From Fragmentation to Financial Integration in Europe

Chapter 1. Securing a Safer Financial System for Europe1

Charles Enoch, Luc Everaert, Thierry Tressel, and Jianping Zhou
Published Date:
December 2013
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Charles Enoch, Luc Everaert, Thierry Tressel and Jianping Zhou 

The global financial crisis hit the European Union (EU) at a time when EU financial markets had moved a considerable way toward integration, and a European architecture to safeguard stability was being designed and was just beginning to be built. Since the start of the global financial crisis, it has become increasingly clear that resolution of the crisis, as well as maintaining stability thereafter, will depend upon the development and functioning of this architecture, and decisions made within this architecture, as well as those at a national level. Two somewhat contradictory forces are strengthening as the crisis continues: intensified progress toward a European framework, with new institutions established and old institutions given new powers; and retrenchment from integration as banks reassess risks in cross-border activities and de-lever from them, while governments and national supervisors—mindful of obligations to national taxpayers—seek ring-fencing and other constraints on cross-border activities to protect themselves from the costs that many of them have already incurred or will incur one way or another from the inability to handle cross-border considerations effectively. It is the restoration of confidence in financial stability in the EU—or, for a number of purposes, the euro area—as a whole, that will serve to mitigate and ultimately reverse this latter trend. Also, it is the emerging European architecture and its track record of operations as it comes into play that will be critical for establishing this confidence.

This volume derives from a study undertaken by IMF staff in late 2012 looking at EU institutions and the issues that they will need to address in this environment; it also draws upon analysis of comparable exercises at a national level. The next section summarizes the volume and elucidates what the various chapters will cover. The remaining sections of this chapter provide the overview and the key findings of the study.

Summary and Overview

From Integration to Crisis Management

Before the global financial crisis, Europe had made considerable progress in integrating its financial system, although the institutions supporting integration and stability remained mostly at the national level. The Treaty of Rome in 1957 put Europe on a steady course toward a single market. It proved much easier to integrate goods markets than markets in services, including financial services, but the Single European Act (1986) provided momentum for also a single financial market, characterized by free flows of capital and free provision of financial services across borders. Integration was facilitated by far-reaching political measures in the EU to reduce regulatory obstacles to cross-border activity, promoting a single market in financial services, and more specifically by the creation of the euro in 1999 following the 1992 Maastricht Treaty (see Chapter 2). The creation of the euro and expectations of convergence resulted in a surge in capital inflows to the emerging economies of Europe and to the periphery of the euro area. Large banks and insurance companies from western Europe established strong local presence in the newly opened emerging economies of Europe.

The process of financial market integration came to a halt, and indeed began to be reversed, after the 2008 global financial crisis. Prior to the crisis, integration was strong, albeit uneven, across countries and markets, and macro-financial risks were not fully foreseen (Chapter 3). Integration in the euro area had gone farthest in wholesale funding markets and bond markets while retail lending markets remained mostly national. Large EU banks had maintained strong expansion abroad and had broadened the scope of their activities, becoming larger, more systemic, and complex to resolve. When the crisis hit, fragmentation forces first affected emerging Europe as some banks from western Europe reduced or withdrew their presence, weakened by losses on legacy assets and facing funding pressures aimed at curtailing liquidity lines to subsidiaries, and in some cases encouraged by their home country supervisors. The so-called Vienna initiative brought together the major banks with supervisors and policy makers from both “home” and “host” countries, and helped stabilize the foreign capital invested in emerging Europe, although, it did not resolve underlying problems. The reassessment of risks by banks and their supervisors, and the lack of an effective cross-border resolution mechanism, led to a resumed reduction of cross-border exposures. Within the euro area, similar and even stronger reversals have contributed to fragment the financial system and disrupt the transmission channels of monetary policy. The collapse of cross-border exposures was particularly severe in the wholesale funding market and sovereign bond markets; the amplification of the resultant adverse sovereign-bank links caused the most visible and extreme problems in the periphery of the euro area.

Restoring financial stability in the EU has been a major challenge. The initial policy response to the crisis in the EU was handicapped by the absence of robust national and EU-wide crisis management frameworks. Moreover, the initial conditions and the macroeconomic background have made resolving the crisis particularly difficult. In the low-growth environment, several EU countries are still struggling to regain competitiveness, fiscal sustainability, and sound private sector balance sheets. Their financial systems are facing funding pressures as a result of excessive leverage, risky business models, and an adverse feedback loop with sovereigns and the real economy (Chapters 4 and 8).

Much has been done to address these challenges. Banks have boosted their capital adequacy ratios, although partly through deleveraging. Unconventional monetary operations have enhanced liquidity and firewalls have been put in place (Chapter 5). New tools for addressing financial stability, including coordinated stress tests, have come into play. The newly established European Supervisory Authorities (ESAs) are making their marks. More specifically, the European authorities are strengthening bank stress testing procedures and their application (Chapter 6). Following the poor reception of the 2010 exercise, the 2011 solvency stress testing and recapitalization exercises were marked by extensive consistency checks, higher hurdle rates, and more transparency about methodology and data, for example, regarding sovereign exposures. The exercises succeeded in prompting banks to increase the quantity and quality of their capitalization, and they contributed to a reduction in uncertainty and an increase in the credibility of the process. Progress has been made with bank resolution and restructuring, especially in the context of EU rules on national government support to distressed banks, whereas 10 to 15 percent of the EU banking system is now under the State Aid framework and undergoing some forced restructuring (Chapter 7). Perhaps most significantly, market confidence was enhanced with the agreement that was reached in December 2012 to establish a Single Supervisory Mechanism (SSM) for the euro area, but open also to non-euro area members.

Underpinning Financial Stability

Nevertheless, financial stability has not been assured. Despite banks raising more than €200 billion as a result of the European Banking Authority (EBA) recapitalization exercise, confidence in European banks is not fully restored, as market concerns remain about the quality of bank assets. Recent IMF Financial Sector Assessment Program (FSAP) assessments of individual EU member states have noted remaining vulnerabilities to stresses and dislocations in wholesale funding markets; a loss of market confidence in sovereign debt; further downward movements in asset prices; and downward shocks to growth. These vulnerabilities are exacerbated by the high degree of concentration in the banking sector, regulatory and policy uncertainty, and the major gaps in the policy framework that still need to be filled.

A key priority, EU-wide, is to complete the framework for financial oversight needed to sustain a currency union and the single market for financial services. The crisis has shown that national decisions, even well-intended ones, have Union-wide repercussions on financial stability, and that there is a need for single frameworks for crisis management, deposit insurance, supervision, and resolution, with a common backstop for the banking system, especially for the monetary union. Recent measures taken by national authorities and central banks, together with a euro-area-wide backstop for sovereigns, have mitigated downside risks. Although progress has been made, the lack of a full embrace of a Union-wide approach to financial stability leaves the system vulnerable to shocks and generates incentives for national ring-fencing and fragmentation.

In the near term, more forceful action is warranted to cement recent gains in market confidence and end the crisis. The priorities are repairing bank balance sheets, including addressing impaired assets; fast and sustained progress toward the SSM and the banking union; and essential steps toward a stronger EU financial oversight framework. Governance arrangements need to be adapted to have an EU- (or banking union)-wide perspective and also evolve to meet the diverse needs of members of the euro area, SSM members not part of the euro area, and other members of the EU (Chapter 9). The effectiveness of the banking union will also hinge critically on strong legal underpinnings (Chapter 10).

It will be critical that the SSM delivers high-quality supervision as soon as it becomes effective (Chapter 11). Operational risk regarding the SSM needs to be guarded against by ensuring that the European Central Bank (ECB) builds supervisory expertise of the highest quality and has at its disposal resources commensurate to its supervisory tasks. The ECB’s effectiveness as a supervisor needs to be safeguarded by giving it powers to maintain general oversight over all banks and to intervene when necessary in any bank, and ensuring information-sharing and cooperation within the SSM. The ECB’s governance and its “will to act” need to be robust, including through ensuring that the SSM avoids “nationality dominance” and that a regional perspective is consistently maintained.

The SSM—while critically important—represents only one of a number of crucial steps that need to be taken to fill key gaps in the EU’s financial oversight framework. The Single Resolution Mechanism (SRM) should become operational at around the same time as the SSM becomes effective (Chapter 12). This should be accompanied by agreement on a time-bound roadmap to set up a single resolution agency and common deposit guarantee scheme (DGS) with common backstops (Chapter 14). Eventually providing an explicit legal underpinning for financial stability arrangements of a fully fledged banking union would further strengthen the framework. Recently agreed guidelines for the ESM to directly recapitalize banks need to be finalized as soon as possible, so that it becomes operational as soon as the SSM is effective (Chapter 13).

Proposals by the European Commission (EC) to harmonize capital requirements, resolution, deposit guarantee scheme, and insurance supervision frameworks at the EU level need to be implemented promptly. Recent European Council agreement on the Bank Resolution and Recovery Directive is welcome, as it will introduce bail-in of bank creditors and depositor preference. In addition, more effective supervision and resolution arrangements need to be worked out for financial institutions crossing the borders between the SSM and the rest of the EU and beyond.

Meanwhile, the ESAs and the European Systemic Risk Board (ESRB) need further strengthening. Governance arrangements need to be adapted to avoid potential national biases (Chapter 15). The European Banking Authority (EBA) can play an important role in ensuring a level playing field between countries inside and outside the SSM (Chapter 16). It should be more assertive in cross-border colleges of supervisors and crisis management groups. Importantly, it should ensure that national authorities are undertaking careful and consistent analysis of the underlying quality of bank assets, to ensure the credibility of its stress tests (Chapter 17). The European Securities and Markets Authority (ESMA) has performed well during its first two years of operation, especially in connection with the single rulebook and credit rating agency (CRA) supervision. Going forward, it would need to step up its role in other areas, in particular on supervisory convergence (Chapter 18). Significant issues in insurance also require attention. Importantly, a weak economic environment, if it persists, can threaten the financial health of the life insurance and the pensions industries as they have already been adversely affected by exposures to banks and sovereigns, and they will need to cope with stricter Solvency II requirements (Chapter 19). The European supervisor on insurance and pension funds (EIOPA) has had intensive engagement in its oversight role of supervisory colleges, but much work remains to be done.

The ESRB, as the EU systemic risk watchdog, should play a more important role, and modalities for interaction with the SSM needs to be devised (Chapter 20). It usefully set out in its recommendations the macroprudential policy mandate, institutional arrangements, and more recently, a proposed macroprudential toolkit for EU member states. It needs also to analyze macroprudential effects on the cyclical downside and not just the upside, and ensure consistent application of macroprudential policies across the various parts of the financial sector and across the EU. The ECB’s macroprudential tools should go beyond those identified in the EU’s fourth capital requirements directive (CRD IV). For all these agencies, their heightened responsibilities would warrant increased resources.

Strong coordination across the various supranational agencies will be critical, so that decision-making can be smooth and policies consistent. Especially for crisis management, it would be desirable to establish a mechanism or a committee that brings a holistic perspective, integrating the crisis related work of the ESAs, the ESRB, the SSM, the forthcoming resolution agency, the EU Directorate-General for Competition (DG COMP), and the supranational support facilities.

Risks related to financial infrastructure seem to be manageable but care will be needed on this front too (Chapter 21). The EA’s central bank payment system, TARGET2, functioned well in the crisis although it would be safer if enhanced by information-sharing with the ECB. The ECB’s’ capacity and competences over payments systems should be strengthened as it moves toward a risk-based oversight approach. Increasing reliance on Central Clearing Counterparties (CCPs) and Central Securities Depositories (CSDs) reduces overall risk to the financial sector; risks in the event of the failure of a CCP or CSD are substantial, however, and important work is in train to seek to address them.

Real estate boom-and-bust has seriously endangered financial stability in several European countries, for example Ireland and Spain. The experiences of these countries demonstrated that mortgage laws and practices could lead to different outcomes in terms of mortgage default and foreclosures, as well as influence the speed of resolving the mortgage crisis and recovering of the housing market. Delays in the foreclosure processes create room for moral hazard that lead to increases in default rates (Chapter 22).

Beyond the Crisis

Low growth or renewed recession in the EU makes emergence from the financial crisis and the construction of a framework for financial sector management much more difficult. Past financial crises have been resolved to a considerable extent by the resumption of strong growth, often external, that drove down debt ratios and enabled affected countries to emerge from austerity programs before austerity fatigue had set in too heavily. Earlier forecasts for growth in Europe are now regarded as having been overly optimistic, with some of the countries mostly affected by the crisis showing significant declines in output for several years ahead, and even the stronger economies not providing a powerful enough engine to lift the region as a whole.

The present environment makes even stronger the case for a number of the policies put forward in this volume. Most fundamentally, it reinforces the message about the need to reverse fragmentation and resume economic and financial integration. Given where we are, only a secure and credible EU financial management architecture can be expected to reverse this fragmentation and to provide for resumption in Europe’s progress toward creating a genuine single market. This in turn would contribute toward stimulating growth both in the region and in the wider global economy.

The new financial architecture is being established against two basic paradigm shifts: first, that financial sector oversight in the EU can no longer be predominantly national; and second, that concern for financial sector stability will no longer be an argument justifying that the public sector (the “taxpayer”) will pick up the pieces when things go wrong. But the new paradigms themselves pose challenges.

As important, the oversight architecture being put in place is designed to eliminate, or at any rate to minimize, bailout-related public sector expenditures. Several factors have driven the consensus away from using taxpayer money to resolve banking problems. The first is that most EU countries feel they have exhausted their fiscal space, and that protecting their banks would not be their greatest priority. Moral hazard is the second factor leading to a change in paradigm. Public sector support is seen as a “bail out” of the banks, which in turn implies that the private sector does not incur the costs of its own actions and may therefore not be deterred from undertaking such actions again. While the recent financial crisis was geographically and quantitatively different from previous ones, many of the largest banks played a repeat role in the crisis, having been involved earlier in other crises in other places. There is an increasing view that with bailouts lessons may not be fully learned, and that behavior leading to crisis may rapidly resume.

Proposals to “bail-in” creditors as an alternative to taxpayer bailouts have been in the center of policy debate, often with confusion. Bail-in, a statutory power to recapitalize a distressed systemically important financial institution by writing down or converting (or both) its unsecured debt while maintaining its legal entity, could be a useful additional tool to a resolution toolkit that could help restore a distressed financial institution to viability while reinforcing market discipline and minimizing counterparty risks associated with a disorderly liquidation. However, a clear and coherent legal framework for bail-in is essential. To safeguard financial stability, statutory bail-in mechanisms must be carefully designed to manage systemic risks, including counterparty risks, liquidity risks, and contagion risks (Chapter 23). More importantly, insolvent banks should be allowed to fail in an orderly fashion and with other resolution tools.

Proposals to separate banks’ retail activities from those deemed more risky are no panacea. However, such separation could reduce cross-subsidization of the latter and could make resolvability easier (Chapter 24). These proposals are not substitutes for other enhancements in loss-absorption capacity, such as capital surcharges, bail-ins, ex ante deposit insurance funds, and common backstops, which should in any case be taken forward. Also, care must be taken to avoid regulatory arbitrage to the extent that EU or national proposals differ.

Taking forward the reform agenda set out in this book is urgent and critical for resolving the crisis, and it cannot wait until the economic environment has improved (Chapter 25). Indeed, as argued here, the environment may well not improve until the reform agenda is in place. Reversing the fragmentation in EU financial markets, enhancing disclosure of financial statements, and increasing transparency more generally, as well as building strong banks, are necessary and interrelated conditions to create for the best possible backdrop for taking forward the agenda to establish the new architecture for European financial oversight.

Main Findings

The Regional Dimension for Financial Stability in Europe

The recent financial crisis has underscored the need for the EU to take a regional approach to financial stability. The regional dimension is important at two levels: first, the single currency area that binds many EU countries and second, the existence of an EU-wide single market for financial services. Together, these have left countries highly interconnected through substantial cross-border exposures and common money and capital markets.

Preserving financial stability in such an environment requires a supranational oversight framework. Its construction has been under way for more than a decade, supported by the Lamfalussy process and the follow up to the De Larosiere report, which established the ESAs and the ESRB. However, as flagged in the 2011 European Financial Stability Framework Exercise (EFFE), crisis management and resolution remains an important gap, and it was noted that the new ESAs and ESRB would face challenges to establish their credibility.

Progress has been made toward stronger pan-European approaches. A number of crisis management tools have been established beyond the national level, such as through the European Financial Stability Facility/European Stability Mechanism (EFSF/ESM). EU institutions, such as the DG COMP, have sought to incorporate financial stability considerations in their operations. Meanwhile, central banks engaged in unconventional policies to support macro-financial stability and buy time to address deep-rooted problems. IMF-supported programs were necessary to prevent deeper crises in parts of the Union. The regulatory reform agenda has accelerated and, most fundamentally, the Single Supervisory Mechanism is being established as an element toward the banking union.

The focus of this volume is on these supranational institutions. It assesses the effectiveness of the institutions and the possible contributions of the proposed institutional reforms to financial stability. It analyzes how the EU and European Economic and Monetary Union (EMU)-wide institutional setups can complement national financial stability frameworks and how financial stability risks can be further mitigated. It defers to national Financial Sector Assessment Programs for quantitative analysis to avoid duplication, but draws from them as well as from recent Global Financial Stability Reports (GFSRs) for its financial stability assessment, and from staff papers on the banking union for policy recommendations (Goyal and others, 2013).

Systemic Risk and Vulnerabilities Across Borders

The current financial turbulence in Europe has multiple causes, with EU and EMU-wide policy frameworks playing an important role. Financial innovation, deregulation, and soft touch supervision were key factors that led to the global financial crisis. Europe was afflicted and probably hit harder than other parts of the world because of its traditional reliance on bank-based finance and high bank leverage (Figures 1.1 and 1.2).

Figure 1.1Overview of Financial Structure

(in percent of GDP)

Source: World Bank Financial Structure database (2012).

Note: Data are for 2010, except private credit 2008 for Bulgaria, Czech Republic, Denmark, and Hungary.

Figure 1.2Capital-to-Asset Ratio

(in percent)

Source: IMF, Financial Soundness Indicators.

Note: 2012:Q2, except for Bulgaria (2009), Spain, France (2010), Lithuania, the Slovak Republic (2012:Q1), and the United Kingdom (2011:Q4).

EU and euro area institutional features and the absence of an EU-wide crisis manager amplified the crisis when it hit:

  • Single market in financial services. The EU’s objective to create a single market in financial services, including through passporting and cross-border branching, led to rapid financial integration and sharp increases in cross-border exposure (Figure 1.3).

  • National approach to supervision. Countries continued their own supervisory approach and national financial systems varied in size and structure and relative to fiscal capacity (Figure 1.4).

Figure 1.3Total Intra-EU Foreign Exposure

(in billions of euros)

Source: Bank for International Settlements (BIS) consolidated banking statistics, immediate risk basis.

Note: Ireland and Finland not included due to breaks in data reporting.

Figure 1.4Selected Advanced Economies—Assets of Four Largest Banks/GDP

(in percent)

Sources: Bloomberg, L.P.; and IMF staff calculations.

  • Monetary union. The elimination of currency risk and interest rate convergence contributed to rising cross-border lending, including to sovereigns. However, mechanisms to instill discipline through the Stability and Growth Pact and markets failed.

  • Commitment to euro adoption by the emerging market economies in the EU. Financial liberalization upon joining the EU led to very large investments in western European banks, while expectations of euro adoption fostered foreign currency borrowing. Together with deep integration came credit booms, especially in countries pegging their currencies to the euro (Figures 1.5 and 1.6).

Figure 1.5Market Shares of Foreign Banks in EU Member States

(2011, in percent)

Sources: European Central Bank, Financial Structure database (2011); and Monetary Financial Institutions database.

Figure 1.6Selected Emerging European Countries—Real Private Credit

(Index January 2008 = 100)

Sources: Bloomberg, L.P.; and IMF staff calculations.

EU-wide institutions, still in their infancy, lacked the power to respond to the contagion within the Union. Initial policy responses by national and EU authorities sometimes led to adverse policy spillovers (Figure 1.7). Examples include the guaranteeing of all liabilities of the Irish banking system and the decision to break up some troubled cross-border institutions along national lines. As a result, central banks, in particular the ECB, were forced to step in with unconventional measures, to buy time to address underlying problems (Table 1.1).

Figure 1.7Spillover Coefficient Country Groups

Chart Technical Explanation

The Spillover Coefficient (SC) is estimated in order to quantify the role that contagion plays in driving sovereign spreads. The SC characterizes the probability of distress of a country conditional on other countries becoming distressed. The SC embeds sovereigns’ distress dependence, and how such dependence changes along different periods of the economic cycle, reflecting that dependence increases in periods of distress.

For each country Ai, the SC is computed using the formula: SC(Ai) = ∑P(Ai/Aj) · P(Aj) for all j ≠ l, which is essentially the weighted sum of the probability of distress of country Ai, given a default in each of the other countries in the sample. This measure of distress dependence is appropriately weighed by the probability of each of these events to occur.

The probability of sovereign distress in country Ai, given a default by country Aj, referred to here as the probability of Ai, given Aj, denoted by P (Ai/Aj), is obtained in three steps: (1) the marginal probabilities of default for countries Ai, and Aj, P(Ai) and P(Aj), respectively, are extracted from the individual credit default swap (CDS) spreads for these countries; (2) then, the joint probability of default of Ai, and Aj, P(Ai, Aj), is obtained using the consistent information multivariate density optimizing (CIMDO) methodology, which embeds sovereigns’ distress dependence, and its changes at different points of the economic cycle.1 (3) Finally, the conditional probability of default P(Ai/Aj) is obtained by using the Bayes’ law: P(Ai/Aj) = P(Ai,Aj)/P(Aj).

Sources: Bloomberg, L.P.; and IMF staff calculations.

1 The CIMDO methodology is used to estimate the multivariate empirical distribution (CIMDO distribution) that characterizes the probabilities of distress of each of the sovereigns under analysis, their distress dependence, and how such dependence changes along the economic cycle.

Table 1.1ECB: Unconventional Measures 2007 To Date
Decision dateMeasure
October 8, 2008Fixed rate, full allotment tenders adopted for weekly main refinancing operations, for as long as needed.
Reduction of the corridor between standing facilities to 100 basis points, for as long as needed.
October 15, 2008Expansion of eligible collateral through end-2009.
Enhance longer term refinancing operations through end-Q1:2009.
Provision of U.S. dollar liquidity through foreign exchange swaps.
December 18, 2008Increase of corridor between standing facilities to 200 basis points.
February 5, 2009Fixed rate, full allotment tenders to continue for as long as needed on all main, special term, supplementary, and regular longer-term refinancing operations.
Supplementary and special term refinancing operations to continue for as long as needed.
May 7, 2009One year long-term refinancing operations introduced. Covered bond purchase program announced.
March 4, 2010Return to variable rate tender for three-month long-term refinancing.
May 10, 2010Securities Markets Program introduced to intervene in the euro area public and private debt securities markets.
Fixed rate, full allotment tenders adopted and extended for regular three-month long-term refinancing.
August 4, 2011Supplementary longer-term refinancing operation with a maturity of approximately six months, fixed rate and full allotment introduced and subsequently extended.
October 6, 2011Two longer-term refinancing operations introduced—one with a maturity of approximately 12 months in October 2011, and another with a maturity of approximately 13 months in December 2011. New covered bond purchase program launched.
December 8, 2011Further nonstandard measures introduced, notably: (1) to conduct two longer-term refinancing operations with a maturity of approximately three years; (2) to increase the availability of collateral; (3) to reduce the reserve ratio to 1 percent; and (4) for the time being to discontinue the fine-tuning operations carried out on the last day of each maintenance period.
February 9, 2012Further collateral easing by approving specific national eligibility criteria and risk control measures for the temporary acceptance in a number of countries of additional credit claims as collateral in Eurosystem credit operations.
September 6, 2012Outright Monetary Transactions introduced to purchase sovereign bonds in the euro area in secondary markets.
Sources: European Central Bank and IMF staff.
Sources: European Central Bank and IMF staff.

The absence of a robust cross-border crisis management framework in the EU contributed to negative sovereign-banking loops and financial fragmentation. Where sovereigns ran into trouble, the banking system suffered as the value of sovereign backstops fell and funding costs rose. In countries where banking systems had to be supported, the sovereign weakened, in turn reducing the value of its banking system support. In both cases, the real economy suffered, further fueling the adverse loop (Figure 1.8). This situation led to a reversal of cross-border capital flows and a reduction of cross-border holdings, especially affecting the euro area periphery; this reversal was only stemmed with the introduction by the ECB of its Outright Monetary Transactions program (Figure 1.9).

Figure 1.8Correlations of Sovereign and Bank Credit Default Swap (CDS) Spreads

(January 2010–October 2012)

Sources: Bloomberg, L.P.; and Dealogic.

Figure 1.9Deleveraging by Euro Area Banks—Domestic and Cross-Border

(September 2008–September 2012)

Sources: European Central Bank, Consolidated Banking Statistics; and IMF, International Financial Statistics database.

Note: MFIs = monetary financial institutions. Domestic claims on MFIs are adjusted to exclude claims on the Eurosystem.

Recent financial sector assessments at the national level illustrate that financial stability remains tenuous. Risks include the continued threat of stresses and dislocations in wholesale funding markets; deteriorating or high sustained sovereign risk; and further downward movements in asset prices. Macroeconomic risks are associated with a global recession and protracted slow growth in Europe. Regulatory uncertainty and high concentration in the banking sector in some countries could amplify vulnerabilities (see Chapter 6).

Policy initiatives have helped ease funding pressures, but fragilities and challenges remain. Aggregate capital ratios have increased, but differ considerably between stronger and weaker banks. Banks now face the consequences of the economic slowdown on asset quality, while longer-term market and regulatory forces add to the pressure. Together with weak demand, credit growth has become anemic across the region.

Fragilities stem from four intertwined vulnerabilities:

  • Low growth. Reflecting deep recessions in the euro area periphery, real activity in the euro area is projected to decline slightly in 2013 while slowing in most other EU countries. Low growth will put bank profitability at risk, removing an important source of capital growth. Solvency in the insurance sector is under pressure from low returns and the stagnant economy (Figure 1.10).

Figure 1.10Insurance Market Capitalization in Billions of Euros and Credit Default Swap (CDS) Spreads

(in basis points, 2007–2012)

Source: Bloomberg, L.P.

  • Fiscal vulnerabilities. Lackluster growth will hamper efforts to restore fiscal sustainability where needed. Weak confidence in the fiscal sustainability of many euro area members—and fiscal crises in some—has severely undermined banks given their large exposures to sovereigns.

  • Funding pressure. Market funding remains a challenge with wholesale markets segmenting along national borders, and many banks remaining reliant on central bank support. The eventual withdrawal of central bank support operations will be challenging for many banks.

  • Deleveraging. Since 2008, EU banks have deleveraged considerably, mainly across borders, including outside the EU. Bank deleveraging can be explained by structural and cyclical forces (see IMF, 2012a and 2012b). These include adjustment of business models to new regulatory and economic environments; pressures to build capital; reduction in reliance on unstable market funding; and strained financial conditions and weak demand for credit. Tight lending conditions risk weakening growth and the scope for repairing balance sheets.

Overcoming the Crisis—the Supranational Dimension

Moving banks and sovereigns jointly to safety is essential. This should be accomplished by policy combinations that strengthen banks without weakening public sector balance sheets or vice versa. The first set of policies involves raising private capital. The second set involves policies, such as bail-ins, that minimize the potential burden on the taxpayer from too-important-to-fail institutions. If national capacity is insufficient, support from supranational entities should be deployed in the form of direct support for banks and asset management companies (capital and guarantees); common backstops and safety nets (deposit guarantee schemes, and resolution funds); borrowing from official sources; or further fiscal integration. Many of these elements will be facilitated for those countries that join the prospective banking union.

Good progress has been made but gaps and challenges remain:

  • Bank recapitalization. Banks have raised considerable new capital, both in the context of the European Banking Authority recapitalization exercise and national efforts, but pockets of weak banks remain.

  • Banking system restructuring. During 2007–2012, the number of credit institutions fell by 5 percent: 20 banks were resolved, or are in the process of resolution, and 60 banks have undergone deep restructuring. However, many banks are still excessively dependent on wholesale funding, while others remain exposed to illiquid or impaired assets.

  • Burden sharing with creditors. Recourse to bail-in may be more difficult during periods of stress, and only a handful of banks have so far made progress in raising liabilities subject to bail-in.

  • National sovereign support. Financial system support from sovereigns has been large, which has sometimes triggered an adverse loop between banks and some sovereigns.

  • Sovereign adjustment. Virtually all EU countries have embarked on fiscal adjustment and other reforms to strengthen the sovereign.

  • Supranational support. The EFSF and ESM have provided support to sovereigns in funding difficulties. The eurogroup has reached agreement on the main features of the operational framework of the ESM direct recapitalization instrument but the operational framework must be finalized as soon as possible.

  • Resolution in systemic situation. Common fiscal and monetary backstops are essential, alongside bail-ins and resolvability, to cope in an effective and orderly way.

More forceful steps to overcome the crisis can and should be undertaken in three areas:

  • Bank balance sheet repair. Progress toward strong capital buffers needs to be secured. Greater disclosure requirements, especially of impaired assets, would buttress credibility in the improvement in banks’ condition. The forthcoming asset quality review of euro area banks, required ahead of the start of the SSM, provides an opportunity to resolve the uncertainty about bank balance sheets and improve the prospects for attracting private capital to weak banks. It is also critical to establish the ECB’s credibility as a supervisor.

  • Fast and sustained progress toward an effective SSM and banking union. This will anchor financial stability and ongoing crisis management, and allow the ESM to directly recapitalize banks, thereby weakening the bank-sovereign link. Interests of member states not in the euro area—both those that join the SSM and those that do not—will need to be protected.

  • Further steps toward a stronger EU financial oversight framework. Finalization of the capital requirements directive and regulation is welcome. With respect to capital requirements directives and regulations (CRD IV/CRR), full consistency with Basel III is essential. Swift adoption of the resolution and deposit guarantee scheme directives, as well as strong coordination across various institutions, are important to achieve policy consistency, including with national policies.

With weaknesses in national resolution regimes and without an EU-wide common resolution framework, implementation of the resolution directive is essential. Some enhancements are necessary: to allow for strong early intervention powers; clarification on mechanisms to constrain discretion in bail-ins is needed to ensure predictable and consistent application across countries; introduction of depositor preference in the Council agreement is welcome. Meanwhile, national legal frameworks need to be modified to facilitate borrower restructuring and accelerate collateral repossession to free up management resources, capital, and funding to support viable projects and fuel economic activity.

With the European Central Bank taking on supervision for a large subset of EU members, safeguards for non-SSM members need to be built into governance arrangements for the other pan-European institutions. Coordination across the various supranational agencies will be critical, so that decision-making can be smooth and policies consistent. Especially for crisis management, establishing a mechanism or a committee that brings in a holistic perspective, integrating the crisis related work of the ESAs, the ESRB, the SSM, the forthcoming resolution authority, DG COMP, and the supranational support facilities would be desirable. Within the euro area, such enhanced coordination would be essential.

In addition, a statutory mechanism can be considered to provide clarity, powers, responsibility, and accountability during systemic situations. Such systemic risk exception would lend clarity and credibility to the bank resolution process. Formal vetting procedures would limit moral hazard and protect resolution funds.2

Banking Union—Implementation and Risk Mitigation

The proposed roadmap to a banking union represents a critical way forward. The banking union’s effectiveness will require that the ultimate financial stability framework includes all elements, such as the SSM, the single resolution mechanism based on a single resolution authority, and the common financial safety net, underpinned with a strong legal basis. Meanwhile, risks to the design of the SSM and the ongoing transition to a banking union need to be mitigated.

Single Supervisory Mechanism

The Basel Core Principles provide a basis for defining key elements for an effective SSM. These include (1) operational independence; (2) clarity of objectives and mandates; (3) legal protection of supervisors; (4) transparent processes, sound governance, and adequate resources; and (5) accountability. The EU Council agreement by and large is in line with these prerequisites, but clarity is required, including on resources and responsibilities within the SSM.

The December 12, 2012, agreement on the establishment of the SSM and announced roadmap toward a banking union is appropriately ambitious. It also correctly calls for giving the utmost priority to the adoption of a harmonized regulatory set-up (the CRR/CRD IV), and to reaching agreement on the draft directive for bank recovery and resolution and harmonization of deposit guarantee schemes. A proposal for a single resolution mechanism has been put forth by the European Commission on July 10, 2013.

Establishing the SSM under the existing EU Treaty has implications for its governance and powers. Given the Treaty requirement that all ECB decisions must be made by the Governing Council that comprises only member states in the euro area, a newly created Supervisory Board, comprising representatives from all EMU countries and any other EU member states that join the SSM, will undertake the planning and execution of the supervisory tasks conferred on the ECB, including the proposal to the Governing Council of draft decisions. The Governing Council of the ECB, which comprises the governors of euro area national central banks and the members of the ECB Executive Board, formally has the ultimate decision-making power for any tasks carried out by the ECB, including supervision.

Risks arising from these governance arrangements will need to be guarded against:

  • Decisions by the Supervisory Board may not be fully independent from national interests. The ECB functions in a nationality-blind manner, but it will be harder to ignore national interests when taking supervisory decisions, particularly at the outset.

  • As the Governing Council of the ECB will be in charge of both supervisory and monetary policy decisions, the ECB will need to establish a comprehensive framework for transparency and accountability for the SSM and Chinese walls between supervision and monetary policy at an operational level. Nonetheless, the setup should still permit synergies between the two functions, for instance from data sharing. Accountability needs to be further safeguarded through appearances of the ECB leadership before the European Parliament, and where relevant also before national parliaments.

  • As non-EMU countries cannot vote on the Governing Council, credibility in the maintenance of a level playing field for such countries that join the SSM will need to be achieved through the operation of the envisaged special arrangements.

The ECB is to take direct supervisory responsibility for the largest 150 banks and for the effectiveness of the SSM, but will have authority to directly supervise any bank it deems necessary. The mandate appears pragmatic, given the resource and other challenges that will be faced by the ECB, and it will be important that the metrics for identifying the 150 banks are clear and capture the importance of a bank in cross-border activities, and in domestic and EU significance. However, the crisis has illustrated that problems can emerge also from amongst the smaller banks, especially when confidence is fragile. According to the EU Council Agreement, the ECB retains the responsibility and scope for oversight over the rest of the banking sector and has power to quickly exert direct supervisory authority over any bank, or group of banks, if it deems it necessary. To ensure consistent supervision and safeguard against forebearance, the national supervisory authorities, which will continue to supervise most banks in the countries covered by the SSM, are required to share information and cooperate among each other and with the ECB.

Transition risks will need to be managed. Initially, the ECB will need to rely on cross-country teams supplied by national authorities and led by an ECB supervisor. It will be critical to avoid mistakes during this start-up period, since these could cause a loss in credibility that would take much time and effort to reverse. The bank asset quality review undertaken by the ECB with national authorities and coordinated with the EBA will be critical to establish the credibility of the ECB as a supervisor, avoid early difficulties, and get a better understanding of the condition of the banks. The ECB has scope to postpone the date when the SSM becomes effective if the bank feels it is not ready. However, this may have knock-on effects; thus every effort is needed to ensure that the ECB has its necessary resources in place by the SSM’s October 2014 postulated starting date.


It is essential that an SRM for the countries participating in the SSM be established around the same time that the SSM becomes effective. As banks are too interconnected to be effectively supervised at a national level, national resolution regimes would have difficulty, even under harmonized arrangements, in handling the bigger banks of the EU or cross-border contagion. Moreover, incentives among national resolution authorities for least-cost and rapid action to address problems could remain limited; also, coordination difficulties, especially for large cross-border banks, may undermine effectiveness. In addition, there is the danger that—absent a single resolution mechanism—national authorities could be left to bear the fiscal implications of decisions made by the ECB, which would perpetuate bank-sovereign links and create potential conflict (and deadlock) among national authorities in cross-border resolution. As crisis tensions abate, it is important that the implicit sovereign bank guarantees in place for the last several years be effectively removed through a reaffirmation and implementation of the principle that institutions with solvency problems must be resolved. To be fully aligned with best practices, the resolution authority should seek to achieve least-cost resolution of financial institutions without disrupting financial stability. It should protect insured depositors and ensure that shareholders and unsecured, uninsured creditors absorb losses. The SRM will need a mandate to intervene before insolvency using well-defined quantitative and qualitative triggers. It will need strong powers and a range of tools to restructure banks’ assets and liabilities (for example, bail-in subordinated and senior unsecured creditors; transfer assets and liabilities with “purchase and assumption;” and separate bad assets by setting up asset management vehicles); override shareholder rights; establish bridge banks to maintain essential financial services; and close insolvent banks. Coordination with the SSM should be ensured, particularly when early intervention measures are triggered by the SSM.

The SRM will need to coordinate closely with other EU institutions. Coordination with the SSM could be through regular formal meetings with the Chair of the supervisory board of the ECB. Alternatively, the SSM Chair of the supervisory board could serve on the board of the SRM, together with national representatives and representatives of other EU bodies. Coordination with DG COMP will also be important, as unless and until all EU member states participate in the SRM, its interventions may be subject to State Aid rules. Finally, as most large euro area banks have presence outside the BU perimeter, there will need to be coordination between banking union resolution authority and those in the remaining EU states and possibly beyond.

As with the SSM, use of the existing treaty framework determines the structure and operations of the SRM. The SRM will use the framework of the resolution directive, rely in the first place on financing from national authorities, have powers such a bail-ins to reduce likely exposures, and have the ESM as financing backstop. In time, a single dedicated resolution authority should be created. This authority should have backstop financing, including through a single resolution fund. It will need to coordinate closely with the national resolution agencies in the member states outside the banking union, as well as countries outside the EU.

Legal Basis

Due care has been given to underpinning the proposed BU with an as strong as possible legal basis under the current treaties. Article 127(6) of the Treaty on the Functioning of the European Union allows the conferral of specific supervisory tasks to the ECB, and is now being used to establish the SSM. Certain elements of an effective safety net such as an SRM can be designed through secondary legislation on the basis of the current treaty.

In the medium term, providing an explicit legal underpinning for financial stability arrangements in the treaties could further enhance the legal robustness and transparency of those arrangements. It could be useful to enshrine directly in the treaty, similarly to the approach followed for other EU competences, such as monetary union, competition, and agriculture: (1) explicit financial stability objectives; (2) the key institutional set-up of supervision and the financial safety net; and (3) the necessary powers. This would ensure that a single resolution authority could stand institutionally at par with the Commission and the ECB, thus facilitating collaboration and mutual checks and balances. Also, a treaty could explicitly provide for the desired allocation of responsibilities between SSM countries and the broader EU. It would also mitigate legal risks that core aspects of the banking union are challenged before the European Court of Justice.

Strengthening the Financial Stability Framework

The EU’s financial oversight framework will necessarily remain complex. It will need to address the needs of three groups of countries with very different economic and financial governance arrangements: members of the monetary union that will automatically be members of the banking union, non-euro area countries that opt in to the banking union but retain their own monetary policy frameworks, and EU countries that remain outside the banking union. These three groups will retain different degrees of national autonomy, while adhering to (and benefiting from) a single market in financial services.

Ring-fencing of domestic banking from foreign operations has been part of the crisis response. This response, while understandable given policymaker’s accountability to national taxpayers, has itself contributed to instability, leading to initiatives to prevent disorderly cross-border deleveraging and minimize negative externalities from self-interested national moves (e.g., the Vienna initiative). The benefit of capital and liquidity withdrawal and ring-fencing may be more apparent than real, with adverse feedback effects on the initiator of such measures. If risk is properly assessed and there are no policy distortions, capital will flow to where it is most productive. Especially at a time when growth in the EU is anemic, which itself poses a risk to financial stability, restricting such potential flows can exacerbate the problems the policy is designed to avoid. Restoring the single market in financial services could thus enhance financial stability.

To restore safe functioning of the single market, a continued strengthening of its financial oversight framework is essential. With the non-banking part of the single market functioning comparatively well, measures need to focus on banking, but further strengthening of other parts will be important too. Further measures should be guided by an explicit EU-wide financial stability objective so that actions from national and supranational entities are consistent. Priorities discussed below are: remaining regulatory reforms; strengthening and adapting institutions (ESAs and DG COMP); implementing macroprudential policy; addressing structural issues; and securing safe market infrastructure.

Regulatory Reforms

Banking and Deposit Guarantees

Implementing the directive to harmonize deposit guarantee schemes will be a first step toward an EU-wide financial safety net. National deposit guarantee schemes should be aligned not only in terms of quantities (through minimum coverage limits), but also in terms of prices, with premiums adjusted for risk as far as practicable. The length of time to payout should be shortened, likely requiring additional efforts from those member states with the least developed structures. To safeguard depositor confidence and efficient resolution, prefunding of national DGS will be necessary, but may need to be combined with a common backstop should national deposit schemes run out of funds. Agreement is needed on the amount of targeted prefunding and on mutual borrowing agreements across national DGSs. The former can be established on the basis of international practices and phased in over time to modulate pressures on the industry, with transitional arrangements to take account of varying initial conditions.


Timely implementation of Solvency II Directive would help reduce vulnerabilities in the insurance sector. The Directive codifies and harmonizes the EU insurance regulations and its implementation is now scheduled for January 2014, but there remain disagreements, mainly around extending the long-term guarantees package. The delay implies that important aspects of supervision, including valuation, disclosure, and risk management, would remain noncompliant with the International Association of Insurance Supervisors principles (see national FSAPs) in several EU member states, preventing the urgently needed proper assessment of the risks in this sector in the present low-interest-rate environment.

Under the market-consistent valuation of liabilities required under Solvency II, use of a low interest rate discount curve for the valuation of liabilities will be necessary in the current environment. Such a methodology would likely lead to the solvency positions of insurers being seen as weaker than hitherto presented. Indeed, the situation may throw into question insurance and pensions companies’ traditional business models, suggesting that significant refocusing or restructuring may ultimately be called for.


The approval of the Second Markets in Financial Instruments Directive (MiFID2) and reforms to the Market Abuse Directive will be key to fostering market resilience and integrity. Although the text still needs refinement, MiFID2 addresses the main concerns brought by market fragmentation and technological innovation.

Consumer and investor protection issues should get sufficient priority. In particular, approval of Packaged Retail Investment Products and reforms to MiFID and the Second Insurance Mediation Directive (IMD2) to ensure cross-sector harmonization in regard to investment-like products are important.

Addressing risks from shadow banking should continue to be a priority. Provisions to encourage work on reducing reliance on ratings are part of the Third Credit Rating Agency Directive, and the implementation of the Alternative Investment Fund Managers Directive should bring further transparency to the hedge fund industry. Two areas where further work is warranted vis-à-vis the Financial Stability Board agenda are (1) money market funds and exchange traded funds; and (2) securities lending and repos. Regarding the former, the European Securities and Markets Authority has issued guidelines—including in connection to their use of securities lending and repos—which should be the starting point for the reforms to be incorporated in the Undertakings for Collective Investment in Transferable Securities Directive. Feedback from the consultation of the EU green paper should provide further input as to other areas where additional work is warranted.

European Supervisory Agencies

The ESAs have undertaken significant work in the two years of their existence, but there is scope to do more in areas including supervisory convergence, risk identification, and consumer protection. The ESAs are performing a critical role for the single market. They are preparing the single rulebooks and are contributing to the implementation of new directives and regulations. But among other elements in their remits are fostering supervisory convergence (through creation of centers of expertise, and peer reviews), risk identification, and investor protection. To fulfill these, they need additional resources and better governance arrangements.

The upcoming review of the ESAs should be an opportunity to sharpen mandates and strengthen governance arrangements. Governance arrangements should be reviewed with the aim of promoting a more supranational orientation of decision making. Providing voting rights to the Chairs of the ESAs, moving fully to a full-time board, or delegating more decisions to the management board should be considered.

Data transparency is a significant handicap to effective supervision and market discipline. Lack of direct, easy access to institution-specific data creates inefficiencies, poses reputational risks, and should be replaced by a mechanism allowing joint but still direct and straightforward access. Since the ESAs need to go through national supervisory authorities (NSAs) to obtain detailed supervisory data, delays and bureaucratic costs arise, which affect work on real-time analysis of risks and crisis-related work. In particular, requiring a vote from the NSAs to provide data for particular studies for an ESA might undermine the timeliness of the ESA’s work.


The European Banking Authority (EBA) had high visibility from the moment of its creation. It has significant achievements in its first two years of existence, but the pace and prioritization of its activities have been dictated by the crisis. EBA played a crucial role in securing bank recapitalization, but despite a high level of transparency, the June 2011 stress tests failed to signal some subsequent bank failures. The recapitalization exercise in June 2012 was more effective and led to substantial infusions of capital into EU banks, although some banks enhanced their capital positions through risk-weight optimization. Despite its limited resources and cumbersome governance structure, EBA has made significant progress in the area of rule making, but it needs additional resources and independence and to seek synergies with ESRB, such as on cross-sector risk assessment.

EBA should continue to prioritize strengthening transparency and the reliability of data. The 2011 stress test exercise showed the value brought by disclosure of detailed information. But now EBA should strive to enhance the quality assurance process; coordinate an asset quality review; standardize nonperforming loan definitions, loan classifications, and provisioning rules; and promote the timely disclosure of granular asset quality information. EBA should accelerate convergence on Pillar 2 practices (common methodologies for risk assessment) and raise supervisors’ awareness on asset quality issues, in particular by issuing guidance for supervisors on best practices for the conduct of asset quality reviews (Box 1.1).

Box 1.1Lessons and Recommendations for European Banking Authority Stress Testing

It is important that full transparency about banks’ data be obtained, preferably through an asset quality review. A high degree of transparency, including on reference date data and on sensitivity to differences in data definitions, would strengthen confidence; conversely, further failures of banks after passing a stress test would substantially damage the credibility of the process.

In light of these considerations, the following are recommended:

  • Moving to standardize definitions of nonperforming loans, loan classifications, provisioning, etc. while initiating a review of input asset quality data.a This review would complement an enhanced system of consistency checks built into the stress testing procedures. Acknowledgment of the concerns, and quantification of possible effects through sensitivity analysis, would be worthwhile.

  • Continuing to publish a wide range of detailed information on banks.

  • Incorporating as far as possible banks’ funding and capitalization plans in the 2013 stress test projections, including the effects of the phase out of the Long-Term Refinancing Operations. Further efforts could be made to assess the sensitivity of results to likely changes in balance sheet composition.

  • Ensuring the consistency and quality of tests run by national supervisory authorities and the Single Supervisory Mechanism with its own, and running tests on hitherto relatively neglected topics such as structural issues and funding vulnerabilities. Developing furthering liquidity stress testing, and running stress tests and related simulations to incorporate longer-term and cross-sector factors (for example, using contingent claims analysis) that relate to structural issues are needed.

a The definitions should be as consistent as possible while recognizing real differences, for example, in loss given default rates across countries and across time.

The creation of the SSM will bring a new dimension and urgency to EBA’s supervisory convergence role. The ECB will need to implement supervisory procedures and guidance for the operation of the SSM in the established time-frame, which may front run some parts of the envisaged European Supervisory Handbook. While this is unavoidable, it is important that EBA work closely with the new supervisor so that the SSM can build its procedures on best available practice.

EBA will have a key role to play in supervisory colleges after the establishment of the SSM. Most large EU banks have activities inside and outside the SSM perimeter. EBA should be assertive in the colleges in ensuring a level playing field, and that practices do not diverge across the two areas. It can have a major role also in the EU’s relationships with the outside world.

In the area of consumer protection, EBA has EU-wide responsibility. More staff and building of knowledge are needed. Support may be drawn from the other ESAs, which have been more proactive, issuing guidelines, and reports on good practices and consumer trends.


The European supervisor on insurance and pension funds (EIOPA) can point to some significant achievements. In contributing to a common supervisory culture, a soft approach has been taken, based on peer reviews, training, and frequent engagement in the colleges of supervisors. In anticipation of the introduction of Solvency II, EIOPA has been developing regulations and designing technical standards, guidelines, and recommendations. Its work on Solvency II equivalence certification has concluded on three countries, and transitional Equivalence measures for several countries are being evaluated. The mutual recognition work with the United States continues. EIOPA has created a common EU voice in insurance and pension matters on selected international topics.

Challenges ahead will require EIOPA’s realignment, particularly if weaknesses in the industry become apparent. Solvency II is scheduled to be implemented in 2014 and revised legislation for occupational pensions should be soon in force. Shifting from developing technical standards toward monitoring, implementing, and enforcement will be necessary. EIOPA will need to prevent delays in Solvency II implementation that could result in regulatory arbitrage. EIOPA’s human resources framework as well as its operational processes will need to be realigned to the new challenges.

EIOPA’s engagement in its oversight role of supervisory colleges has been intense, but much remains to be done. In 2012, colleges of supervisors having at least one actual meeting or teleconference were organized for 69 groups. Important issues such as crisis preparedness were introduced and some aspects tested, confidentiality agreement templates were developed, and best practices on group supervision presented. However, work is needed to ensure a harmonized level of group supervision in the EU once the Level 3 legislation is in force. Also, EIOPA’s engagement in colleges should go beyond the EU and encompass larger international groups active in Europe, as well as take a leading role in the supervision of the largest EU groups.

EIOPA has been proactive in consumer protection. Promoting transparency, simplicity, and fairness in the market for consumer financial products and services across the internal market is a stated objective. EIOPA is engaged in the revision of IMD2 and working with ESMA on MiFID2, where EIOPA is in a position to highlight the particular aspects of insurance products and insurance distribution practices.

The approval of internal models is a crucial step in evaluating capital levels, and resources need to be allocated to this effort. The level of expertise and amount of work required is imposing severe strain on the NSAs. EIOPA has agreed a work process for the NSAs and insurers. Consideration should be given to centralizing aspects of the approval of internal models, so as to make best use of limited highly-qualified resources.

EIOPA’s stress tests under a Solvency II regime should focus on EU-wide vulnerabilities and interlinkages. To date, EIOPA’s main effort has been to quantify the effect on assets of single factor shocks and traditional insurance factors such as mortality, lapse, and market exposures. EIOPA’s stress tests should complement national stress testing activity with a special focus on identifying EU-wide risks, spillovers to and from other sectors, and medium-term resilience related to, for instance, low profitability in some business lines, and to coordinate with EBA and the ESRB in assessing risks related to bancassurance.

Securities Markets

Within its resource envelope, ESMA has performed well during its first two years of operation, especially in connection with the single rulebook and credit rating agencies supervision. Technical standards, opinions, and advice to the EC were developed. ESMA has built up its expertise on credit rating agencies and has worked on the development of a risk framework to anchor its supervisory program. Results are more modest in connection with other functions.

As it acknowledged, ESMA needs to step up its role in other areas, in particular on supervisory convergence. It has set up strategic directions for each area, and in many cases has identified concrete actions.

  • Supervisory convergence. Reengineering and strengthening peer reviews is essential. Reviews can be made more rigorous by increased onsite work, and their outcomes enhanced by linking reports to the development of best practices and/or guidelines, implementation of which can be monitored; if necessary, for instance for breach of law, stronger actions should be taken. In this context, it is important that the national supervisory authorities take the necessary steps to ensure the enforceability of ESMA’s opinions and guidelines in their respective jurisdictions.

  • Risk identification and crisis management. Projects under way will allow ESMA to make a qualitative jump in its contribution to financial stability and crisis management. To this end, besides needing timely and granular data, ESMA should coordinate simulation exercises amongst the national supervisors, setting out common assumptions to ensure comparability of results.

  • Investor protection. ESMA’s emphasis on product monitoring is warranted. Effective monitoring of financial innovation should also improve financial stability.

  • ESMA is encouraged to acquire skills that enable validation of the complex risk models of CCPs, including for the clearing of OTC derivatives. As the accuracy of these models is essential to safeguard CCPs in extreme market circumstances, the independency of the review of these models should receive attention.


Competition and State aid policy has served as the de facto coordinating mechanism in bank restructuring during the crisis, as it is the only binding EU framework available for this purpose. The EU DG COMP has the exclusive mandate and power to ensure that State aid is compatible with the treaty, and that State aid provision is accepted in exchange for strict conditionality. Member states have provided aid through capital injections, guarantees, and asset purchases. Compensatory measures required by DG COMP have included divestments, penalty interest rates, management removals, dividend suspensions, and burden-sharing (shareholder dilutions, and, lately, bail-in of subordinated debt).

Interventions by DG COMP have been instrumental in imposing restructuring on banks but have on occasion heightened macro-financial concerns. In particular, there have been concerns about the speed of decision making and insufficient transparency, and the impact of compensatory measures on financial stability and economic growth. Since DG COMP could only act in response to national state aid proposals, decisions were taken case-by-case on an individual basis even in the presence of system-wide problems.

State aid management is evolving to respond more flexibly to the crisis, but faces fundamental challenges. DG COMP is assigned a difficult task in mitigating competitive distortions, preserving financial stability, and limiting the costs to the taxpayers while ensuring the long-term viability of the institutions that receive state aid. The design of intervention strategies, therefore, sometimes involves significant trade-offs. Procedures have been accelerated, and sector-wide implications have been taken into account. The ongoing Spanish arrangement, for example, takes a broader approach. The Commission’s powers regarding the resolution of banks have been strengthened further, since ESM support to bank recapitalization is now conditional upon the Commission’s approval of those banks’ restructuring plans. The new mechanism has given DG COMP greater influence in the restructuring and resolution of banks receiving state aid and led to a significant acceleration in the approval process. For instance, it took less than six months to approve the restructuring plans of eight Spanish banks, consistent with the timelines of the European program of assistance to Spain. Stronger coordination with other institutions is desirable with a view to achieving the Commission’s objective of “restoring financial stability, ensuring lending to the real economy, and dealing with systemic risk of possible insolvency.”

DG COMP’s practices in systemic cases can be further enhanced to ensure consistency with a country’s macro-financial framework. Phasing and composition of bank restructuring is critical to mitigate adverse macroeconomic effects. DG COMP seeks to set the right incentives to make the best use of state aid and withdraw from state protection as soon as possible. A pricing policy has been established based on recommendations of the ECB that seeks to limit moral hazard by ensuring a sufficient degree of burden sharing, although at a level which is still below the remuneration that would, in the absence of state aid, be requested by the market. However, increased transparency in pricing and proposed deleveraging would give added credibility to DG COMP’s efforts, which sometimes appear to be ad hoc. An examination, for instance with the IMF and ECB, of its policy for determining the remuneration of instruments used for capital support would be appropriate, to ensure on the one hand that it is not double-hitting a fragile institution and on the other not simply delaying the institution’s demise, and thereby undermining financial stability going forward. Similarly, it would be helpful to look again at the methodology for determining the required degree of bank deleveraging.

DG COMP’s role will change as a dedicated resolution framework for the banking union is developed. The challenge will be to find a balance to foster a more integrated approach between the Commission as the guardian of competition and institutions that, concomitant with the banking union, will be charged with overseeing bank resolution and safeguarding financial stability at the EU level. One option would be to foster a permanent coordination mechanism between DG COMP and financial stability authorities to deal efficiently with the competition and State aid aspects of future resolution cases. Moreover, as most large euro area banks have presence outside the likely banking union perimeter, there is likely to be an important role in coordinating between the banking union resolution authority and those in the remaining EU member states using the framework of the prospective resolution directive.

Macroprudential Policies and the ESRB

The role of macroprudential supervision is to identify and reduce risks to financial stability. Macroprudential policy relies on instruments to: (1) limit the buildup of financial imbalances; (2) address market failures to assess risk externalities among financial institutions; and (3) dampen the procyclicality of the financial system. It can apply both at the peak of a cycle “taking away the punchbowl,” as well as at the trough, to ensure that procyclicality on the downside does not prevent a revival of growth after a downturn.

Currently, national authorities in the EU are responsible for macroprudential oversight, although adequate frameworks are still lacking in some countries. Coordination and internalization of cross-border spillovers is achieved at the EU level by the ESRB through a (non-binding) “act or explain” mechanism for member countries in response to its warnings and recommendations. In December 2011, the ESRB issued recommendations on the macroprudential mandates of national authorities. As national authorities establish institutional arrangements, guidance for establishing common macroprudential toolkits is being developed. Some harmonization of tools is required to facilitate coordination and reciprocity of those policies with cross-border effects, but flexibility must be allowed to tailor responses to local conditions.

The coordination of national macroprudential policies is especially important in the EU, given its highly integrated markets, as well as constraints on the use of monetary policy in the EMU. National authorities may not have power over all lending within their territory, including by foreign bank branches. The use of macroprudential instruments over a particular activity could be referred by national authorities to the ESRB for approval so that all EU banks regardless of origin are covered. Such coordination is important to minimize negative spillover effects of national policies, reduce the possibility of regulatory arbitrage, and foster policy effectiveness. The last is particularly relevant for emerging European economies with a high degree of cross-border banking activities and direct cross-border lending. The ESRB has announced its intention to establish coordination procedures when considered appropriate.

The ESRB currently lacks binding legal authority, so relies on “soft” power. It is also handicapped by its very limited resources and burdensome governance structure. Nevertheless, it has established itself as an important body. Its first warning, over foreign currency lending in emerging European economies, was effective, although the ESRB will achieve further credibility once it issues warnings to major “core” economies and obtains a positive response. Further work on the downside of the cycle, looking, for instance, at the aggregate effects of deleveraging or of asset sales, would be particularly relevant at the present juncture.3

Within the countries of the SSM, the ECB will have a role in macroprudential policy, as well as the national authorities, as it takes on its microprudential responsibilities. There are synergies with microprudential policies; also, the ECB already has good understanding of European financial markets, and its deep knowledge of the monetary transmission mechanism will be helpful in assessing the transmission mechanism of macroprudential policies. Moreover, a key challenge for macroprudential supervision will be to design and calibrate macroprudential instruments and implement them against political interference. The established independence of the ECB would help in this regard; the national macroprudential authorities also need adequate independence. Since the monetary union prevents participating member states at different points of the cycle from having divergent monetary policies, macroprudential instruments may be particularly important for these countries. The ECB should cooperate closely with national authorities to benefit from their local knowledge, as well as with the ESRB in the oversight of non-EMU countries and the non-bank financial sector. It should be responsible for a wide range of instruments going beyond those included in CRD IV/CRR.

The ESRB will continue to have an important role and will continue to be responsible for macroprudential oversight over the financial sector at the EU level. While the ECB only has authority over banks, the ESRB covers the entire financial system, including insurance and occupational pensions, as well as market infrastructure and financial markets and products. The ESRB would be well suited for effective identification, analysis, and monitoring of EU-wide systemic risks, and for assessing the array of instruments potentially available to address them. The ESRB should interact with the ECB on macroprudential toolkits when the ECB takes on macroprudential responsibilities, as it does with national agencies. It must be able to exercise its powers and issue the same kind of recommendation to the ECB as it does to any national central bank or bank supervisor; this would require a substantial revision to the ESRB legal framework, a detachment from the ECB “umbrella,” and a clear delineation with the mandate of the latter.

Structural Reforms

High-level working groups chaired respectively by John Vickers of Oxford University and Governor Erkki Liikanen of the Bank of Finland assessed the need for additional banking reforms. These could be targeted at individual banks to reduce the probability and impact of failure, ensure the continuation of vital economic functions in the event of failure, and better protect vulnerable retail clients. One conclusion was that the experience of the crisis showed that no one type of bank performed systematically better than the others, and no one type did systematically worse.

The Liikanen group recommended the mandatory separation of the investment banking business. This type of business was deemed riskiest, and that separation would limit danger of contagion to core functions such as deposit-taking and payments and hence reduce taxpayers’ contingent liabilities. It would also limit the scope for cross-subsidization, improve the scope for effective monitoring and risk management, and facilitate resolution. This proposal is in the spirit of others elsewhere, including the Volcker Rule in the United States and the Vickers group’s recommendations for ring-fencing of retail banking.4 More recently, the French authorities proposed that banks separate the same businesses that are prohibited by the Volcker rule, albeit banks would be allowed to run these businesses in a separate subsidiary.

The Liikanen proposal allows the preservation of the universal banking model, characteristic of much of Europe. It mandates that businesses be placed in a stand-alone subsidiary including proprietary trading, market making, and investments in hedge funds and private equity funds. The trading subsidiary and the subsidiary housing deposits and payments would need to meet capital and other regulatory requirements on a stand-alone basis. The report argues that any increased costs from the removal of synergies between the two may simply reflect the withdrawal of the hidden taxpayer subsidy for the implicit saving of the institution.

Proposed measures to enhance resolvability are welcome. The Liikanen group argues for enhancing the bank resolution regime, developing a comprehensive system of bail-ins, applying more robust weights in the determination of minimum capital, more consistent treatment of internal risk models, and governance reforms. It recommends higher loss absorbency requirement for the trading subsidiaries engaging in separated businesses via a leverage ratio.

However, separation of banking activities would not have helped address some of the most serious problems of the crisis. Lehman Brothers, for example, was not a retail deposit-taking institution. Also, many banking sector difficulties derived from the “plain vanilla” side of banks, most particularly lending for residential real estate. Now the sovereign-bank linkage is causing difficulties, particularly for those banks that invested in their countries’ government bonds, notionally the most conservative of strategies. Most importantly, from the perspectives of ease of resolution and minimizing contingent fiscal liabilities, separation may not work as intended because trading subsidiaries may remain systemically important, especially since they will house market-making operations of the largest banks.

Consistency with structural reform proposals in comparable jurisdictions, at least insofar as application to internationally active banks is concerned, is important.

  • There is a danger that the major international banks may optimize across different structural constraints by moving operations, changing corporate structures, and redesigning products in ways that could weaken policy effectiveness. This would put further pressure on cross-border supervision and resolution.

  • It will be important to manage differences across the proposals so that they do not result in mutually inconsistent structural constraints on internationally active banks.

  • A level playing field will need to be developed vis-à-vis banks from outside the EU that are competing within the EU.5

Financial Market Infrastructure


The adoption of the European Market Infrastructure Regulation (EMIR) and the legislative work on the draft Central Securities Depositories (CSD) Regulation are important for the creation of a single market for CCPs and CSDs. The regulations significantly reduce sources of risks related to the cross-border offering of clearing and settlement services, and they provide for a level playing field, enhancing fair and efficient competition between CCPs and CSDs. The intention of the Commission to further centralize supervisory responsibilities in the medium term is appropriate.

Measures are needed to ensure that recovery and resolution plans for CCPs and CSDs will work across borders in case of large market disruptions. With national competent authorities bearing the primary supervisory responsibilities, the framework does not provide safeguards to ensure that the national interest may sometimes prevail over the general interest to have safe and efficient CCPs and CSDs. The active participation of ESMA in the CCP colleges should contribute significantly to supervisory consistency and oversight. Access rights of CCPs and CSDs for other markets and infrastructures should be further developed in line with international standards. The establishment of a comprehensive framework for cooperation between national supervisors of CSDs is needed too, given the increased cross-border nature of CSDs. The supervision and oversight of the two international CSDs in the EU should be enhanced, in cooperation with the ECB in its responsibility for financial stability and by participation in the SSM, as competitive pressures may encourage competition on risk management frameworks.

Regulatory risks arise due to differences in the legal and regulatory frameworks in the EU, the United States, and elsewhere to handle the mandatory clearing obligation for standardized derivative contracts. Globally operating OTC derivative CCPs face regulatory uncertainty and inefficiencies. Regulators should continue ongoing joint work to give priority to the identification and mitigation of conflicts, inconsistencies, and gaps between EMIR and other non-EU frameworks through bilateral and multilateral coordination. The EU has drafted flexible arrangements for the identification and recognition of third-country CCPs that limit the risks of conflicts of laws by ensuring that foreign CCPs remain subject to their home regulation.

EU crisis management procedures for financial market infrastructures should be further developed and tested. A notification regime should be in place that allows for immediate information-sharing between all relevant authorities, CCPs, CSDs, and other systems and market participants. Central monitoring of potential market-wide disruptions should be enforced, for example in relation to the quality of collateral kept by CCPs and international CSDs.

Euroclear’s Soundness and Efficiency

Euroclear Bank is a securities settlement system that contributes to the safety and efficiency of global markets for government bonds and other international securities but also concentrates systemic risk. It is one of the largest securities settlement systems worldwide with a daily average settlement value of around €1.1 trillion, providing settlement services for securities from 44 markets in 53 currencies. In particular, Euroclear Bank services the largest global banks with triparty repo arrangements to secure their interbank financing.

Important risk measures have been taken to reduce systemic risk, but some of the risk management frameworks need to be further improved to fully observe the recently adopted international standards.6 Euroclear Bank should in particular prepare measures to be operationally ready for the implementation of its recovery plans and plans for the orderly winding down of its operations. In addition, it should upgrade some risk management policies and practices to reduce its (potential unsecured) credit exposures to participants and other linked securities settlement systems. It has recently made important improvements to its collateral and its liquidity management frameworks.

Euroclear Bank is subject to effective regulation, supervision, and oversight of the National Bank of Belgium and the Financial Services and Markets Authority, but cooperation with the Luxembourg authorities should be improved. The legal framework provides the Belgian authorities with sufficient powers to obtain timely information and induce change. However, as Euroclear Bank is in competition with the Luxembourg-based Clearstream Banking Luxembourg—which offers similar settlement and banking services—close cooperation with the Luxembourg authorities is needed to avoid any competition on risk management frameworks. As both entities are highly relevant for the global financial stability, the Belgian and Luxembourg authorities should evolve from the existing cooperation toward a cooperative framework that would allow them to take common decisions and implement these simultaneously in both entities. The plans to include Euroclear Bank on the list of eligible banks for the SSM may further contribute to a level playing field.

The national securities depositories of Belgium, France, and the Netherlands, which share a common information technology platform provided by the Euroclear Group, are subject to effective regulation, supervision, and oversight of the Belgian, Dutch, and French authorities, despite the fact that the legal frameworks differ substantially between the three countries. The cooperation between the different authorities is effective and contributes to the financial stability in Belgium, France, and the Netherlands. Crisis management frameworks are in place that are regularly tested and updated.

TARGET2’s Soundness and Efficiency

TARGET2 displays a high level of observance of international standards. The system has a sound, coherent, and transparent legal basis. It has developed an adequate risk management framework to address financial and operational risks. As a real-time gross settlement system, credit risk is minimized. Liquidity risk is mitigated by participants having access to central bank intraday liquidity based on adequate collateral and the liquidity saving mechanism offered by the system. TARGET2 business continuity arrangements are well developed and comprehensive, covering operational as well as communication network aspects.

Nevertheless, TARGET2 crisis management and risk communication procedures can be enhanced by giving the ECB direct access to information on participants’ liquidity as well as collateral positions. For most large participants, liquidity positions are maintained in several countries, and national central banks can only monitor positions maintained on their own account systems. Furthermore, the collateralization process and securities holding are decentralized. Centralizing the monitoring of participants’ liquidity and, where possible, collateral positions at the level of the ECB is crucial in order to allow the Eurosystem to maintain financial stability across the euro area by acting quickly and effectively in the event of financial distress.

Eurosystem’s Oversight Framework for Payments

The ECB’s oversight capacity should be strengthened. The ECB is in the process of moving from a rule-based to risk-based and forward-looking oversight approach. In particular, it is developing more dynamic oversight tools such as interdependencies analysis, stress testing, and an early warning system. The ECB oversight team has the responsibility to define the Eurosystem’s strategy and policy, develop rules and guidance, coordinate the Eurosystem, and contribute to international forums. In addition, the ECB will soon participate in several EMIR colleges for CCPs. In order to implement the new risk-based approach credibly, the ECB needs access to confidential bank-by-bank data which is within the remit of the NCBs and to strengthen the capacity and the skill of its staff. ECB oversight staff should be significantly increased, and their work organized in cluster modules, focusing on overseeing individual entities as well as on specific risks across entities. They need the right skills and continuity in running critical areas, such as interdependencies and stress testing.


    GoyalRishi and others2013A Banking Union for the Euro AreaIMF Staff Discussion Note 13/01 (Washington: International Monetary Fund).

    International Monetary Fund2012aGlobal Financial Stability Report: The Quest for Lasting StabilityWorld Economic and Financial Surveys (WashingtonApril).

    International Monetary Fund2012bGlobal Financial Stability Report: Restoring Confidence and Progressing on ReformsWorld Economic and Financial Surveys (WashingtonOctober).

This chapter derives heavily from the Financial Sector Stability Assessment of the December 2012 EU Financial Sector Assessment Program (FSAP) and reflects also contributions from the rest of the FSAP team.

This is discussed further in Goyal and others, 2013, Box 4.

Recommendations on money market funds and bank funding were approved by the ESRB General Board in February 2013.

Among the differences of the Vickers proposal from Liikanen are: Vickers pushes almost all investment banking activities out of the deposit bank, whereas Liikanen allows the deposit bank to retain underwriting and client facing hedging services; Vickers would apply to almost all banks, whereas Liikanen would apply only to the largest banking groups; Vickers applies the ring-fencing only to the U.K. business, whereas Liikanen would apply to all affiliates of an EU banking group. Both the Vickers and the Liikanen proposals differ from the Volcker proposal for the United States in that retail and investment banking would be allowed to remain within the same legal entity.

Further discussion of this topic will be provided in a forthcoming IMF paper, “Making Banks Safer: What Role Can Structural Measures Play?”

Committee on Payment and Settlement Systems (CPSS) and the Technical Committee of the International Organization of Securities Commissions (IOSCO) Principles for Financial Market Infrastructures.

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