Risk-Based Approach

The transition is rapid, sequenced in a pragmatic manner, with a focus first on banks requiring public support, then on systemic banks. The SSM will come into operation one year after the legislation enters into force or when the ECB considers itself ready, whichever is later, after a comprehensive assessment of euro area banks is completed. The December 2012 EU Council agreement provided that when the ESM requests the ECB to take over direct supervision of a credit institution as precondition for direct recapitalization, the ECB may immediately assume its supervisory duties concerning this bank, regardless of the starting date of the SSM. On October 23, 2013, the ECB announced key features of the comprehensive assessment of the banking system, which will be concluded prior to assuming supervisory tasks in November 2014.

Coverage

The SSM would cover all credit institutions established in participating countries, although most tasks related to the supervision of those institutions considered “less significant” would normally be carried out by the national authorities. The criteria under which banks would be under the direct supervision of the ECB include size, importance to the economy of the European Union or of a member state, and significance of cross-border activities.² The ECB appropriately retains the power to bring any bank under its direct supervision, if it deems necessary.

Mandate

The ECB is provided with a clear mandate for bank safety and soundness and financial stability.

Tasks and Powers

The ECB is provided with broad powers that are available to competent supervisory authorities under EU legislation. Broad investigatory and supervisory powers include enforcing compliance with prudential norms regarding its own funds, large exposure limits, liquidity requirements, leverage, disclosure requirements, licensing and withdrawal of authorization, assessing mergers and acquisitions, performing on-site inspections, requesting all necessary information, carrying out stress tests and assessment for public recapitalization, imposing macroprudential (capital and liquidity) buffers, conducting consolidated supervision and supervision of financial holding companies, carrying out early intervention tasks in relation to the listed prudential requirements, and assessing governance and internal capital adequacy processes.

Operational arrangements now need to be specified. These must ensure an adequate division of labor between national authorities and the ECB, make incentives compatible, and provide for appropriate information sharing within the SSM to underpin effective supervisory decision making at the supervisory board. The ECB is to adopt a detailed framework for the practical modalities of supervisory cooperation within the SSM.

Other EU Countries and Institutions

Nonparticipating member states will be able to enter into close cooperation with the ECB, under the condition that the national authority will abide by ECB guidelines and requests and provide all necessary information that the ECB may require. The ECB is tasked to coordinate and express a common position of euro area national supervisors at the Board of Supervisors and with the management of the European Banking Authority for issues relating to the supervisory tasks conferred on the ECB.

Governance

A Supervisory Board (aided by a Steering Committee) will be created to achieve appropriate governance and facilitate timely supervisory decision making by, or subject to the oversight and responsibility of, the Governing Council. The council agreement strengthened the governance arrangements relative to the European Commission proposal, reflecting concerns related to the separation between monetary policy and supervision (to minimize conflicts of interest between the two functions) and to ensure that non-euro area countries have a voice in the SSM (since non-euro area “opt-ins” cannot be represented on the ECB’s Governing Council). Strict differentiation between monetary policy and supervision will apply, including by strengthening the power of the supervisory board with a complex voting procedure that ensures representation of the non-euro area members.

Draft decisions of the Supervisory Board will follow a “silent procedure,” that is, they will be deemed adopted unless the Governing Council objects within a short period (10 days in normal times, and two days in stressful times). A mediation panel and a Steering Committee are to be created to help resolve disagreements and aid decisions. In practice, it will be important to balance the representation of national interests and public officials from the ECB in the governance structure of the SSM. It will also be important to ensure that the complexity of the set-up does not undermine effective and prompt supervisory decision making.

Accountability

The Governing Council, and in particular the chair of the supervisory board, is accountable to the Eurogroup and the European Parliament, among other things through an annual report on the execution of the ECB’s supervisory tasks and the transparency of its supervisory budget. The European Parliament added transparency and accountability requirements stipulated in an Inter-institutional Agreement between the ECB and the EP. These will include, in particular, providing the ECON committee of the EP with comprehensive and meaningful records of the proceedings of the Supervisory Board to enable an understanding of the discussions, including an annotated list of decisions. Moreover, the ECB is subject to internal and external audits, also by the European Union Court of Auditors, and judicial scrutiny by the European Union Court of Justice. Both the ECB and the national authorities are responsible for the banks under their direct supervision, although the ECB is responsible for the effective and consistent functioning of the SSM.

Role of National Authorities

National authorities will prepare and implement ECB acts under the oversight of the ECB, perform day-to-day supervision activities, and directly supervise banks not classified as “significant.” They will remain exclusively responsible for consumer protection and anti-money laundering tasks, receiving notifications from credit institutions related to the right of establishment, supervising the activities of the branches of third countries’ credit institutions, and supervising payments services.

Macroprudential Policies

The ECB will be able to impose capital buffers, such as a countercyclical capital buffer, in addition to capital requirements and any other measures aimed at addressing systemic or macroprudential risks as specified in EU acts, such as the legislative package that yielded the Fourth Capital Requirement Directive and Capital Requirement Regulation. The Council agreement provided both national authorities and the ECB with powers to make use of macroprudential instruments, in close collaboration with each other, and included specific reporting to national parliaments to strengthen accountability. But the ECB powers are limited to those specified in the relevant EU directives. Either party that takes such a step needs to inform and hear the other party ahead of time. In practice, cooperation will be critical to ensure the coherence and effectiveness of measures.

Resources

Supervision could be financed partly by risk-based levies on credit institutions.

Preconditions

According to the BCPs, a number of preconditions for sound banking supervision must be met in the longer term. A clear framework for financial stability policy must be in place, one that includes the provision of strong macroprudential oversight and, for the sake of crisis management and resolution, the provision of ways to deal effectively with bank failure and minimize disruptions. An appropriate common safety net is essential to deal with risks to confidence in the financial system and contagion to sound banks while minimizing distortions.⁹ Some preconditions are beyond the jurisdiction of supervisors, and some elements are not yet in place at the euro area level. For example, resolution regimes (and safety nets) remain national, and in most countries they need to be strengthened to be aligned with the Financial Stability Board’s “Key Attributes for Effective Resolution.”¹⁰

Prerequisites

A set of prerequisites is essential to establish a sound basis for the SSM. The supervisory mechanism should have operational independence consistent with its statutory responsibilities, legal protection for its supervisors, transparent processes, sound governance, and adequate resources, and it should be accountable for the discharge of its duties. Among these, the following considerations are noteworthy.

• Objectives and mandates. As supervisor, the ECB should ensure the safety and soundness of credit institutions, while adopting a systemic approach to financial stability that helps preserve the integrity of the single market for financial services. Under the EU Treaty, the primary objective of the ECB is price stability, and its secondary objective is to support the general economic policy objectives of the European Union, such as a high level of employment and sustainable and non-inflationary growth. Involving the ECB in supervision will give it access to supervisory information in support of its monetary policy and lender-of-last-resort functions and will also provide the ECB with more information to separate illiquid from insolvent banks. Housing both supervision and monetary policy under one roof can also lead to difficult choices when monetary policy decisions impact the soundness of important banks. Therefore, a revision of ECB objectives through EU Treaty changes may be warranted to provide greater clarity with respect to the interaction between the ECB’s monetary mandate in the monetary union and its supervisory mandate in the banking union. It may also be warranted to explicitly specify that the ECB’s supervisory mandate includes financial stability and macroprudential oversight.

• Operational independence and legal protection. Operational independence regarding the ECB’s supervisory mandate derives legally from the ECB/ESCB statutes. But bringing supervision under the umbrella of the ECB creates risks to the ECB’s independence (and hard-won reputation), given the added potential for political interference. Modifications to the Treaties should be considered to safeguard the ECB’s independence in its supervisory mandate as well and to strengthen legal protections for supervisors.

• Governance. The Governing Council is the decision-making body of the ECB, and is responsible for supervisory tasks according to Article 127(6) of the EU Treaty. Sound governance will be crucial to ensure early identification of risks and timely and effective decision making in the interest of the whole banking union (and not of individual countries). Because supervisory decisions have distributive implications, the decision making body may have to adopt a mechanism that protects effective and timely decision-making (e.g., to ensure the “will to act”).

  • ▪ A one-member-one-vote rule would ensure that regional interests are better accounted for and would provide a balance to large countries’ influence. On the other hand, allocating voting rights based on economic size would align countries’ rights with the relative importance of their economies. A balance between the two could be considered (perhaps a uniform set of basic votes, combined with voting rights relative to economic size). Consideration should be given to providing voting rights to non-euro area members that join the supervisory mechanism.

  • ▪ Robust firewalls between monetary policy and supervision would protect the independence and credibility of each function of the ECB, ensure the confidentiality of supervisory information, and help limit potential conflicts of interest while ensuring that synergies between the two functions are exploited. (Conflicts of interest may arise when interest rate policies impact weak banks, or when the lender-of-last-resort function safeguards financial stability but risks lending to insolvent banks). In the United Kingdom, for example, the supervisory function is being established as a subsidiary of the central bank.

  • ▪ One way to ensure swift decision making based on delegation is to establish a Supervisory Board within the ECB, assisted by a Steering Committee and a Supervisory Department, which could be given supervisory tasks and related decisions (as under the European Union regulation establishing the SSM). Under this model, which was agreed to by the European Union Council in December 2012, monetary policy and supervision decisions would be reconciled at the Governing Council. Alternatively, a separate body from the Governing Council could be established to provide stronger firewalls and ensure full representation of non-euro area countries. However, establishing a separate body in this way could make coordination and synergies more complex to achieve, could be legally complex to establish, and would require a change to the EU Treaty.

  • ▪ Additional considerations relate to the delegation of supervisory tasks to national authorities and the need to establish clear chains of command and adequate incentives.

• Accountability. Independence must be complemented with accountability to European citizens. Pursuant to the EU Treaty, the ECB’s standard monetary policy reporting is addressed to the European Parliament, the European Union Council, the European Commission, and the European Council. Given the fiscal implications of supervision, stronger (such as more frequent) reporting to the European Parliament and to the euro-group could be envisaged for the supervisory function. The EU regulation establishing the SSM also added accountability to national parliaments.

• Resources. Any supervisor needs secure and adequate funding. Pragmatism will need to govern decisions related to funding and implementation, both in the near term and in the steady state, but the resources obtained should allow the ECB to build adequate capacity while protecting it from influence by national authorities or the industries. In particular, the ECB will need to establish highly trained and independent staff at the center, including but not only from national authorities, to be able to directly supervise a subset of banks (including globally systemic banks). In this regard, the challenge of developing the requisite competence at the ECB and building credibility in supervision should not be underestimated. At the same time, national supervisors must retain sufficient resources to perform their tasks. Funding models could consider combinations of industry levies (based on the size and the risk profile of supervised banks) and central bank support (seigniorage) that balance these considerations, provided that budgetary transfers from the ECB’s monetary policy leg (seigniorage income) to its supervisory leg do not hamper the execution of its monetary mandate.

Sovereign-Bank Links

The motivations for forming the banking union include weakening, or severing, sovereign—bank links and limiting the buildup of systemic risk. Large and cross-border banks should be included. But, as the experience of Spain and others has demonstrated, small banks with correlated risks can represent a major fiscal risk to the sovereign and a systemic risk to the euro area. Covering only “systemic” banks (with the difficult decision of demarcating systemic from nonsystemic banks), while potentially easier to implement technically and politically, would only partially address these risks.

Competitive Distortions

A banking union covering only a subset of euro area banks would have implications for the level playing field and could encourage regulatory arbitrage between centrally and nationally supervised banks.

Uneven Distribution of Costs and Benefits

Because banking size and activities differ greatly across euro area countries, a partial banking union that covered only a subset of large banks would benefit some countries more than others and would therefore have implications for the distribution of costs and benefits of the banking union across countries.

Principles

To ensure effective supervision, bank supervisors should have clear responsibilities and objectives for each authority involved in supervision (following BCP No. 1). To the extent that the ECB will be a supervisor in its own right, it will have to comply with the BCPs. Assessing the SSM will also require discerning how effective it is to have a supranational setup sharing some responsibilities with national authorities and delegating some of the tasks. The effectiveness of the SSM, which will be the responsibility of the ECB to ensure, will depend, among other things, on the functions delegated, the capacity constraints, and the accountability and control mechanisms used.

Tasks

The ECB should have clear responsibilities over the life cycle of banks to fulfill its safety and soundness mandate. This implies that the ECB should be tasked with authorizing banks; assessing and authorizing mergers and acquisitions; ensuring compliance with prudential requirements; imposing additional buffers (including countercyclical and systemic buffers); applying requirements regarding internal bank governance and processes; imposing all measures determined necessary to address, early on, banks’ unsafe and unsound practices; carrying out stress tests; conducting consolidated supervision; and taking on tasks related to home-host arrangements for cross-border banks. The EU regulation establishing the SSM broadly confers these tasks on the ECB.

Powers

To carry out its tasks effectively, possibly including the solo supervision of a set of banks (without delegation to national authorities), the ECB should have adequate formal powers to do all of the following:

• Enforce minimum prudential standards and any restrictions prescribed by the supervisory review, including increasing the prudential requirements for individual banks and banking groups based on their risk profile and systemic importance (BCP No. 1 and No. 16).

• Request information and have full access to banks’ boards, management, and staff records, and perform general investigations and onsite inspections (BCP No. 1 and No. 10).

• Require all necessary early corrective actions to address unsafe and unsound practices or activities that could pose risks to banks or to the banking system, and prevent banks from breaching standards (BCP No. 11).

• Ring-fence banks from the actions of parent companies, subsidiaries, parallel-owned banking structures, and other related entities in matters that could impair the safety and soundness of a bank or the banking system (BCP No. 11).

• Take measures and sanctions in line with the gravity of the situation, including revoking licenses (BCP No. 11).

• Determine supervisory plans (BCP No. 8).

• Review, reject, and impose conditions on transfers of ownership and major acquisitions (BCP No. 7).

• Perform consolidated supervision, including application of prudential standards for an entire group (BCP No. 12).

• Withdraw licenses and collaborate with relevant authorities in deciding when and how to effect orderly resolution (BCP No. 11).

• Identify and assess the buildup of risks, trends, and concentrations within and across the system, in coordination with other relevant authorities, and address proactively any serious threat to the stability of the banking system (BCPs No. 8 and No. 9). (See below on macroprudential responsibilities.)

Formal versus Real Powers

Distinguishing formal from real power is important. Because supervisory incentives are skewed at the national level, it is essential that the ECB has real powers (requiring adequate resources) and does not simply validate (and take responsibility for) decisions proposed by national authorities. A prerequisite is to confer formal supervisory powers on the ECB, and ensure monitoring of supervisory tasks during a transitional phase, since real powers may continue to reside partly with the national authority until supervisory decision-making and capacity are in place at the ECB. Having a mechanism for the effective delegation and monitoring of supervisory tasks is also important in the steady state when a common backstop is in place.

Ensuring Real Powers

To ensure that national incentives are aligned with those of the center, and that the center has real powers in the conduct of supervision, further arrangements could be considered. For instance, the ECB could be provided with the ability to immediately conduct peer reviews and joint inspections, including lead supervisors from other countries or the ECB, with cross-country teams. The ECB could use a range of metrics, including solvency and liquidity stress tests, to discern which banks warrant particularly close attention or review by the ECB.

“Hub and Spokes” Model

Since all banks are to be included in the SSM, a division of labor between the center and national authorities is necessary, while all information should be shared among supervisory bodies of the SSM. Both of the two extreme models of the division of labor—full centralization and full decentralization—are neither practical nor desirable. A centralized system is not an option, given that supervisory knowledge and resources remain at the national levels. A decentralized mechanism, in which the center validates the decisions taken locally, is not desirable either, particularly when common backstops are fully in place at the euro area level, since consistency cannot be assured in the quality of the local implementation of supervisory practices. Conferring formal responsibilities on the ECB without adequate enforcement power could result in weak supervision and put the ECB’s reputation at risk.

Steady-State Framework

Common risk-based supervision in a supranational setting. A common analytical approach should be agreed to and applied to the SSM, comprising the ECB and national supervisory bodies. A risk-based framework would attribute a risk classification to each banking organization within the euro area. Based on this methodology, the ECB would develop a protocol for supervision and establish the frequency, level, and type of supervisory action to be conducted. The level of centralization and intrusiveness and the mix of multinational members in supervisory teams would be made proportionate to the supervisory assessment of risk. The model would also define a nonrigid perimeter of institutions subject to supplementary intense scrutiny by the ECB, allowing a fluid response to emerging information.

Principles. The framework should create a coherent and consistent supervisory mechanism with final decisions taken at the center. To promote incentive compatibility in the delegated supervisory mechanism, the extent to which the tasks or the supervision of a set of banks is divided between national authorities and the center could be derived from a set of principles, such as these:

1. The systemic dimension. The center will have a comparative advantage in adopting a systemic approach to supervision and internalizing cross-border externalities inherent to the supervision of systemically important financial institutions (SIFIs).

2. Local knowledge and know-how. National supervisors may have better specific knowledge about individual banks, and could therefore be more effective in supervising smaller banks.

3. Risks of regulatory capture. National supervisors may be more likely to favor national banks, which would create distortions that can have financial stability consequences for the region.

4. Discretion in decision making. The degree of delegation must decrease with the degree of discretion associated with specific tasks.

5. Consistency of delegation. When tasks are delegated, the consistency of approach among national authorities and between the national authority and the center is essential.

Bank classifications. An initial framework would classify each bank on the basis of size, interconnections, complexity, cross-border orientation, and whether the bank requires common funding, as follows.

• Group I: Global systemically important financial institutions, banks identified as systemic for the euro area, and banks requiring (or nearly requiring) direct recapitalization by the ESM.

• Group II: Banks of intermediate size, simple but potentially systemic for their sovereign (either individually or as a group).

• Group III: Very small banks unlikely to be systemic or to require access to a common backstop.

Delegation by group. The degree of delegation of day-to-day supervision by the ECB would vary by group. Group I banks would be under the direct and intrusive supervision of the ECB, which would maintain an on-site supervisory presence, with a mix of international supervisors in teams led by an ECB supervisor. Group II could be supervised mainly by national authorities, which would maintain an on-site presence, with supervision performed by teams of mixed nationalities appointed and compensated by their home countries (e.g., for governance purposes), and off-site monitoring by the ECB and the local supervisor. Day-to-day supervision of Group III banks would be fully delegated to the national authority, but the ECB would be entitled and ready to request participation equivalent to the other groups at any time (e.g., if a group of banks became systemic because of correlated exposures). For all groups, off-site monitoring should be carried out by the ECB and the local supervisor. The SSM regulation defines two categories of banks—“significant” banks, which are brought under the direction supervision of the ECB, and “nonsignificant” banks, which remain under the supervision of national authorities—which provides a system of delegation by groups of banks.

Delegation by task. Tasks that are more difficult to standardize, that require more intrusion and discretionary decisions, or that are more critical for the system as a whole or are more subject to political interference would be less conducive to delegation. National authorities could perform day-to-day assessments of banks’ soundness and carry out some examinations (provided they are consistency with the allocation of tasks by groups of banks). The assessment and monitoring of internal risk models could be performed locally, under general guidance from the ECB. But supervisory reviews, licensing, corrective actions, inspections, and decisions about imposing higher individual or macroprudential buffers and about sanctioning and initiating resolutions should be less amenable to delegation. Also undertaken by the center or by supervisors of mixed nationalities would be approvals for the use of advanced approaches, approvals of certain capital instruments, model validations, and thematic/horizontal inspections. The ECB should be closely involved in stress tests to identify pockets of vulnerability among euro area banks and in performing (or requesting from national authorities) intrusive examinations, approving mergers and acquisitions, and initiating early corrective actions, if needed.

Escalation of decision making. Supervisory responses should be escalated appropriately. Preliminary recommendations to address problems detected during supervision would need to be left behind by each inspection team, regardless of their level of risk. For banks with a higher risk classification, such as I and II above, review by the center would be required. For less systemic banks, the national level would implement corrective action and only elevate the issue to the center if concerns had not been addressed by the institution in the established timeframe. As a first step in escalation, inspection reports could be shared with different teams for a peer review.

Two-dimensional delegation. The allocation of tasks within the supervisory mechanism between the ECB and the national authorities could be based on a flexible approach, combining delegation by bank category and by task, with tasks escalating to the center as institutions become more systemic and tasks become more critical to financial stability and subject to greater discretion.

Transitional Stages

Steps toward the steady-state supervisory mechanism include these three stages:

First stage. In a first, urgent phase of the transition, the ECB must be provided with the full legal powers and protections needed to perform its supervisory tasks, including the powers to impose a complete range of corrective actions and initiate resolution. An embryo off-site supervisory structure and a decision-making body must be created at the ECB; standardized templates of information should be developed and supervisory data should be shared; outstanding legal uncertainties must be clarified (e.g., regarding the respective responsibilities of the ECB and national authorities). The centralized analysis should be used to create the first thresholds for centralized supervisory actions, and the classification of banks should be established. A balance sheet assessment of the most important euro area banks must be performed before the SSM becomes effective; it will be key to establishing the credibility of the ECB.

Second stage. In a second stage, the ECB should develop a consistent risk-based supervisory approach, establishing protocols that would specify, for example, the frequency, level, and type of supervisory action, the levels of centralization and intrusiveness, and the mix of multinational members in supervisory teams. It should also establish the characteristics of supervisory processes that will prevail in the steady state. The development of common protocols for corrective action should, ideally, be front-loaded, including protocols for the minimum actions by supervisors. Common timeframes for banks to address detected deficiencies and common settings for the escalation of corrective actions and sanctions should also, ideally, be established up-front.

Third stage. In a third stage, systemically important banks and, more generally, banks higher in the supervisory risk matrix would be brought under the direct supervision of the ECB, and common protocols and design of the system of delegation would be finalized.¹¹ When the ECB started supervising systemically important banks, international teams would start to perform risk assessments of each institution and develop supervisory plans for them. These plans would identify the areas that would need to involve mixed-nationality teams and would estimate the work force and skills needed at headquarters and at the national level. The ECB would decide the most suitable approach for the banks, including whether there was the need for a permanent presence, for intensive diagnostic on-site inspections before a regular cycle of on-site programs could be restored, or for the use of mixed-teams only for the supervisory review process and authorization for advanced approaches.

The Case for Centralization

The ECB should be given the responsibility and powers to perform macroprudential oversight in the euro area and involving national authorities.

Benefits. The ECB should act as a macroprudential oversight institution for euro area countries, with binding powers to use macroprudential instruments if it deems that necessary. The high degree of financial integration calls for a coherent approach to macroprudential policies, one that internalizes cross-border externalities and addresses information and home-host coordination problems when using macroprudential tools. Note, however, that the centralization of decision making does not imply a homogeneity of policies across countries. Policies would still need to be adapted flexibly to macrofinancial developments in particular countries or asset markets, and they would need to be applied to all financial institutions active in these countries or markets.

Costs and limitations. There are costs to building capacity for designing macroprudential policies tailored to specific country conditions. But given the ECB’s established expertise in financial stability, these costs might not be high. There could be an overlap with the role of the European Systemic Risk Board that would require some coordination. There could also be a risk that taking on macroprudential responsibilities could subject the ECB to political pressures or disagreements with national authorities, adding rigidities to the framework. Because the ECB mandate does not include insurance firms or securities markets, it would need to collaborate with competent authorities whenever such institutions were involved.

The Case for a Mixed Model

A pragmatic approach, as provided under the SSM regulation, may be a mixed model that would involve both the ECB and national authorities to ensure effective macroprudential oversight of the euro area, as implied in the legislative proposal for a SSM. In particular, the ECB could be conferred power to impose a systemic or countercyclical capital buffer if national authorities did not act, thus countering the lack of “will to act.” Other tools not included in the Fourth Capital Requirement Directive/Capital Requirement Regulation, such as limits on debt-to-income and loan-to-value ratios, could also be provided to the ECB when a common macroprudential toolkit was in place. Thus, the ECB would be provided a macroprudential mandate for the euro area as a whole and for individual countries.

Alternatively, if national authorities retained some macroprudential policies, as foreseen in the Council agreement, the use of tools might have to be coordinated and validated by the ECB, and mechanisms might need to be designed to resolve conflicts of interest that could arise between national authorities and the ECB (e.g., the ECB could be more prone to act than national authorities, who may be subject to political pressures).

The European Union Setup

The European Union can act only in those areas where it has exclusive or shared competencies, or can support the actions of the member states, as provided under the Treaty. When competencies are shared with EU member states (such as the single market for financial services), under the principle of subsidiarity the European Union may act only insofar as its objectives can be better achieved at the European Union level than at the member state level.

Legal Contours of the SSM

Regarding the supervisory sphere, Article 127 (6) of the EU Treaty provides that specific supervisory tasks may be conferred upon the ECB and therefore presumes the continued existence of “competent authorities of member states.” This implies a division of responsibilities between the ECB and national competent authorities and, consequently, constraints on the design of the SSM.

Governance

The governance arrangements of the ECB are not designed for a supervisory function, and country coverage is restricted to euro area member states. The Governing Council is the ultimate decision-making body of the ECB, as enshrined in the EU Treaty, including for any supervisory tasks conferred upon the ECB under Article 127 (6). The governance structure of the ECB hinges on its monetary mandate, since the Governing Council comprises the governors of the national central banks and the members of the Executive Board; heads of other national supervisory agencies cannot be part of the Governing Council. Given such predetermined design, a number of constraints, as well as legal, repu-tational, and implementation risks, may arise from the assumption by the ECB of supervisory tasks.

Legal Responsibility

Any ECB internal body established for a supervisory task, as foreseen under the draft SSM regulations, cannot have decision-making powers, which are ultimately vested with the Governing Council. Any delegation of activities to a supervisory board—composed of national and ECB representatives—cannot override such a setup.

Delegated Decision Making

The Governing Council will have to process a wealth of information on short deadlines. While being accountable for all supervisory decisions, the Governing Council will scarcely have the capacity to analyze each case brought to its attention. Rather, the Governing Council will validate the decisions prepared by the Supervisory Board, following a “silent procedure,” that is, the decisions will be deemed adopted unless the Governing Council objects within a short period (10 days in normal times, and two days in stressful times). The following risks are of potential concern.

• There is a risk that, within the supervisory board or Governing Council, decision makers may not be fully independent from national interests.

• There is a risk of conflicts of interest between the monetary policy function and the supervisory function. Given that the ECB Governing Council must pursue its primary objective of price stability, it may take decisions that from a supervisory perspective are not optimal.

• Member states that are not part of the euro area but join the SSM cannot be represented in the Governing Council, which will nonetheless take decisions affecting them. This may open the door to conflicts and accountability problems within the SSM. At the same time, if such states have the possibility to opt out of decisions taken by the Governing Council, the level playing field of the single market may be tilted.

Banks under Direct ECB Supervision

To ensure stability, it is essential that the ECB be able to identify risks at an early stage, including for banks that will not be under its direct supervision. The regulation of the SSM specifies a set of criteria to identify which banks are “significant” for the euro area and should therefore be directly supervised by the ECB, and which banks should remain under the direct supervision of national authorities. These criteria relate to the importance of cross-border activities, domestic and EU significance, and size. Moreover, the ECB will be able to designate as “significant” and bring under its direct oversight institutions (or groups of institutions) that could jeopardize the stability of the euro area financial system—for instance through their impact on the balance sheet of the respective sovereign. The SSM regulation safeguards the capacity of the ECB to investigate all credit institutions and bring them under its direct oversight at any time. Nevertheless, at least during the transition stage, the process of taking over credit institutions from national authorities may be lengthy and unwieldy and could therefore allow risks to build up.

Identification of Macroprudential Risks

The ECB will have to be able to identify pockets of growing systemic risks and take action at an early stage. A purely microsupervisory approach is insufficient when banks are interconnected or take correlated exposures and also when localized macroeconomic conditions affect a specific region or a specific type of institution. Thus, the microprudential analysis will need to be complemented with a macroprudential approach to risk assessment.

Incentives under Decentralized Supervision

National authorities may be biased toward favoring the national banking system. Risk-based supervision will always rely, to some extent, on supervisory judgment, and the ECB may rely on such qualitative assessment by national authorities. Yet national authorities may tend to be too optimistic about their respective banks, thus increasing the risk of supervisory slippage at the SSM level. The accountability mechanisms could reinforce these incentives to the extent that the ECB would be responsible for the effective and consistent functioning of the SSM and for the supervision of “significant banks,” while the National Competent Authorities under the instruction of the ECB would be responsible for the direct supervision of all other banks. The risk could be compounded during the transition due to the very limited resources available to the ECB, including resources to control actions at the national level. As a result, the ECB’s ability to reach its own supervisory judgment on the soundness of institutions’ risk management could be put at risk during the transition.

National Supervisory Practices, Frameworks, and Enforcement

In practice, the ECB will need to operate with recourse to the national supervisors for ongoing supervision, especially on-site supervision. Moreover, in order to apply nonpecuniary administrative sanctions—different from the remedial measures provided under the draft SSM regulation—the ECB will need to instruct national authorities, which will implement the sanctioning actions according to national laws. Recent Financial Sector Assessment Programs in EU countries have identified supervisory laws and practices—and especially enforcement practices—that differ from country to country and diverge from international best practices and standards. Thus, ensuring uniformity of treatment may be difficult.

National Resolution Regimes

The ECB will be given powers to withdraw a license, but until an SRM based on a strong single resolution authority is established, the SSM may have to operate with multiple regimes and authorities. This will entail additional operational complexity because the ECB, local supervisors, resolution agencies, and DGSs will have to interact both in the preparation and validation of recovery and resolution plans for SIFIs and in decisions leading to the possible withdrawal of bank licenses. Lack of a credible resolution framework could also impede timely decision making by leaving national authorities to deal with the fiscal consequences of others’ supervisory decisions.

Capacity, Expertise, and Resources of the ECB

Currently, the ECB has impressive human capital to conduct monetary policy and monitor financial stability in the euro area, but it has no supervisory expertise. Overall supervisory resources in the euro area are fixed in the near term; it will take time to build supervisory resources, skills, and expertise at the center without depleting the local level of its own needed experts. Although the dates for being operationally ready have been reasonably set in the SSM regulation, there is a risk that the ECB may be pressured to operate as a single supervisor before it is adequately resourced.

Data Management and Information Sharing

To operate, the ECB system and staff must be able to receive, store, and analyze large amounts of confidential information, and they must also be able to translate these analyses into supervisory operations and decisions. Establishing systems and internal mechanisms to handle these tasks will be demanding.

Harmonized Legislation

Agreement to and adoption of harmonized legislation should proceed swiftly, as should its transposition into national laws. From this perspective, it is important not only to adopt the Capital Requirement Regulation/Fourth Capital Requirement Directive, but to build a uniform single supervisory rule-book in the European Union. The rule-book should go beyond the necessary harmonization prompted by the Capital Requirement Regulation/Fourth Capital Requirement Directive, the BRRD, and the deposit insurance directive. The European Banking Authority can play a positive role here in ensuring that supervisory practices are harmonized.

Effective Governance

A steering committee, supporting the work of the Supervisory Board, will play a useful role in the chain of supervisory tasks that could avoid cumbersome processes at the higher level. The establishment of internal and external monitoring mechanisms or “watchdogs” would also enhance checks and balances, contribute to better scrutiny, and incentivize the effectiveness of the ECB supervision. Effectiveness could also be enhanced by a more significant representation of permanent, full-time officials or independent experts at the Supervisory Board who are not linked to national interests. In time, the governance structure could be buttressed by measures that would require a treaty change—for instance, allowing non-euro area countries to have representation in the Governing Council when deciding supervisory matters.

Accountability Mechanisms

Additional accountability mechanisms, such as the possibility of reporting to national parliaments in addition to the European Parliament, are provided in the SSM regulation. However, the respective responsibilities of the ECB and the NCAs should be clarified to help make the system of decentralization incentives compatible, given the ECB’s ultimate responsibility for ensuring the effectiveness of the SSM.

Risk Mapping Exercise

The ECB should receive from the national supervisors the risk assessments and local risk classifications of the local banks as soon as possible. Based on this information, the ECB would map banking risks and target supervisory actions accordingly—for instance, by requiring national supervisors to undertake additional due diligence on specific portfolios and capital planning, or by providing information on the availability of additional shareholder resources.

Asset Quality Assessment

The ECB must undertake an asset quality assessment or review for a set of banks as they are brought under the SSM. The exercise, which would need to be conducted with the involvement of the national supervisors and third parties, should follow harmonized guidance on how such assessments must be conducted, as issued by European Banking Authority, in coordination with efforts to review and harmonize data and relevant definitions (e.g., of nonperforming loans, provisioning rules, and risk weights). Such an asset quality review is critical to establish the credibility of the ECB as a supervisor. To ensure success, it should be based on a forward looking framework that incorporates risks to growth and is clearly communicated in advance of the exercise; it should cover all banks that will come under the direct supervision of the ECB.

Moreover, independent third-party involvement (preferably from the private sector), along with the ECB, the European Banking Authority for the stress tests, and national authorities, would be essential to ensure full credibility and transparency of the exercise. In the absence of such involvement, prospects for raising private capital would be jeopardized. There should be an agreed strategy on how to address capital shortfalls to avoid creating uncertainty and procyclical deleveraging. This would encourage a realistic write-down of assets and full recognition of losses, which would encourage private capital. Absent such a strategy, there is a high risk that the asset quality review (which will be followed by stress tests) would be counterproductive: if banks shed assets to preemptively build buffers, this could reinforce fragmentation rather than resolve it. The incentives to conduct a thorough and credible exercise could be distorted, whereas a clear plan would encourage a realistic write-down of assets and recognition of losses, which would help attract private capital. In the event that both private capital and fiscal space were limited, clarity about a common backstop would be critical to avoid reigniting adverse bank—sovereign links and to improve the incentives to recognize losses. The ECB announced the methodology for the comprehensive assessment of euro area banks on October 23, 2013. The exercise is expected to start in November 2013 and be completed in time for the SSM’s inauguration in January 2015 (see Box 11.1 for a description of the methodology of the comprehensive assessment).

ESM Recapitalization

Reaching final agreement on the possibility of ESM recapitalization of banks is of the utmost importance. The possibility of direct recapitalization of banks would provide incentives to make progress in addressing solvency issues in countries by relieving pressures on weak sovereigns. The interpretation given to the ESM Treaty is that it is flexible enough to enable the ESM to recapitalize banks directly—subject to political agreement and unanimous consent of the ESM membership. Indeed, under Article 19 of the ESM Treaty, the Board of Governors may also review and change the range of financial assistance instruments that can be made available by the ESM. The Board of Directors may adopt guidelines for implementing financial assistance through recapitalization or loans.

Ultimately, the breadth of the investment decisions that can be made by the ESM rests upon the decision of its member states, in due consideration of the risks and potential upsides or downsides inherent in such investments. It will be important to agree on and clarify the investment mandate of the ESM as well as the specifics of ESM recapitalization, including the definition of legacy assets, the pricing of assets, the role of bail-ins, the principle for access, and the design of instruments. Moreover, if the ESM were to inject ordinary equity into banks, governance arrangements and ownership policies would need to be carefully elaborated. Possible conflicts arising from concurrent significant stakes in competing institutions would need to be dealt with, and disclosure requirements would need to be strengthened.

Lastly, it would be important to ensure that the ESM had adequate capital, not only to allay any investor concerns about ESM credit quality, with resulting rating implications, but also so it could leverage its capital to play the role of a common backstop for bank recapitalization. The Eurogroup agreement of June 20, 2013, on the “ESM direct bank recapitalization instrument” is an important step forward and provides the main features of the operational framework, including conditions for access, time of entry, burden sharing, valuation, conditionality, and governance. Nevertheless, the recapitalization instrument will require further clarification and detailed features, in particular regarding the timing (since the final agreement has been linked to the adoption of the BRRD and the DGS Directive), conditionality, burden sharing, size, and conditions for access (see Chapter 13 for greater details).

Build Capacity and Expertise at the ECB

The ECB should be able to intervene in a timely manner in any bank, as deemed necessary, and it should be able to bring any bank under its direct supervision. The off-site supervisory structure should be established as soon as possible at the ECB. Specialist expertise should be hired externally and also obtained by secondments from national authorities. Cross-country teams led by an ECB supervisor should be in place as soon as possible for the most systemic or fragile banks (including those requiring ESM direct recapitalization). Funding of the ECB’s supervisory activities should be derived not only from transfers from the national supervisory authorities, but also from additional revenues, in part to minimize potential adverse effects on national supervisory resources.

Specify the Roles of National Authorities and the ECB

It will be important to specify the respective roles of national authorities and the ECB and how cooperative action under the SSM will be performed. The SSM hinges on a division of labor between the ECB and the national authorities. Clear, precise, and transparent rules defining such divisions of labor and the attribution of tasks given by the ECB to the national authorities will be important to prevent overlaps, gaps, or conflicts. For this purpose, the ECB should, as soon as possible, prepare a supervisory manual and clarify any outstanding legal uncertainties.

Define Steps Toward a Single Resolution Authority

EU authorities should define and agree on steps toward a single resolution authority and common backstops, and establish an SRM around the time the SSM is declared effective. It will reduce the risks of an incomplete framework and ensure that national interests do not prevail over that of the European Union. Pending the establishment of an EU-wide resolution framework, it is welcome that the prompt update of national resolution regimes has been agreed to be a priority. In the meantime, it is essential that an SRM be established for the countries participating in the SSM around the time that the SSM becomes effective. Leaving resolution at the national level while supervision was being centralized would carry significant risks, such as perpetuating bank—sovereign links and creating potential conflicts (and deadlocks) among national authorities. An SRM based on a strong centralized resolution authority would allow for swift decisions on burden sharing while ensuring stability and least-cost resolution.

An effective common fiscal backstop, combining a credit line to the ESM as a bridge to a more permanent solution and a single resolution fund backed by industry resources, would weaken sovereign-bank links. The European Commission proposal for an SRM, described in Chapter 12, is an important step forward, as it would provide the possibility for a strong central resolution authority backed by a single resolution fund, which are desirable characteristics, in time for the start of the SSM. However, the proposal itself would need to be strengthened along several dimensions and may be subject to legal challenges.

Develop the ECB’s Macroprudential Powers

The ECB should identify systemic risks, take early actions, and use macroprudential instruments when deemed necessary, in coordination with national authorities and the European Systemic Risk Board.