Why do we need a full European banking union?

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 European Insurance and Occupational Pensions Authority, which ensures financial products transparency and helps protect insurance policyholders, and pension scheme beneficiaries.

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 DG