The strengthening of the European banking has become a topic of debate again lately. In this article we will develop our knowledge of what we mean by banking union, the steps have already been taken toward creating a banking union for the eurozone and of the current challenges and opportunities for future developments.
Why a banking union?
Everything starts in 2007, with the collapse of the US real estate market, which exposed the weaknesses of the financial sector. The crisis was quickly transmitted to Europe, and it became immediately clear that European regulation and supervision had failed to follow market developments. In particular, banks were exploiting the benign environment by seeking higher returns, with little concern for the risks that were emerging, notably from securitization and derivatives.
In light of the difficulties that banks were experiencing, member states rushed to provide liquidity to those banking institutions that were considered of vital importance for the country’s lending system, highlighting the need for a common methodology to assess capital and liquidity needs. Moreover, the crisis drew attention to the intrinsic risks of having too tight domestic sovereign-bank links.
So, in June 2012, the European leaders found an agreement to start working on a banking union for the euro area.
The idea was to establish a single supervision mechanism (first pillar), a single resolution mechanism (second pillar) and a more solid deposit insurance framework based on a common set of rules (third pillar). This was meant to ensure banks became stronger and (more) profitable and to provide a level playing field for banks located in different countries.
Measures already taken
In response to the financial crisis, the Basel Committee on Banking Supervision developed the Basel III framework, aimed at strengthening regulation, supervision and risk management of banks. This has been with modifications adopted by the EU.
Several European supervisory authorities were set up, in order to enhance oversight at the European level of some sectors of the economy deemed to be more in need of regulation:
the European Banking Authority, in charge of conducting 'stress tests' on European banks to identify weaknesses in their capital structures; it has the power to overrule national regulators if the latter fail to regulate their national banking sector properly;
the European Securities and Markets Authority, competent to ensure financial markets stability, to improve cooperation among relevant national authorities and to improve investor protection;
The first pillar of the banking union became operational in 2014: the Single Supervisory Mechanism, that implies a transfer of competence concerning the supervision of systemically significant banks from national authorities to the EU and therefore ensures independent supervision of the euro area banking system.
The second pillar was the Single Resolution Mechanism, born to manage the rescue and recovery of failing or likely to fail banks in the euro area. The Single Resolution Board was created as the competent EU authority in this matter, with the power to use the Single Resolution Fund in case it deems it is in the public interest.
Of particular importance as a first step towards the third pillar is the Revised DGS (Deposit Guarantee Scheme) Directive, which aims to establish common rules for deposit coverage in the EU and cooperation modalities among national schemes. The minimum coverage level of deposits was set at 100,000€ or equivalent. In general, the national insurance systems are funded and managed differently, and without some effective risk sharing among national funds, single countries may be perceived as vulnerable and as providing an insufficient level of insurance, thus encouraging deposit withdrawals and, potentially, bank runs, in case of adverse events. Still, national discretion is largely allowed in many aspects of the scheme.
In order to ensure that the positive trend banks have been following continues and that a deeper banking union can be developed, the euro area needs to build three instruments: a European Deposit Insurance Scheme, a regulatory treatment of sovereign exposures and a European safe asset. We will break down each of them in the following paragraphs.
The European Deposit Insurance Scheme (EDIS)
To induce integration in the banking sector, we need to have a European single market with uniformity of rules and standards across borders. To this end, the third pillar of the banking union is still missing.
A common European deposit insurance, to be created as a development of Revised DGS, would be able to prevent bank runs as weaknesses of single national systems would be eliminated by coverage at the European level. Moreover, it would enjoy the benefits of a larger insurance systems, such as a more efficient allocation of resources.
Naturally, localized risks would have to be addressed so as to reduce the risk that payouts from the common scheme would go unidirectionally to the most vulnerable countries. Different proposals for the design of EDIS are being discussed.
According to the weakest one, national systems would be complemented by a simple re-insurance form, with a mandatory lending provision where national DGSs would provide liquidity to other national schemes if they run out of funds. These “loans” from one national insurer to another would have to be repaid, implying no loss coverage.
The European Commission, instead, in 2015 has proposed a form of EDIS which would gradually be developed to be a fully mutualized deposit insurance capable of meeting all liquidity needs in the event of a pay-out or in a resolution procedure across the banking union. This means that if a bank fails or needs restructuring, citizens holding deposits will be reimbursed up to €100,000 with funds coming from the entire EU.
To prevent moral hazard issues, EDIS can internalize banks’ risks through risk-based contribution to the scheme, so that a riskier bank would have to contribute more, promoting incentive to increase systemic financial stability.
The regulatory treatment of sovereign exposures (RTSE)
The new banking regulations have not managed to fully limit the link between banks and sovereigns. Currently, the Basel III framework as implemented in the EU, allows banks to apply a zero percent risk weight to any sovereign exposures denominated and funded in the currency of the central government. This means that such debt holdings are subtracted from the total assets when calculating the Capital-Asset ratio as if they had no risk attached, which makes the bank seem safer. Indeed, this does not provide incentives to reduce exposure.
Three main approaches have emerged to more effectively tackle this issue:
Changing accounting standards: at least a share of the sovereign debt held are liquid assets, meant to be sold at need. Currently, however, these securities are included in the Held-to-maturity or Receivables parts of the balance sheets, so that any change in market value is not reflected in banks’ accounts. By mandating these securities were accounted for as Trading or Available for Sale securities, banks would have to be more cautious in managing their exposure to sovereign debt, to avoid market prices volatility be transposed to their own balance sheets.
Contributions to EDIS: more exposed banks could be required to pay higher contributions to EDIS. The major weakness of this approach is that linking contributions to sovereign exposures could imply redistribution favoring banks less exposed to their country’s bonds as not all events requiring EDIS payment to depositors are caused by sovereign exposures.
Pillar 1 regulation to account for sovereign risk: this could be made through establishing capital risk weights which differs from zero or through exposure limits and concentration charges (the more a bank is exposed to its corresponding sovereign debt, considering the ratio on total assets, the more weight is assigned to sovereign debt in the determination the bank’s risk). Both options would allow correction of distorted incentives for sovereign bond holdings and a systemic leverage decrease through improved bank risk management causing losses to be more spread out in case of default, although it would also probably lower profitability.
However, these proposals could be very dangerous for the most vulnerable sovereigns. They could indeed raise funding costs for national governments that already have a high debt or are perceived as risky. In the advent of a negative cycle, positive risk weights would imply getting rid of riskier debt, thereby increasing economic divergence and differences in funding costs across countries, rather than helping convergence.
This means that significant transition periods will be required when introducing the proposals discussed, so as to allow for a smooth adjustment of debt holdings across market players and across borders, without negative consequences for national states’ finances.
A euro area safe asset
Issues related to regulating banks’ sovereign exposures have led to the proposal of the creation of a European safe asset, some form of common debt issuance in the euro area that would finance all countries in the euro area collectively. It would be a powerful diversification instrument that would foster euro area financial stability: banks holding it would be exposed to the euro area countries as a whole, effectively eliminating any specific sovereign risk.
This instrument would improve stability of government financing. It would also imply easier financial integration and more effective transmission vehicle of monetary policy, while at the same time capturing the market’s demand for safe assets and improve the potential of the euro as an international currency.
Again, three main approaches have emerged. The first one imagines euro area countries jointly issuing 'Eurobonds' backed by common guarantees or some form or equity. The second approach works through a euro area fiscal authority created with the power to issue debts, backed by predetermined future revenues. The last one, based on the European Commission’s proposal, is called Sovereign Bond-Backed Securities and entails the creation of a financial entity that would issue euro debt securities backed by a portfolio of underlying euro area sovereign bonds.
All proposals concerning EDIS and the euro area safe asset imply a minimum degree of risk mutualization and resource pooling since all countries would participate in covering depositors’ funds regardless of where the failing bank is based, raising moral hazard concerns that national governments would not have incentives to preserve their fiscal sustainability, in light of the implicit euro area guarantee. Hence the need to create a common fiscal policy coordination framework designed to enforce the commonly agreed budgetary plans.
We have seen how EDIS is at the heart of the completion of the banking union. It will help increase financial stability, lower banks’ exposures to their sovereign debt and help build trust in the banking system. Measures to reduce local risk and to prevent that riskier banking systems benefit disproportionately from a stronger European safety net will have to be taken. Finally, a European safe asset can complement the completion of the banking union.
As you can see, a lot of work needs to be done but the foundations are good.
This article is based on the European Stability Mechanism Discussion Paper Series.