From Fragmentation to Financial Integration in Europe

Charles Enoch, Luc Everaert, Thierry Tressel, and Jianping Zhou

• Publisher: INTERNATIONAL MONETARY FUND
• Year: 2013
• ISBN:
  9781484387665

NONE

Chapter 1. Securing a Safer Financial System for Europe¹

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 ...