From Fragmentation to Financial Integration in Europe
Chapter

Chapter 9. Banking Union and Single Market: Consistent Setup and Risk Mitigation

Author(s):
Charles Enoch, Luc Everaert, Thierry Tressel, and Jianping Zhou
Published Date:
December 2013
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Author(s)
Thierry Tressel

The fiscal and financial crisis in the euro area has exposed critical gaps in the architecture of stability in the region.1 In the years preceding the crisis, large capital flows within the euro area fueled the buildup of sovereign and private sector imbalances. The subsequent deterioration of balance sheets and reversal of flows has forced very sharp economic contractions and financial market fragmentation (Figure 9.1). Borrowing costs of sovereigns and national private sectors have diverged widely and persistently, cuts in monetary policy rates have had limited or no effects in several economies, and adverse sovereign—bank—real economy dynamics have been prevalent across the region (Figures 9.2 and 9.3). The monetary union, in short, is malfunctioning.

Figure 9.1Financial Market Integration and Fragmentation

Sources: Bank for International Settlements (BIS); and IMF staff calculations.

Note: Shows BIS cross-border bank claims (in percent of reporting country’s GDP). DEU = Germany; ESP = Spain; FRA = France; GRC = Greece; IRL = Ireland; ITA = Italy; NLD = the Netherlands; PRT = Portugal.

Figure 9.2Diverging Funding Costs in the Region Do Not Reflect Falling Policy Rates

Source: European Central Bank.

Note: ECB = European Central Bank; NFC = nonfinancial corporations.

Figure 9.3Sovereign–Bank Loops: Sovereign and Bank Funding Costs Have Moved in Tandem

Sources: Bloomberg, L.P.; and the European Central Bank.

Note: OMT = Outright Monetary Transactions.

Important measures—for near-term crisis management and longer-term architecture—have been undertaken. Adjustment programs are being implemented and progress is being made to unwind fiscal and external imbalances that developed over years. Regional firewalls—the European Financial Stability Facility and European Stability Mechanism (ESM)—have been created and strengthened to smooth adjustment. The framework for fiscal and economic governance has been enhanced through the “Six Pack” and the Treaty on Stability, Coordination and Governance. The European Central Bank (ECB) has provided substantial liquidity to banks, stepped in to address market strains through government bond purchases, announced its framework for Outright Monetary Transactions, and given forward guidance. The Eurosystem has recycled part of the capital flight from the periphery to the core through the “TARGET2” payments balances.

As part of this comprehensive policy response, the role of a banking union for the euro area is twofold. As part of crisis management, it can reduce fragmentation of European banking markets. Direct bank recapitalization by the ESM can help restore the health of bank balance sheets and remove tail risks and potential contingent liabilities affecting sovereigns under stress. A precondition for direct recapitalization of banks by the ESM is the creation of an effective single supervisory mechanism (SSM), which was called for by euro area leaders in June 2012. In steady state, an integrated architecture for financial stability in the euro area would bring a uniformly high standard of enforcement, remove national distortions, and mitigate the buildup of risk concentrations that compromises systemic stability. By moving responsibility for potential financial support—and the associated banking supervision—to a shared level, it would reduce financial fragmentation and weaken the vicious loop in many countries of rising sovereign and bank borrowing costs.

The European Commission (EC) presented a plan on September 12, 2012, on the elements of a new SSM that could begin operating in 2013. It called for adoption by end-2012 of European Union (EU) legislative proposals establishing a harmonized regulatory setup, harmonized national resolution regimes for credit institutions, and standards across national deposit insurance schemes. On December 13–14, 2012, the European Council agreed that the SSM would come into operation in March 2014 or one year after the SSM legislation enters into force, whichever is later, and put out a roadmap toward the banking union. A compromise agreement between the Council, the European Parliament, and the EC on the SSM regulation and on the modifications of the European Banking Authority (EBA) regulation was reached on March 19, 2013. Once the SSM legislation is adopted, ESM direct recapitalization could occur, with the ECB supervising the bank in need of assistance. The Council noted that adoption of a harmonized regulatory set up transposing Basel III in the EU (Fourth Capital Requirement Regulation and Directive (CRR/CRDIV)) is “of the utmost priority,” and called for the adoption of the draft Directive for bank recovery and resolution (BRRD) and for harmonization of deposit guarantee schemes (DGS) by June 2013. It affirmed that a Single Resolution Mechanism (SRM) based on a common resolution authority with adequate powers and tools is required. This mechanism would be based on financial sector contributions and backstop arrangements that recoup taxpayer support over the medium term. The CRR/CRDIV was adopted by the Council of the European Union on June 20, 2013, and the new rules will apply from January 1, 2014. The euro-group reached an agreement on the main features of the operational framework for ESM direct recapitalization on June 20, 2013, while finalization has been linked to adoption of the BRRD and of the DGS Directive. On June 27–28, 2013, the European Council reached agreement on the BRRD. Progress on the various elements of the banking union are summarized in Table 9.1. Last, on July 10, 2013, the EC published a draft proposal of a regulation establishing a Single Resolution Mechanism.

Table 9.1Progress on the Banking Union and the Single Rule Book
Single Supervisory MechanismSingle Resolution MechanismCapital Requirement Regulation & Directive IVBank Recovery & Resolution DirectiveDeposit Guarantee Scheme Directive
European Commission ProposalSeptember 12, 2012July 10, 2013July 20, 2011June 6, 2012July 12, 2010
Decision at CouncilDecember 13–14, 2012May 15, 2012June 27, 2013
Tri-partite Agreement Council/EP/ECMarch 19, 2013March 27, 2013
Adoption CouncilExpected September 2013Expected end current EP termJune 20, 2013Expected end-2013Expected end-2013
Transposition to national legislation as required/New rules applyOne year after entry into force of regulation / ECB declares SSM effectiveJanuary 1, 2014Expected end-2014
Note: EC = European Commission; ECB = European Central Bank; EP = European Parliament; SSM = single supervisory mechanism.
Note: EC = European Commission; ECB = European Central Bank; EP = European Parliament; SSM = single supervisory mechanism.

While agreement has been reached on the SSM and on the main features of the operational framework for ESM direct recapitalization, there remain differences of views on the modalities of the other elements of a banking union. These differences partly reflect concerns over the potential mutualization of liabilities and asymmetric cost sharing across members, as well as on the desirability of separating near-term crisis resolution, such as needed fiscal solutions and backstops for bank recapitalization, from longer-term architecture issues. They also reflect the complexities and difficulties of setting up a banking union in a relatively compressed period of time, and striking the right balance between allowing national flexibility and ensuring predictability and consistency of rules across EU member states without unsettling markets during crisis resolution.

How Will a Banking Union Help?

The EU single market for financial services supported by national stability frameworks worked too well in the run-up to the crisis. Before the crisis, the common currency and single market promoted financial integration and interconnections in the EU. Banks and financial institutions operated with ease across countries; credit went where it was in demand; portfolios became increasingly more diversified. The interbank market functioned smoothly, monetary and retail interest rate conditions were relatively uniform across the euro zone. There were side effects, such as large capital flows within the euro area and the associated buildup of sovereign and private sector imbalances. By and large, a hybrid financial architecture based on a single currency and common market, as well as nationally based financial safety nets, bank supervision, and regulation, seemed to serve the euro zone well.

The crisis laid bare the deep tensions inherent in this institutional design. Private borrowing costs rose with those of sovereigns, imparting procyclicality (costs rose as conditions deteriorated and capital flew out) and impairing monetary transmission (as rate cuts had limited or no effect in countries that needed them the most). This amplified financial fragmentation (Figure 9.1) and volatility, and thus exacerbated the economic downturn. This adverse dynamic resulted from the inability to control local interest rate conditions in the economic and monetary union, interacting with an architecture that strengthened the links between a country’s banking and real sectors and the health of its public finances. In hindsight, it is evident that, in good times, banks grew in many places to a scale that overwhelmed national supervisory capacities, while in bad times, they overwhelmed national fiscal resources. It is also clear that, in the existing architecture, if a sovereign’s finances are sound, then its backstop for its banks is credible. But if they are weak, then its banks are perceived as vulnerable and, therefore, face higher funding costs, which exacerbates the downturn (Figures 9.2 and 9.3).

The crisis also brought to the forefront a tension in the national approach to supervision. Nation-bound regulators may unduly favor a country’s banking system and economy and may not internalize cross-border spillovers, which lie beyond their mandates. This national approach to supervision can be very damaging as the single currency requires an integrated financial system to function effectively. In good times, they may not take into account how their actions contribute to the buildup of excesses and imbalances in other countries. In bad times, they may encourage uncoordinated reductions of cross-border activities by their banks, exacerbating financial fragmentation and the disruption of monetary policy. Moreover, delays in resolving stresses—potentially as a result of closeness between national regulators and their banks—only exacerbate the eventual cost. But because a bank’s distress may have adverse significant cross-border externalities in an integrated financial market, other countries may have no choice but to support those whose banking systems run into trouble.

Would a Banking Union Have Prevented this Crisis?

The banking union would not have halted the sovereign debt crisis in some countries such as Greece. But a well-functioning banking union could have substantially weakened the adverse sovereign—bank-growth spirals, maintained depositor confidence, and attenuated the liquidity and funding freezes that followed and affected simultaneously banks and their sovereigns. The credibility of safety nets would not have been dependent on the sovereign’s strength; and significant bailouts would not have resulted in loss of market access by the sovereign (as happened in Ireland). As a result, the rate cuts of the ECB would more likely have fed through to lower borrowing costs for the private sector in countries with the deepest downturns. A strong banking union would also have limited the concentrated exposures of banks to certain risks. For example, euro area-wide supervisors would arguably not have allowed size, structure, and concentration risks to grow as they did in countries such as Cyprus, Ireland, or Spain—or for general banking weaknesses to have accumulated in some other places. That said, as the United States and other recent experiences suggest, supervision would have had to strive to be of a high standard. Merely reorganizing supervisory structures would not of itself have addressed the buildup of systemic risk or the too-big-to-fail problem. Effective single supervision would have to take a broader perspective, and would need to counterbalance any tendency of common safety nets to allow imbalances to grow even larger.

A banking union will not solve all the euro zone’s problems but it can help speed the process of repairing banks. Having common resources deployed through the ESM will help recapitalize and repair banks where the sovereign is weak by removing future contingent liabilities from the sovereign balance sheet. Having a credible, deep-pocket shareholder such as the ESM will also provide assurance to creditors that an investor would stand ready to shoulder future unexpected losses. This would contribute to generating a virtuous cycle of lower funding costs for both the sovereign and the banks. To align incentives, proper governance and control must be in place. Common supervision at the ECB will mitigate regulatory ring-fencing and ensure timely intervention in banks.2 Having a SRM aligned with international best practices would also help ensure least cost and swift resolution while protecting financial stability. All in all, these actions will reduce fragmentation of financial markets, help repair monetary transmission, and stimulate the provision of credit to sound borrowers, thereby facilitating the economic recovery in the euro area.

The EU Proposal for a Banking Union

EU Agreements

The September 12, 2012, EC proposal and December 13–14, 2012, EU Council agreement covered the design of an SSM, the passage of three draft EU legislations, and the role of the EBA. According to the agreement, the ECB would start carrying out supervisory tasks in March 2014 or one year after the SSM legislation takes effect, whichever is later. Banks receiving or requesting public financial assistance would be targeted first; at the ESM’s request and as a precondition for direct recapitalization, the ECB could begin directly supervising these banks, regardless of the starting date of the SSM. The Council further called for adoption of the CRR/CRD IV as of the utmost priority, and for adoption by June 2013 of draft EU legislations harmonizing and strengthening national resolution regimes and DGS, thus creating a “single rule book.”3 The powers of the EBA were confirmed as the regulatory and supervisory standard-setter and the mediator of cross-border supervision and resolution issues arising in the EU.

A tripartite agreement between the Council, the European Parliament, and the EC on the SSM regulation and on the changes to the EBA regulation was reached on March 19, 2013. The euro-group reached an agreement on the main features of the operational framework for ESM direct recapitalization on June 20, 2013, and on the way forward-linking finalization of the operational framework to finalizing the BRRD and the DGS Directive with the European Parliament, which makes final agreement uncertain. On June 27—28, 2013, the European Council reached agreement on the BRRD (including on features of bail-ins of bank creditors and depositor preference), with the aim of reaching agreement with the Parliament and adoption by end-2013, and also called for adoption of the DGS Directive by end-2013. It also reiterated that, to break the adverse cycles between banks and sovereigns, the ESM should have the possibility to recapitalize banks directly when the SSM is effective, and that Council agreement on the EC proposal for an SRM should be reached by the end of the year with a view of adoption by end of the parliamentary cycle. The Council also noted the importance of the balance sheet assessment comprising an asset quality review and a stress test to be conducted in the transition toward the SSM. Agreement on the SSM regulation was reached at the European Parliament on September 12, 2013, after transparency and accountability requirements were strengthened, and at the Council on October 15, 2013. The regulation entered into force following its publication in the official journal of the EU on October 29, 2013, and the ECB will fully assume its supervisory tasks 12 months later or when the ECB declares itself ready. On October 23, 2013, the ECB announced key features of the comprehensive assessment of the banking system, which will be concluded prior to assuming supervisory tasks in November 2014.

The EC published its proposal for an SRM on July 10, 2013. The SRM proposal goes in the right direction of establishing a strong central resolution authority and a single resolution fund, essential elements of a banking union that would reduce fragmentation and mitigate sovereign—bank links. It provides for strong centralized powers (at the EC and at a new Single Resolution Board) to achieve swift and least-cost resolution while protecting stability and internalizing cross-border effects. There are, however, issues to be resolved and clarified, such as: the scope of the EC powers and associated risks; the division of responsibilities between the EC and the SRB; the governance of the SRB; the operational independence of the SRM; and the lack of a common fiscal backstop (apart from ESM and the single resolution fund). There is also a risk that the legal basis for the SRM may be challenged before the European Court of Justice. Given explicit opposition to the proposal by some member states, the discussions are likely to be complex and difficult. The legal foundations of the EC proposal for the SRM have been scrutinized by the European Council Legal Service (CLS). CLS agreed that Article 114 of the Treaty on the Functioning of the European Union may be a suitable legal basis for the establishment of the SRM subject to certain conditions. However, the SRM proposal encountered legal objections over the envisaged delegation of powers to the Board. CLS argued that the powers delegated to the SRB in the EC proposal need to be further detailed to be compatible with the EU treaties and the Meroni doctrine. Separately, the EC announced a new state aid regime for banks that appropriately affirms financial stability and minimal fiscal costs as overarching objectives, but the regime also introduces rigidities such as giving the EC an ex ante veto right on restructuring plans, and requiring bail-ins of shareholders and of junior unsecured creditors as a precondition for state aid (see Chapter 12).

Supervision

The SSM regulation specifies a clear mandate for bank safety and soundness to the ECB and its accountability to the EP and the euro-group. The ECB would directly supervise banks accounting for about 80 percent of euro area banking assets, including banks with over €30 billion in assets or 20 percent of national GDP or if otherwise deemed systemic (for example, given cross-border reach). At least the three largest banks in each member state would be directly supervised, with the ECB retaining the power to bring any bank under its supervision if deemed necessary. At the ECB, a supervisory board and a steering committee are being created to prepare and implement decisions and give voice to non-euro area members that opt in (as the Governing Council remains ultimately responsible).

Operational Details

The SSM regulation appropriately confers broad investigatory and supervisory powers on the ECB, which is responsible for the effective and consistent functioning of the SSM (although national authorities are also responsible for the banks remaining under their direct supervision). The challenges of effective implementation must not be underestimated. Operational arrangements now need to be specified—these must make incentives compatible between national authorities and the ECB, ensure an adequate division of labor, and provide for appropriate information sharing within the SSM to underpin effective supervisory decision-making. The ECB is to adopt a detailed framework for the practical modalities of supervisory cooperation within the SSM. The governance set-up is complex but must seek to promote, not hinder, timely decision-making. Moreover, to be effective, it is essential to appropriately and urgently staff the ECB. The SSM regulation provided both national authorities and the ECB with powers to make use of macroprudential instruments specified in the relevant EU Directives, although accountability must be clarified. In practice, close cooperation will be critical to ensure coherence and effectiveness of measures.

Resolution and Safety Nets

An SRM is an indispensible supplement of effective supervision, ideally centered on a single resolution authority, deposit insurance, and common backstops. The Council recognized the importance of an SRM with adequate powers and tools, and the EC subsequently published a draft regulation for an SRM. This mechanism is to be based on financial sector contributions and backstop arrangements that recoup taxpayer support over the medium term, and could ensure that an SRM is established around the time the Single Supervisory Mechanism is declared effective. Though the immediate priority is to strengthen and harmonize national regimes, funds raised over time from financial institutions could cover individual small-to-medium-size bank failures. Common backstops are essential to handle systemic failures. A time-bound roadmap to common safety nets—needed for depositor confidence and to break sovereign bank links—would limit the risks of an incomplete banking union.

Design of the Banking Union

Steady-State Analysis

This section presents considerations for a banking union in the longer run, but highlights where some issues are particularly important in the near term. Transition and crisis management issues are elaborated on further in the section below on “Transition in Crisis Time.”

High-Level Principles to Design a Banking Union

To complete the monetary union and provide effective stability architecture, the banking union must have all three elements in place. Progress is required on all elements now; under the well-known economic principle that effective control and resources must go hand-in-hand. Aligning incentives is important for the steady-state, but also in the near term as elements of the banking union are put into place. The governance of and steps toward the banking union must provide the right incentives and promote timely decision making that would help repair banking systems swiftly and at a least cost, lest national interests prevail and effectiveness is compromised.

  • A Single Supervisory Mechanism without an SRM and common safety nets will do little to break the vicious circle between banks and sovereigns or to stabilize the euro area. Moreover, lack of a credible resolution framework would hamper the effectiveness of the SSM, and impede timely decision making by leaving national authorities to deal with the fiscal consequences of others’ supervisory decisions. This would open the door to conflicts with potential reputational consequences for the ECB.

  • Bank recapitalization, as well as resolution mechanisms, would lack credibility without the assurance of fiscal backstops and burden-sharing arrangements.

  • Conversely, common safety nets and backstops without effective supervision and resolution would break sovereign—bank links, but would risk distorting incentives, reinforcing tendencies for regulatory forbearance, and shifting losses to the euro area level.

What is the Necessary Country Coverage?

A banking union is necessary for the euro area, given how destabilizing financial fragmentation and sovereign—bank links are in a monetary union. In short, a monetary union is not viable if financial markets are not integrated, and a banking union would provide the stability architecture supporting integration. An EU banking union would also be desirable given the single market for financial services and the deep financial interconnections among EU countries. But this raises more complex issues, not least the interaction of multiple central banks, lenders of last resort, and exchange rates. Potentially different access to backstops or safety nets, such as the ESM that is a euro area intergovernmental institution, adds to the complexities. It is, therefore, prudent to proceed first with a euro area banking union, albeit with an option to “opt in” for non-euro area EU members and with adequate governance safeguards for those who wish to stay out.

What Should be the Institutional Coverage?

All banks should be included, regardless of size, complexity, and cross-border reach. Banks that are systemic at a global level or for the euro area as a whole should be included in the banking union, given the spillovers that they generate. But banks systemic at the national level could also become significant for the euro area if they destabilize their sovereign, and should therefore also be included. However, larger numbers of small banks with correlated exposures can threaten systemic stability (for example, Spanish cajas), especially when policy buffers are low. Hence, banks of a variety of size, complexity, cross-border relevance, and business models may become systemic for the euro area and require the need for common solutions and backstops. The ultimate goal should therefore be to include all banks, not just systemic or vulnerable ones. This approach would also allow for complete and evenhanded treatment and limit the scope for regulatory arbitrage or capture.

Design of a Single Supervisory Mechanism

What is the Role of the Single Supervisory Mechanism?

The SSM would facilitate a more systemic approach to tracking the buildup of risk concentrations, and contribute to achieving a comprehensive macroprudential oversight of the euro area. It would coordinate supervisory actions across countries, and ensure consistent application of prudential norms. It would foster convergence of best practices across members, partly alleviate concerns of regulatory capture at the local level, and promote integration of the single market for financial services. In concrete terms, higher standards of supervision in place before the crisis might have meant a swifter identification of an unsustainable build-up of risk (for example, in Ireland or Spain) and a more timely and effective intervention to diffuse such risk (for example, by applying higher capital buffers or restricting excessive concentrations).

Why is the Single Supervisory Mechanism Centered on the ECB?

Conferring supervisory tasks and responsibilities upon the ECB is reasonable under the current Treaty on the Functioning of the European Union, given its financial stability expertise and the existing institutional frameworks in the euro area. The ECB has access to supervisory skill sets as most Eurosystem national central banks are also national supervisors. Involving the ECB would give it access to supervisory information in support of its monetary policy and lender-of-last resort duties. Having banking oversight and monetary policy under one roof could potentially lead to difficult trade-offs between the two, for example, when monetary policy decisions impact bank solvency, or when the need to safeguard financial stability may call for liquidity provision to insolvent banks, but it will also allow to exploit synergies between the two functions. It will also help ensure that microprudential regulation does not overlook systemic considerations. As a creditor, the ECB may also face conflicts of interest when, as a supervisor, it is required to withdraw a license and trigger resolution, resulting in losses to its own claims. These trade-offs call for appropriate checks and balances, such as transparency in the decisions taken and implemented by the supervisory board.

Guidance for effective supervision is provided the Basel Core Principles (or “Core Principles for Effective Supervision”). According to these Principles, a number of preconditions and prerequisites will have to be met at the euro area level. Some of the preconditions are beyond reach in the immediate future, but they are essential for the effectiveness of the new system in the longer term.

  • Preconditions for sound banking include: (1) the implementation of coherent and sustainable macroeconomic policies; (2) a clear framework for financial stability policy; (3) an effective crisis management and resolution framework to deal with bank failures and minimize disruptions; (4) an adequate safety net to deal with a confidence crisis while minimizing distortions; (5) a well-developed public infrastructure; and (6) effective market discipline.

  • Prerequisites to establish a sound basis for the SSM include: (1) operational independence; (2) clear objectives and mandates; (3) legal protection of supervisors; (4) transparent processes, sound governance, and adequate resources; and (5) accountability. The EC proposal and EU Council agreement by and large meet these prerequisites (see below). But clarity and strengthening is required on resources, and aspects of the governance mechanism and legal robustness, for example, on the specifics of the delegation mechanism.

Effective supervision will also require designing an effective delegation mechanism involving interactions between supranational and national institutional layers. Designing a system involving many countries is a complex undertaking. Given that the euro area has over 6,000 banks (a similar order of magnitude as in the United States, see Figure 9.4), an appropriate division of labor will be needed between the center and the national agencies, as no single new body could supervise all banks with full effect in the near future. Thus, some degree of delegation is necessary. Full centralization is neither practical nor desirable, as supervisory knowledge and resources remain at the national levels. Full decentralization in which the center merely validates decisions is not desirable either, particularly when common resources are at stake (for example, ESM direct recapitalization of banks or future common backstops).

Figure 9.4Banks under Supervision

Sources: European Central Bank; Federal Reserve; Federal Deposit Insurance Corporation; and National Credit Union Administration.

How Should Delegation be Designed Within the Single Supervisory Mechanism?

Supervisors at the national level and at the ECB must have clear responsibilities and the powers necessary to perform their tasks. Having formal responsibility but no real enforcement power (as could occur at the ECB level) would carry serious risks, while having the power but no clear responsibility or accountability (as could occur at the national level) could lead to misaligned incentives and distorted outcomes. A mechanism of monitoring and clarity over tasks and responsibilities, thus, becomes important. The goal should be to create a coherent and consistent supervisory mechanism with adequate information flow and final significant decisions taken at the center.

To ensure incentives are compatible, the degree of delegation should be clarified. It would depend on the ECB’s supervisory classification of risks for each bank, and factors such as the importance of local knowledge and know-how, the systemic dimension of banks and/or tasks, and the amount of discretion required in decision making. For example, institutions with systemic implications should be subject to more intrusive supervision from the center, as should functions that are more subject to discretion, capture by the industry, or influence by politics. Consolidated supervision of financial groups would involve interagency coordination to oversee nonbank financial institutions as well.

In sum, the ECB will need to rely partly on the competencies and resources at the national level, with clarity on the allocation of tasks and powers as well as strong oversight and accountability to ensure incentive compatibility and contain risks of slippages. At the same time, the ECB must be adequately resourced to ensure that it has the capacity to perform key and strategic tasks itself while being able to supervise systemically important banks and those that require or may potentially require public support.

The ECB must have powers to perform effective macroprudential oversight. Given its financial stability expertise, the ECB is well placed to ensure information-sharing, home-host coordination, and internalization of cross-border externalities. Hence a shift in macroprudential mandates, powers, and tools is appropriate, away from member states and toward the ECB. The ECB should be given binding powers to use macroprudential instruments if it deems necessary. At the same time, the framework should involve national authorities and be sufficiently flexible to tailor solutions to local conditions. In particular, national authorities should also be able to make use of macroprudential tools in response to local conditions within the parameters and guidelines set by the ECB.

Design of a Single Resolution Mechanism

What is the Role of a Single Resolution Mechanism?

Without a strong SRM complementing the Single Supervisory Mechanism, the credibility and effectiveness of the banking union would be jeopardized. Leaving resolution responsibilities at the national level while supervision is centralized carries significant risks, such as perpetuating bank—sovereign links and creating potential conflict (and deadlock) among national authorities in cross-border resolution. A single resolution authority, as presumptive receiver of failed banks, can facilitate timely resolution, including of banks that operate across borders. It provides a mechanism to internalize home-host concerns and reach agreement on least-cost resolution and burden-sharing when common backstops are needed, and is therefore important to ensure effectiveness of the SSM. It can thus help to avoid the protracted and costly resolutions that occurred, for instance, in the cases of Fortis and of Dexia (Box 9.1). A single authority is also necessary to align incentives for least-cost resolution—since a common backstop in the context of a decentralized mechanism would provide incentives to shift residual losses from national taxpayers to those in the euro area. Pooling bank resolution capacity in a single body would achieve economies of scale, avoid incoherence and duplication, align incentives, and accumulate expertise including for preparation and implementation of recovery and resolution plans for systemic institutions.

Box 9.1Resolutions of Fortis and Dexia

Fortis. In the aftermath of the Lehman collapse, an agreement was reached on September 28, 2008, to save the troubled Fortis group with taxpayer support from Belgium, Luxembourg, and the Netherlands. The agreement, however, fell apart soon thereafter as liquidity pressures mounted. Subsequently, the Belgian parent company sold the shares of the Dutch parts of Fortis to the Netherlands’ government, whereas Belgium and Luxembourg sought a common solution for their parts of Fortis, eventually agreeing to sell the banking arm to BNP Paribas. This break-up along national lines constitutes a setback to financial integration in the Benelux and was likely more costly than a first-best joint solution for the group.

Dexia. Dexia failed in 2011 after losing access to wholesale funding and it faced increased collateral demands on interest rate derivatives. The resulting break-up was segmented along national interests. On October 10, it was announced that the Belgian operations would be purchased by the Belgian government; foreign subsidiaries in Canada, Italy, Luxembourg, Spain, and Turkey would be put up for sale; and parts of the French operations would be purchased by two French public sector banks. The remaining troubled assets, including a €95 billion bond portfolio, would remain in a bank in runoff (Dexia SA) that would receive funding guarantees of up to €85 billion provided severally (but not jointly) by the governments of Belgium, France, and Luxembourg, along with recapitalization of €5.5 billion. At end-2012, the EC approved the resolution plan for Dexia group.

Characteristics of a Single Resolution Mechanism

The SRM should comply with emerging best practices as laid out in the Financial Stability Board’s “Key Attributes of Effective Resolution Regimes for Financial Institutions.” The SRM should seek to resolve financial institutions without disrupting financial stability. It should minimize costs to taxpayers, protect insured depositors, and ensure that shareholders and unsecured, uninsured creditors absorb losses. There are prerequisites and preconditions of effective resolution:

  • Preconditions for effective bank resolution include: (1) a well-established framework for financial stability; (2) an effective system of supervision, regulation, and oversight of financial institutions; (3) effective safety nets and protection schemes; (4) a robust accounting, auditing, and disclosure regime; and (5) a well-developed legal framework.

  • Prerequisites for a strong authority include: (1) operational independence consistent with the statutory responsibilities; (2) transparent processes; (3) legal protection; (4) sound governance, rigorous evaluation and accountability mechanisms; and (5) adequate resources.

  • The SRM should be centered on a single resolution authority. A single resolution authority would be based on supranational legislation, but any treaty change would require time. A single authority would need a mandate, alongside the supervisor, to develop resolution and recovery plans well ahead of, and intervene before, insolvency using well-defined quantitative and qualitative triggers. They would need strong powers to take early intervention measures (for example, to require capital conservation measures or restrictions on activities), restructure banks’ assets and liabilities (for example, apply a “bail-in tool” to subordinated and senior unsecured creditors, transfer assets and liabilities—“purchase and assumption”—to a sound acquirer, and separate bad assets by setting up an asset management vehicle), override shareholder rights (subject to them being no worse off), establish bridge banks to maintain essential financial services, and close banks.

Burden Sharing

The SRM should provide clear and specific burden-sharing mechanisms. As resolution involves sensitive choices over the distribution of losses, clear ex ante burden-sharing mechanisms would be necessary to realize least cost resolution. The resolution mechanism should specify clear exit strategies that maximize the value of participations acquired and prohibit national preference.

  • Hierarchy. Respecting the hierarchy of creditor claims, the resolution authority should be able to haircut or extinguish unsecured liabilities, starting with equity and potentially extending to senior unsecured debt (that would be bailed-in), according to a clear creditor priority list. This would reduce uncertainty in the capital structure and any eventual resort to taxpayer funding. Given their explicit taxpayer backing, insured depositors would need to be given clear priority among unsecured and secured bank liabilities, to maximize recovery of deposit payouts from failed banks in resolution. Hence, depositor preference provisions should be included in EU legislation such as the recovery and resolution directive.

  • Contributions from the industry. A resolution fund, partly funded ex ante by contributions from the industry, should be used first to finance resolution after unsecured claimants have been extinguished. Insofar as private sector contributions and loss allocation across uninsured and unsecured claimants would be insufficient in a systemic crisis, a common backstop, adequately designed, would also need to be tapped.

  • A systemic risk exception. A systemic risk exception for the banking union could be considered for systemic events to override the least cost requirements. This approach would adapt the U.S. statutory “risk exception” and would provide clarity and credibility to the bank resolution process. To address moral hazard concern, a high bar would be needed to invoke the exception.

Institutional Considerations

Given the complex fiscal decisions involved and the need for checks and balances, the resolution authority should be set up independently of, but on par with, the ECB supervisory mechanism and should manage the resolution and deposit insurance fund. Collaboration and information sharing between the two is essential. For instance, consideration could be given to the creation of a committee comprising the head of the supervisory function of the ECB and the chairman of the resolution authority. Alternatively, the ECB head of supervision could serve on the board of the resolution authority, together with national representatives and representatives of other EU bodies.

Common Safety Nets

Why a Common Deposit Insurance and Resolution Fund?

By pooling risk, a deposit insurance and resolution fund will not only help countries avoid disruptions that may overwhelm their individual capacities but will also form a key pillar in the incentive compatibility of banking union. If a weak sovereign is perceived not to be able to honor its safety net obligations, losses of confidence can quickly follow, triggering capital flight and deposit outflows. A pooled mechanism with credible backstops would be more effective in protecting confidence and in diversifying risks across banks. Without common safety nets and backstops, the banking union would remain an incomplete and risky construct that fails to delink the funding costs of weak sovereigns from that of their banks. It would also risk jeopardizing the credibility of the ECB and the SSM by leaving the system vulnerable to financial fragility.

What Could be the Size of the Fund?

The resolution and deposit insurance fund could be relatively small and cover some individual bank failures, with fiscal and central bank backing to be used in the event of a systemic crisis. The fund could, in practice, cover both resolution and deposit insurance—if the ranking of claimants is clear and adequate, the objectives of the two functions would be aligned. While there is no well-established good practice, the typical target size of resolution and deposit insurance funds could range from about 1 to 2 percent of total liabilities (excluding equity) in large systems, where the aim is to cover two to three mid-sized banks and four to six small banks.

Why Centralize Lender-of-Last-Resort Functions at the ECB?

The lender-of-last-resort makes liquidity support available to solvent yet illiquid banks. Centralizing all lender-of-last-resort functions at the ECB would in the steady state eliminate bank—sovereign linkages present in the current Emergency Liquidity Assistance (ELA) scheme (that were described in Box 9.1). This would require changes to the ECB’s collateral policy, as by definition euro area banks that tap ELA cannot access Eurosystem liquidity owing to collateral constraints. Until such time as all banks are brought under the ECB’s supervisory oversight, ELA would be sourced through both the ECB (for banks brought under its purview) as well as national central banks (NCB) (for banks that remain under national supervision, albeit with adjustments made to the national ELA limits).

European Stability Mechanism Direct Recapitalization

Purpose

Mobilizing the ESM direct bank recapitalization tool in a forceful and timely manner is critical to developing a path out of the current crisis and would complement other measures such as the ECB’s Outright Monetary Transactions. Recapitalization of frail, domestically systemic banks in the euro area, including some migration to the ESM of existing public support to such banks, can help break the vicious circle between banks and sovereigns, reduce financial fragmentation, repair monetary transmission, prepare for banking union, and thus help complete the economic and monetary union. To be sure, failing nonsystemic banks should be resolved at least cost to national resolution funds and taxpayers. Equally, systemic banks benefiting from ESM support will need effective supervision and reform to be returned to full viability and private ownership, with state aid rules mandating formal restructuring plans. In some cases, the sovereign itself may need an adjustment program, providing an enabling environment for asset price recovery.

Approach

The mobilization of the ESM direct recapitalization tool should ensure frail, domestically systemic banks have adequate capital, access to funding at reasonable cost, and positive profits—in short, a viable business model. To this end, asset valuations are critical, as are the roles of shareholders, creditors, and the domestic sovereign in bearing costs.

  • Purpose. In principle, there would be significant advantages to breaking the vicious bank—sovereign circle if all capital needed to ensure that a systemic bank was adequately capitalized was ultimately provided by a central fiscal authority. This would especially be the case if the scenario were to play out in a small jurisdiction, and even more so if it also had to internalize spillovers to others (that might result, for example, if external creditors did not share in losses, for fear of triggering wider problems). More generally, pooling risk would provide protection ex ante to all, as any country could in theory find itself in a similar position in the future.

  • Principles. In practice, although the Treaty establishing the ESM provides for the possibility of losses, such losses are not expected in its financial operations, including bank recapitalization. As a bank investor, the expectation is that the ESM must be careful to take balanced risk positions. It likely could not provide capital that a patient investor would not expect to recover over time. Thus, capital needed to bring a systemic bank out of insolvency (that is, to bring it from negative to nonnegative equity) would in the first instance need to be provided by shareholders and creditors, and then by the national government, with any remaining shortfall covered by the ESM. Fortunately, there are unlikely to be large, insolvent banks currently in most economies.

  • A balanced approach allowing the possibility of risk sharing would prudently internalize the benefits of ESM capital support by looking ahead over a time horizon sufficiently long to realize the benefits. As a patient, deep-pocket investor, the ESM should take a long-term perspective in its investment decisions, cognizant that gross upfront crisis outlays tend to dwarf ultimate costs net of recoveries/capital gains and, in many instances, generate positive financial returns. In other words, while the ESM would not take on expected losses, it would shoulder the risk of unexpected losses going forward. This approach is in line with efficient risk sharing, wherein the patient investor bears the residual risk.

  • Asset valuation. The implications for asset valuation, which determine the size of recapitalization needs as well as the investors’ up/downside risk, are twofold. First, asset values should be neither too high (which would imply mutualization through the back door) nor too low (in which case, the private sector could simply buy the assets, and there would be limited benefit to having an official investor). Second, because the ESM is a patient investor willing to give the banks the necessary time to restructure, assets should be priced at values that give due consideration of the positive effect of recapitalization on asset values. This includes not just the direct positive effect of recapitalization (including more favorable funding costs) and recovery but also the removal of tail risk events (see next bullet).

  • Safeguards. There should be safeguards for the ESM (for example, built into the sales contract) against domestic policies that could directly harm the viability or profitability of the recipient banks (for example, onerous taxes ex post or stiff resolution levies). But ESM investments should not benefit from loss protection provided by the sovereign. Such approaches would preserve sovereign-bank links, undermining the purpose of ESM direct recapitalization.

  • Exit strategy. There should be incentives for an early ESM exit and private investor entry. The timing would be built around the EU-approved restructuring plans. Mandatory sunset clauses should be avoided as they could affect negotiating power ahead of the deadline.

  • Adequate resources. Direct equity injections into banks could absorb significant amounts of ESM capital. It would be important to ensure that the ESM has adequate capital to not only allay any investor concerns about ESM credit quality, and thereby limit any rating implications, but also play its potential role of a common backstop for bank recapitalization.

Legacy Assets

This term has been very controversial, reflecting concerns that creditor countries could be expected to put capital into nonviable banks. This is not what is being suggested above. Rather, losses on impaired “legacy” assets should be recognized through upfront provisioning and proper (long-term/postcrisis) valuation. It is not recommended that all impaired assets be segregated from the bank prior to ESM direct recapitalization and placed into recovery vehicles ultimately backed by the national taxpayer; such an approach would greatly reduce the effectiveness of the tool in addressing bank—sovereign links. Rather, bank health should be restored with shareholders, including the sovereign, bearing the expected loss of past excesses by being subjected to an independent valuation exercise consistent with the shared commitment to restore full viability after the restructuring period.

Further Support

To further support balance sheet clean-up, certain classes of legacy assets could be transferred to asset run-off vehicles such as asset management companies (AMCs) under ESM ownership. Expected losses would remain with the sovereign, given the terms of the foregoing recapitalization. But to limit further contingent fiscal liabilities and harness efficiencies, consideration could be given to allowing the ESM to set up and own AMCs. Possible roles for the ECB in supporting AMC operations could also be considered (although concerns regarding the prohibition on monetary financing may also be raised). ECB funding, if possible under its statute, would help smooth over time the warehousing and disposal of hard-to-value and hard-to-sell assets. An alternative would be for the ECB to support AMC operations indirectly by accepting ESM-guaranteed AMC bonds issued to banks in Eurosystem refinancing operations.

Transition in Crisis Time: How Do We Get There?

In an ideal world, the transition to a banking union would be gradual. After all, there was a decade between the European Council decisions to realize the monetary union in 1989 and the launch of the euro in 1999. Most likely, it would start with harmonizing supervision, resolution, and safety nets across countries—a process that may take some years before EU Directives are agreed upon and fully adopted at the national levels. This would be followed by gradual development of new common institutions, including fiscal backstops and burden-sharing arrangements. Finally, the process would culminate with the transfer of powers and responsibilities to a full banking union, with an SSM, a single resolution authority, a common resolution and deposit insurance fund, and common backstops.

But times are far from tranquil, and rapid action is needed. Repairing the financial sector, ending fragmentation, and reestablishing a properly functioning monetary policy transmission mechanism are key elements of any crisis resolution strategy. From that standpoint, the decision by euro area leaders to allow the ESM to recapitalize banks directly once a SSM involving the ECB is effective is the right one. In the context of private and public sector deleveraging, raising resources domestically to recapitalize banks is challenging (and impossible in some jurisdictions). At the same time, closing domestic systemic banks continues to pose a risk of uncontrollable consequences. Shared support for recapitalization would facilitate financial and economic stabilization at the national level, and thus for the monetary union as a whole, although it raises questions about burden-sharing and moral hazard. Hence, the transfer of financial responsibilities to the center needs to be balanced by the transfer of supervisory power. In that context, the decision to subordinate ESM direct recapitalization to the establishment of an effective single-supervision mechanism within the ECB is a sensible one.

How to Sequence the Banking Union?

All the elements—an SSM, single resolution with common backstops, and common safety nets—are necessary for a successful banking union. Missing elements would result in an incoherent banking union and, at worst, an architecture that is inferior to the current national-based one. Therefore, ideally, progress would be made on each of the elements. Given the need to resolve outstanding differences of views on the details and timing, however, it may not be possible to make progress on all the elements now. However, a well-defined timetable at the outset would remove uncertainty, bolster confidence in the political willingness to build a robust financial stability architecture, and anchor execution. In this respect, the timeline agreed upon by the EU Council is commendable, although agreement on the third component (common safety net) is still missing. But above all, agreement upon and adoption of the single rule book in national laws (the CRD IV/CRR, the recovery and resolution directive, and the deposit insurance directive) must proceed urgently to ensure robust environments are in place at the country level as the SSM is rolled out.

Finally, although working under the existing treaty framework is the swiftest way to start, strengthening the legal framework over time would minimize implementation and litigation risks (Box 9.2).

How Should the ECB be Judged as Having Become Effective?

Following the finalization of the agreement on the SSM regulation, the ECB will take full supervisory responsibilities one year after the SSM regulation enters into force, or when the ECB declares itself ready, whichever comes later. An approach based on the Basel Core Principles would take years to achieve as it would demand completeness of the banking union. Instead, the more modest and pragmatic approach adopted by the EU Council at their December 2012 meeting is appropriate. A phased roll-out of the SSM could seek to make it “effective” for troubled systemic banks during the transition. The forthcoming balance sheet assessment (or asset quality review) of euro area banks together with an agreed strategy on how to address capital shortfalls and to restructure failed banks. It will increase transparency about the condition of European banks and provide the ECB with a consistent view of the banks it will supervise under the SSM. It will be critical to establish the ECB’s credibility as a supervisor and prevent procyclical deleveraging. The emphasis should be on establishing a strong SSM in which the ECB has formal powers, the decision-making processes, and the capability to perform essential supervisory tasks in an intrusive delegated monitoring model. A well-functioning information and evaluation infrastructure must be established quickly so that the ECB can serve as a central supervisor. The ECB must be able to request and receive all necessary information, conduct off-site diligence, field on-site inspections while relying on cross-country teams, and pursue further action on any bank in the euro area. The ECB would need to put in place adequate resources and organizational capacity to commence selected supervisory tasks, which will be a complex and demanding exercise. Based on information to be provided by national authorities on their banks’ supervisory histories and risk profiles, the ECB could then start offsite stocktaking of the banks under its supervision to prioritize institutions in need of deeper diagnostics based on risk.

Box 9.2Legal Considerations

Legal basis of the banking union. Under Article 127(6) of the Treaty on the Functioning of the European Union (TFEU), the ECB is able to take on specific supervisory tasks without treaty change, upon a unanimous decision of the European Council and after consultation with the European Parliament and the ECB. The EU Council agreement vests in the ECB exclusive authority for a wide range of supervisory tasks. While Article 127(6) provides a legal basis, it has been interpreted expansively in order to establish the SSM. The draft SSM regulation carefully attempts to specify the ECB remit, but litigation risks may in principle not be excluded, as any financial institution confronted with a supervisory decision by the ECB could bring a case before the European Court of Justice on grounds of lack of competence. In the medium term, providing an explicit legal underpinning for financial stability arrangements in the Treaty would further strengthen their legal soundness. This would allow to anchor financial stability as a key objective under the Treaty and to define roles and powers of all the safety net players, including a fully fledged resolution authority with a common backstop.

Shared competences and responsibilities. Under Article 127(6) and the regulation that is based upon it, supervision will remain a shared competence between the ECB and member states. The ECB will be responsible for certain supervisory measures, while member states retain their powers with respect to any aspect that is not covered by the draft SSM Regulation (for example, anti-money-laundering, consumer protection, and some macro-prudential tools). For the tasks conferred to it, the ECB would take the final decisions vis-à-vis “significant” banks, while the national competent authorities (NCAs) will assist the ECB with the preparation and implementation of such decisions, pursuant to the ECB’s instructions. For other banks, NCAs will formally take supervisory decisions, but still under ECB instructions. The ECB will be responsible for the effective and consistent functioning of the SSM, and both the ECB and the NCAs will be subject to a duty of cooperation. The overall division of tasks and responsibilities will need to be clarified, to remove any remaining uncertainties as to who, as a legal matter, will be ultimately accountable for supervisory decisions.

ECB Governance. The Governing Council is the ultimate decision-making body of the ECB, as enshrined in the Treaty, including for any supervisory tasks conferred upon the ECB under Article 127(6). Several challenges may arise from this setup. First, as the Supervisory Board can only prepare the supervisory decisions to be taken by the Governing Council, it is only the latter that will formally be responsible for supervision, in addition to monetary policy. Therefore, the separation of monetary and supervisory responsibilities can only be implemented at an operational level, as the legal mandate of the ECB, pursued by the Governing Council as the ultimate decision making body, remains unaltered. Second, the existence of multiple layers of governance arrangements, coupled with the impossibility to delegate decisions to the Supervisory Board, may create a burdensome process; legal risks may arise from the need to align the practice of daily supervision with the legal requirements dictated under the Treaty and the SSM regulation. Lastly, as non-euro area SSM participants cannot be represented on the Governing Council of the euro area, taking part in the SSM decision making process would require alternative arrangements to have their voices heard, such as through the supervisory board, with mediation channels to resolve differences.

EU banking laws. The EU’s banking laws feature significant weaknesses on both form and substance. On form, the current approach based on directives implemented in national laws must swiftly be replaced by a directly applicable single rule book. On substance, current weaknesses in EU banking law will also have to be remedied, e.g., weak fit and proper criteria and the absence of restrictions on related party lending.

Legal actions at the national level. Whether the EU Regulation conferring on the ECB supervisory tasks also requires legal changes at the national level is unclear. However, legal amendments of national legislation seem to be inevitable to provide legal clarity to ensure a smooth functioning of the SSM. Absent a single, directly applicable rule book, such amendments of the domestic legislation may also be necessary to improve national supervisory regimes.

The Single Resolution Mechanism

It is essential that the European Council commit to a firm timeline for implementing an SRM, including burden-sharing arrangements, on the basis of the EC proposal. When agreements on adequate resolution (and deposit insurance) funding and backstops are in place, the single resolution authority could begin operating. Meanwhile, resolutions would be handled by the national authorities under strengthened regimes (and, as needed, support from the sovereign with borrowing from the ESM). During the interim period, the SSM would work with national resolution authorities to resolve or restructure weak institutions, until a single resolution authority with common backstops is established. To facilitate the process, there may be merit to establishing a temporary body or creating urgently an EU agency tasked with the coordination of bank crisis management and resolution among national authorities and the ECB. Agreeing on clear principles about the hierarchy of claimants and reducing expectation of bailouts would also help contain the fiscal costs of future resolutions, including by allowing the possibility of bailing-in uninsured creditors. But, to be sure, a strong SRM, is critical to minimize risks to the credibility of the SSM and to ensure timely and least cost resolution while protecting financial stability. It should become operational at around the time when the ECB takes full responsibility for the SSM in 2014 to enhance the ECB’s effectiveness as a supervisor.

Common Safety Nets

Steps should also be taken toward common safety nets to remove stability risks and help delink sovereigns and banks. A reinsurance scheme, for instance, could be created from national DGS, funded at the euro area level through industry levies and contributions from member states. It would pool risk and weaken sovereign—bank links. Ex ante agreement on the shares of national and supranational funding in depositor payouts would limit moral hazard. Over time, the fund would build administrative capacity and could be a step toward a permanent euro area scheme and resolution fund.

The Banking Union and Non-Euro Area EU Member States

Non-euro area EU member states will benefit indirectly from a euro area banking union. A banking union is necessary for the euro area. It should be recognized upfront that, by enhancing stability and removing financial market fragmentation, a well-functioning euro area banking union generates positive spillovers and enhances the functioning of the EU single market for financial services as a whole. Therefore, other EU member states have a legitimate interest in ensuring that the new system is set up properly. A single euro area supervisory mechanism can also solve coordination problems related to the supervision of cross-border banks.

A euro area banking union raises a number of complex issues for the “outs.” To ensure the integrity of the single market for financial services, the system must be balanced between the interests of the “outs” and decisions taken by the SSM. Specifically, decision making in the EBA and supervisory colleges where the SSM would be represented by the ECB must ensure integrity of the single market, including on issues such as the fiscal consequences of decisions on banks with cross-border operations. It is also important that the interests of those who wish to join the banking union but keep their own currency be represented, within the constraints of the EU Treaty under which they would not have a voice in the ECB Governing Council. The banking union should also be made more attractive to join, for instance, by facilitating access to backstops and safety nets, albeit with commensurate contributions.

The role of the EU bodies should be reaffirmed when the banking union is established. Strengthening EU bodies will enhance the effectiveness of the banking union and reinforce the EU architecture. The EBA provides an avenue not only for protecting the interests of the “outs” but also for coordinating action and harmonizing rules (such a regulation and supervision) within the EU. In this regard, the EC proposal and EU Council agreement confirming the role of the EBA as the mediator of cross-border supervision and resolution issues and as the regulatory and supervisory standard-setter in the EU is helpful. Non-euro area EU members should retain an adequate voice within the EBA. The European agreement modified voting procedures within the EBA Board with double-majority voting to balance the interests of the “outs.” It will be important that the EBA be an effective and credible force in the single financial market, including limit concerns about regulatory arbitrage. Likewise, the European Systemic Risk Board’s role as the main macroprudential oversight body in the EU for banks and non-banks would need to be strengthened further. It should cooperate closely with the ECB, once the ECB takes on greater macroprudential responsibilities, but should also acquire independence.

Non-euro area countries are provided voice in the SSM. The SSM regulation agreed upon by the EU lawmakers provides a welcome opt-in for non-euro area EU countries, through representation and procedures on the supervisory board (since these members cannot be represented on the ECB’s Governing Council). Draft decisions prepared by the supervisory board are deemed adopted, unless the Governing Council objects within 10 days in normal times or two days in stressful ones. A mediation panel and a steering committee would also be created. These structures seek to aid decision-making and resolve disagreements and to reinforce cooperation between the ECB and national authorities. But it will also be important to ensure that the complexity of the setup does not undermine effective and prompt supervisory decision making.

Further steps will be needed to incentivize opt-ins and stabilize their participation in the banking union. Over time, some EU countries may want to be part of the banking union even if they do not join the euro area. A strong banking union that offers risk sharing (while avoiding the mutualization of legacy issues) and ensures least-cost bank resolution could be an attractive proposition for non-euro area countries as well. Moving supervision to the ECB could improve supervisory quality in some countries, reduce compliance costs for cross-border banks, limit scope for regulatory arbitrage, eliminate host-home coordination issues, and increase the congruence between the market for financial services and the underlying prudential framework. A single resolution authority and common safety nets, with backstops, would provide further benefits in terms of risk-sharing, when these are in place. But there are also drawbacks and complications, including the interaction of multiple central banks (with implications for the lender-of-last-resort function and the conduct of macroprudential policies), difficulties in ensuring adequate participation of the “opt-ins” in SSM decisions, a loss of sovereignty, and potentially less flexibility to deal with country specificities. These costs are likely to be less, especially for those whose currencies are pegged to the euro, or have high levels of foreign currency liabilities, or have a sizable presence of euro area banks in their financial systems. If these members adopt the euro at the same time as they join the banking union, the benefits would likely outweigh the costs, just as it does for euro area members currently.

References

    AgarwalSumitDavindLuccaAmitSeru and FrancescoTrebbi2012Inconsistent Regulators: Evidence from BankingNBER Working Paper No. 17736 (Cambridge, MA: National Bureau of Economic Research).

    GoyalRishiPetyaKoeva BrooksMahmoodPradhan and others2013A Banking Union for the Euro AreaIMF Staff Discussion Note No. 13/1 (Washington: International Monetary Fund).

This chapter draws on the February 2013 IMF Staff Discussion Note “A Banking Union for the Euro Area (Goyal and others, 2013).” The contribution by the authors of the Staff Discussion Note is gratefully acknowledged.

Agarwal and others (2012) show that, in the United States, federal regulators are significantly less lenient than state regulators (although the United States also has federal backstops in place).

Agreement between the Council and the EU Parliament on the CRR/CRD IV was reached on March 27, 2013, and the new rules were adopted June 20, 2013.

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