building block. One important objective of the SSM Regulation is to improve the quality of supervision and to ensure homogenous supervisory standards across the euro area. The SSM, from its operational start in November, will base its supervisory work on the best supervisory practices. The general principles, processes and methodology for supervision will be described in the SSM Supervisory Manual. A comprehensive public version is being prepared.

The SSM will lead to a convergence of rules and standards and a harmonised supervisory culture. For example, by imposing common principles about methods and parameters that improve the reliability of banks’ internal models, it will address the problems created by differences in the way that banks calculate risk-weighted assets. Importantly, the SSM will ensure that the same risks are given similar weights – recognising, of course, that the same types of risk can have different manifestations in different markets, reflecting the local economic situation. There will also be a harmonised treatment of non-performing exposures and provisioning rules, which at present varies between jurisdictions and are not directly comparable for investors. More generally, the substantial compliance costs, from having to observe different sets of rules and different sets of reporting requirements, as well as having to interact with several different authorities, will be reduced.

Under the SSM, direct supervision of significant banking groups will be undertaken by joint supervisory teams. These will comprise supervisors from both the ECB/SSM and National Competent Authorities, enabling a fully integrated approach to the supervision of cross-border banks. Compared with supervision at national level, this integrated approach will enable the SSM to detect excessive risk-taking and the cross-border externalities associated with it, and therefore to be proactive if local financial situations develop into threats to broader financial stability.

These changes in the supervisory framework should contribute to reducing fragmentation, by creating a level playing field for financial institutions and spreading best practices across borders, thus removing the barriers that existed in the past. An important consequence of those changes, which is essential for de-linking banks from sovereigns, is the trust that, for banks both directly and indirectly supervised by the SSM, a genuinely European financial system is being developed. This can help normalise interbank markets and overcome financial fragmentation.

That said, high standard banking supervision does not focus on preventing bank failures at any cost. In fact, to effectively perform its tasks, a supervisor must also be able to let failing banks exit the market. This is the reason why the SSM has also been given the competence to withdraw the authorisation to operate from credit institutions. However, given the role of banks in the financial system and in order to safeguard financial stability, the supervisor has to feel confident that the resolution of banks can be conducted in an orderly fashion. This brings me to the second pillar of the Banking Union, the SRM.

The establishment of the SRM is the second crucial step towards addressing financial fragmentation and breaking the bank-sovereign nexus. This is because the orderly resolution of banks, even large ones, helps avoid costly rescues by sovereigns that may endanger their own finances.

The SRM creates a single authority responsible for the resolution of banks in the euro area and participating Member States. This will enable swift and unbiased resolution decisions, which will address notably cross-border resolution cases in an effective manner. In this respect, the SRM should be viewed as a necessary – and logical – complement to the SSM. It would indeed be ill-advised to elevate the responsibility for supervision to the European level, while keeping resolution at the national level. This would create a mismatch of responsibilities, undermine the credibility of the SSM as supervisor, and delay the resolution of banks – a task that has to be done swiftly.

An important element of the SRM is the Single Resolution Fund, which will be financed via levies on the banking sector and gradually mutualised. Starting with national compartments, it will become a truly single European Fund in the course of eight years. By mutualising the cost of bank resolution, this approach will loosen the link between domestic banks and their sovereigns and further level the playing field. A shortcoming of the SRM, however, is the absence of a clear common financing arrangement that would provide additional temporary resources when needed.

In practice, however, the SSM and SRM may not be sufficient to completely sever the ties between sovereigns and their domestic banks. The effect of SSM and harmonised supervision on trust among banks may be more limited than expected, while, more importantly, the SRM may face legal limitations to autonomously managing the orderly resolutions of significant banks using its own funds. These limitations come from the Bank Recovery and Resolution Directive (BRRD), which is applicable to all 28 EU member countries.

The BRRD is one of the most crucial regulatory changes in Europe of late. It represents a true paradigm change, ending the culture of bail-out and ushering in a culture of bail-in. As of 2016, in all resolution cases, the BRRD will require a bail-in of shareholders and creditors equal to at least 8% of total liabilities of a given bank, including own funds. Only after the 8% threshold can money from the resolution fund be used and for a maximum amount of 5% of total liabilities (including own funds) of the bank under resolution. Public money, either from national governments or from direct European recapitalisation of banks, can only be used at the very end of the process which, in practice, should happen exceedingly rarely. Bail-in of shareholders and creditors plus the use of the Resolution Fund should, in most conceivable cases, be enough to ultimately cover for the losses incurred by the bank.

The “Government financial stabilisation tools” that the Directive introduces open the possibility of broader public interventions in the case of serious systemic risk situations. It remains however, an instrument of last resort. We are still far from the initial plan of direct European recapitalisations regarding this important question but the goal of avoiding to overburden the sovereign with banks’ rescues has in practice been achieved.

The amount of 8% is very substantial compared to the losses banks faced in the recent crisis. To give an idea, between 2008 and 2010 only one bank had losses exceeding the 8% threshold, and the average for all other banks was slightly less than 3%. If we look further back at the Nordic financial crisis in the 1990s, none of the banks affected by that crisis faced losses of more than 8% of total liabilities including own funds. Thus, under the BRRD, the injection of public money into banks, either from national governments or from direct European recapitalisation, should happen exceedingly rarely. Bail-in of shareholders and creditors plus the use of the Resolution Fund should in most conceivable cases be enough to cover the losses incurred by a failing bank.

Next we describe what happens once a bank enters into resolution and how the so-called “bail-in tool” works under the new framework. The bail-in tool follows a sequential approach. Before any resolution fund can be tapped, shareholders and creditors have to first absorb losses amounting to at least 8% of total liabilities including own funds. Although uninsured deposits from individuals and small firms come last among liabilities possibly subject to bail-in, they would be included if needed to attain the 8% total. According to the new rules, only insured deposits are totally excluded from the bail-in tool. Only after the 8% amount is bailed-in from shareholders and creditors, can money from the resolution fund be used and for a maximum amount of 5% of total liabilities (including own funds) of the bank under resolution. Public resources can then be used only in case those two measures would not be not enough (which, based on past crisis experience, would be exceptional).

While we all agree with the objective of protecting taxpayers’ money, it is important to examine what are the implications of the new rules for the banking market and for the sovereignty of member states. As a natural result of the backlash against banks in our democratic polities following the huge crisis rooted in the financial system, the new framework imposes that banks’ bailout with public money is the ultimate resource after extensive bail-in tools have been activated. Bailouts, especially when shareholders and bank management are not penalised, may create moral hazard that may feed subsequent reckless management behaviour down the road. The difficult judgement is of course to navigate in a general financial crisis between the Scylla of moral hazard and the Charybdis of financial collapse.

The second aspect to highlight is that by avoiding the commitment of public money and protecting tax payers as much as possible – a goal widely shared – participant countries in the Banking Union must shed considerable sovereign power, showing a remarkable willingness to continue to deepen European integration, thus reinforcing monetary union. In fact, large countries with strong public finances must renounce to provide domestic banks with the implicit subsidy of public support. This will reduce their strength in competing in the European space with an advantage and will be progressively reflected in banks’ ratings and funding costs. On the other hand, countries with vulnerable public finances and smaller banks will no longer be able to support, and possibly keep, their national champions. Finally, in both cases, governments accept the transfer of supervision and resolution of banks to the European level in what has to be considered a remarkable sharing of sovereignty.

Another aspect of the BRRD reflecting the reluctance in the use of public money is the disposition that foresees that a criterion to put a bank formally into resolution is that it “requires extraordinary public support”. This disposition will apply as of January 2015 and will very likely be in force when the corrective supervisory action stemming from the SSM Comprehensive Assessment will be in course of implementation. There is a possible exemption to this rule. But according to certain interpretations, the rule is applicable, for instance, to a listed bank that fails the baseline scenario of a stress test, cannot raise private capital and has to request public assistance. Very likely, if such a bank is formally put into resolution, it may suffer irreparable damage in the market place, further complicating its situation and generating spillover effects on other banks.

This could mean, according to those interpretations, that under the BRRD, a bank may be put into resolution before actually attaining the point of non-viability if it just fails a baseline scenario of a stress test. Attention should be paid that resolution does not lead to resurrection of the institution and, as seen by the market, normally implies deep restructuring, downsizing or even its winding down.

The interpretations already mentioned would also imply that the public backstops for the purposes of the SSM Comprehensive Assessment announced last November, if used, would trigger putting the bank into formal resolution if the exemption mentioned before would not apply. The terms of the exemption, surrounded by several conditions, are basically dependent on the need to avoid a serious disturbance in the economy of a Member State and preserve financial stability. We certainly hope that in the context of such a wide-ranging undertaking to assess the robustness and resilience of European banks, there will be reasonable financial stability aspects to justify them. Also, in 2015 such an exemption should have no operational implication for the bail-in rules of the Directive as, contrary to the rest of the BRRD articles, its bail-in rules will be applicable only after January 2016. The granting of such an exemption would also not preclude the application of the only bail-in rule in place in 2015 which exists in the context of State Aid principles.

The bail-in rules now in place stem from the European Commission's communication of July 2013 on “State Aid rules to support measures in favour of banks in the context of the financial crisis”,⁴ which establishes that any public support to banks considered as State Aid should be preceded by bail-in of bank shares, contingent capital hybrids and subordinated debt. Again, in this case, the text contemplates that exceptions “can be made where implementing such measures would endanger financial stability or lead to disproportionate results”. For concrete cases, at the end of the SSM Comprehensive Assessment, it may be adequate to invoke such principles.

In 2015, another potential complication may come from problems of a legal nature that can create difficulties to the maintenance of a level playing field in the context of our exercise. Some countries may have no national law or legal ability to implement burden sharing rules ahead of the entry into force of the BRRD bail-in rules in 2016.

Amid these concerns, all the relevant legislation and related exemptions should be applied in the wake of our Comprehensive Assessment with the adequate balance between the different values of avoiding moral hazard, assuring market discipline and level playing field and safeguarding financial stability.

The present situation of apparent easy access to capital markets driven by investors’ appetite to invest in banks provides hope that the whole question of public backstops can move to the background. If this situation remains unchanged until November banks that need to reinforce their capital buffers should be able to raise money in the private market. Nevertheless, it is recommended that all banks, besides raising adequate levels of capital, carefully study the new legislation on resolution and bail-in. The bank market and even competition for controlling capital stakes will be significantly affected as the legislation enters into force. At the same time, investors should learn and internalise the new bail-in rules that will dominate the market for bank securities from now on.

Clearly, to avoid moral hazard, any public interventions should penalise shareholders and managers appropriately, as was done in the exemplary case of the Nordic banking crisis. Here financial and economic collapse was avoided with, in the end, virtually no costs for taxpayers when the restored banks were sold. Thus, after the misbehaviour of several institutions that triggered the recent crisis, the change of culture from easy public bailouts to a new culture of private bailing-in is recommended. The burden of proof should be put on those who want to invoke exemptions to the new approach.

Yet, it is not only direct public support for banks that has a cost for taxpayers, but also financial instability – indeed, the costs of the latter may be higher. Compare the worldwide costs for taxpayers stemming from the absence of public intervention to rescue Lehman Brothers, with the zero cost for taxpayers following the USD 700 billion injection into US banks in 2008 (which have by now been totally repaid by the banks). In other words, financial instability can have a meaningful cost to taxpayers even if it is not visible in the very short term – a notion that all policy makers should keep in mind.

For this reason, we should not take away from public institutions, that understand the externalities of financial crises, the capacity to make balanced and complex judgements. The new European legislation does allow, as a last resort, for interventions that can safeguard financial stability in a Member State or in the area as a whole. This legislation should be applied by the competent authorities with rigour, wisdom and a sense of proportion in the aftermath of the Comprehensive Assessment.

2

Banks’ balance-sheet repair and the economic recovery

Now the article will focus on the implications of Banking Union for the economy in general.

Some economists are of the view that negative developments in bank credit in the euro area are predominantly due to credit supply restrictions – namely, insufficient capital to absorb supposedly still unrecognised losses.⁵ This view is not entirely correct. We have observed a marked increase in banks’ capital ratios since the beginning of 2009. Since the onset of the global financial crisis, the top 20 European banks have increased capital in dollar amounts, net of share buy-backs, by much higher numbers than the corresponding top 20 American banks: USD 289 billion by EU banks against USD 179 billion by US banks. And according to the FDIC, the leverage ratios of the biggest European banks, calculated according to the same accounting standards, are very close to their American peers.⁶ Since the middle of 2013 in particular, European banks have implemented write-offs and increased provisions and capital, partly anticipating the Comprehensive Assessment that the ECB is conducting this year. As a result, confidence in the euro area banking sector is now starting to rise. This development has been recognised by the stock market where banks’ share prices increased by 41% in 2013, above market average growth of 20%.⁷

Nevertheless, the task of bringing back confidence in the EU banking sector still needs to be completed. This is why the Banking Union, and in particular the Comprehensive Assessment of banks’ balance-sheets, is so important. It will trigger corrective supervisory action where it is needed and dispel any remaining doubts about asset valuations and the corresponding level of provisions. This in turn will help bring the deleveraging process in the banking sector to a swifter conclusion.

In the short-term, this may have a pro-cyclical effect. However, a fast and targeted rebooting of the banking system could have two positive effects going forward.

The first effect is cyclical. A well-functioning banking sector will support the transmission of our monetary policy in all parts of the euro area, thus helping observed growth to rise towards potential growth and the output gap to close. This is because, on the asset side, banks that are restructured and recapitalised will no longer have incentives to ration lending towards smaller firms with higher capital charges. And on the liability side, as they gradually reach their target loan-to-deposit ratios through raising deposits, the funding costs between banks in the core and periphery of the euro area will further converge.

The second effect is structural. To the extent that the Comprehensive Assessment helps fixing the bank lending channel and ends the so-called “ever-greening” of loans,⁸ it will support an efficient credit allocation process. This could in turn support the overall process of reallocation within the euro area economy, thus boosting productivity and possibly reversing the slowdown in potential growth.

Nevertheless, a word of caution is warranted in the sense that a sudden jump start of credit growth may not immediately result. The recent behaviour of credit cannot be explained solely by credit supply restrictions, but is also largely linked to lack of demand. Completing banks’ balance-sheet repair is thus a necessary but not sufficient condition to consolidate the on-going recovery.⁹ The weak domestic demand outlook prevailing in the euro area combined with under-utilised industrial capacity is the most important explanation for the drop in private investment during the crisis, and the most important limiting factor for higher growth.

3

Other important effects of the Banking Union

The on-going overhaul of bank supervision and resolution frameworks will also have implications that go well beyond the primary objectives of financial stability and completion of the Monetary Union. Let me focus on three effects in particular.

Further integration of the European banking market

The first effect is the likely consolidation of the European banking sector. Restructuring in the euro area banking sector has already been on-going since 2008. For example, in net terms the number of credit institutions has fallen by 9% since 2008, or around 600 institutions, while total assets of the euro area banking sector have declined by almost 12%. However, this consolidation was more due to retrenchment than to active M&A deals in the industry, which have instead been rather weak. From 2008 to 2012, the overall value of deals decreased fourfold to just EUR10 billion, with cross-border deals being the most affected. Yet, the Herfindahl–Hirschman concentration indicator for the euro area banks remains, at the 690 level, well below the 1600 level above which concentration becomes detrimental, which means that there is margin for further efficiency-driven consolidation. The weak profitability and excess capacity of the European banking sector also suggests that efficiency gains could be reaped from more consolidation. This, together with the on-going repair of bank balance-sheets, should set the stage some time down the road for a new phase of M&A geared towards improving efficiency.

It also seems likely that the Banking Union will create the conditions for further integration of the European banking market. Unified supervision should create greater trust among banks and cross-border banking groups will be able to optimise their internal management of capital and liquidity and reduce compliance costs. We expect hidden barriers to disappear and liquidity and capital management to take place at the SSM level. Thus, the movement towards subsidiarisation that we observe in other parts of the world has no justification inside the SSM perimeter. This should also reinforce the consolidation dynamics previously mentioned: it is natural for the establishment of the SSM and the Comprehensive Assessment of banks’ balance-sheets to a period of general, market-driven restructuring in the European banking sector.

Enhancement of the role of capital markets

The second effect is enhancing the role of capital markets in the euro area. In the euro area, banks have historically played an important role in financing the real economy. Bank loans account for most of household borrowing and around 50% of non-financial firms’ external financing. This is very different from the US where around 75% of firms’ financing comes from capital markets (equity and debt securities).

However, recent evidence suggests that corporate bond financing was an important alternative to bank financing in the euro area during the financial crisis, when banks were unwilling or unable to lend, mostly reflecting pressures to de-lever.¹⁰ Although these pressures have eased and the economic recovery in Europe is beginning, a the shift towards more capital market-based intermediation to persist going forward is expected. One reason is that the new regulatory environment gives banks incentives to hold marketable, liquid securities, such as corporate bonds or asset-backed securities, as opposed to corporate loans. This should increase the complementarities between marketable assets and corporate loans within banks’ balance sheets, where in the past they were considered as substitutes.

Europe should not abandon its intermediated model of financing. Rather, it should complement it, more than in the past, with alternative sources of finance. This change, combined with the structural deleveraging of the banking system and the new regulatory regime, should enable the financial sector to keep providing adequate levels of credit to the economy. The diversification of the financing mix will have obvious advantages for euro area firms, as it will allow them to access a larger pool of non-bank investors and to better insulate themselves from shocks in the banking sector.

The role of macro-prudential policies

The third effect linked to Banking Union is the emergence of new macro-prudential policy tools for the ECB. Before the crisis, banking supervision in most (but not all) countries was fundamentally “micro-based”, focusing on the safety of individual institutions. But the crisis has shown that the stability of individual financial institutions alone is not enough to ensure the stability of the financial system as a whole. This is the reason why the SSM will have not only micro-prudential powers but also new macro-prudential instruments to counter financial imbalances. And it will be able to apply prudential measures in both borrowing and lending countries, which was not possible before the crisis.

At the current juncture, macro-prudential policies can address at least two related issues. First, by strengthening banks they can contribute to increasing credit flows to the real economy, thus mitigating the likelihood of a so-called credit-less recovery – a type of recovery that is generally quite mild.¹¹ At the same time, as macro-prudential policies can be targeted at specific sectors or regional developments, they can help attenuate the credit cycle heterogeneity that characterises the euro area and support a more balanced recovery.

Second, one cannot exclude that present accommodative monetary policy generates pockets of instability in some specific market segments. Macro-prudential tools can, in principle, allow the ECB/SSM to address such financial imbalances in a granular way. For example, instruments like the counter-cyclical capital buffer can be applied at the national level to curb domestic credit booms, allowing monetary policy to remain focused on euro area aggregates.

Going forward, by dealing with imbalances specific to a group of countries or to a given sector of the euro area economy, macro-prudential policies should effectively take into account heterogeneities among Member States. They should thus contribute to reducing dispersion, which in turn enhances the uniform transmission of monetary policy.

4

Conclusion

Banking Union is an essential complement to Monetary Union and a project with vast consequences for European integration. It is not, however, the end of the journey. Banking Union must provide a stable and efficient framework for the major endeavour, which is completing the economic and monetary union. The dynamics of Jean Monnet's functional method of integration are still fully operational. With each institutional innovation, others become necessary and more pressing. For instance, to fully reap the benefits of Banking Union, legislative changes that complete the programme of financial services integration, particularly in relation to the capital markets are necessary. That would include changes to company law, bankruptcy rules and procedures, and higher harmonisation in the taxation of financial products. The Commission should promote these issues.

Other necessary institutional developments have also been well identified in the President Van Rompuy's Report “Towards a genuine Economic and Monetary Union”.¹²

First, a more complete Fiscal Union along the lines described in that Report seems necessary for the euro area, which goes beyond mere disciplinary rules. Specifically, it calls for “….the establishment of a fiscal capacity to facilitate adjustment to economic shocks. This could take the form of an insurance-type mechanism between euro area countries to buffer large country-specific economic shocks. Such a function would ensure a form of fiscal solidarity exercised over economic cycles, improving the resilience of the euro area as a whole and reducing the financial and output costs associated with macroeconomic adjustments”.

Second, under the umbrella of Economic Union, further progress towards the completion of the single market of services, and a more co-ordinated approach to macro-economic policy at the euro area level is needed.

Finally, the sovereignty-sharing that monetary union represents implies moving forward towards political union. The euro area is, in the end, a political project. The integration of European nations, while respecting the fact that this unique community is neither a nation nor a state needs to be completed. The question that should guide us is how to preserve and defend national identities and interests in a globalised and challenging world.