The Choice for Banking Union

Power, Politics and the Trap of Credible Commitments

Elena Ríos Camacho

• Publisher: Routledge
• Year: 2021
• ISBN:
  9781000516500
• Edition: 1
• Topic: Politics & International Relations
• Subtopic: European Politics
• Index: Politics & International Relations

This book explains why the European Union (EU) Member States – in response to the euro crisis – agreed to establish banking union, despite previous objections, and why they chose its hybrid institutional design.

Analysing its establishment from 2012 to 2020, the book offers a comprehensive view of the preferences of the Member States and EU institutions, as well as of the negotiation dynamics and latest developments in the three pillars of banking union, namely, the Single Supervisory Mechanism, the Single Resolution Mechanism and the common backstop, and the European deposit insurance scheme. Furthermore, empirically, the book looks beyond the usual focus of the northern and southern coalition of states to underline the influence of powerful smaller Member States in the intergovernmental bargaining process. Adopting a range of theoretical perspectives, it questions the solidity of the northern versus southern camps and reveals distinctive and particular positioning from individual countries during the process.

This book will be of key interest to scholars and students of European financial market regulation, European economic governance, EU institutions, European integration theory and EU politics more broadly.

1Introduction

DOI: 10.4324/9781003153818-1

The financial and euro area sovereign debt crises (2008–2012) posed dilemmas that challenged Europe’s resilience by exposing deep structural flaws in the design of the Economic and Monetary Union (EMU) that had to be fixed for it to survive, creating strong pressures for reform. The international financial crisis, which first affected Ireland and later Spain, together with the domestic fiscal crises in Greece, Portugal and Italy, derived in a sovereign debt crisis, which became a Euro institutional crisis aggravated by the incompleteness and asymmetries of EMU as established by the Treaty of Maastricht in 1991.

Among the various reforms carried out at the onset of the euro area crisis, the establishment of the European Banking Union (EBU) represents the highest transfer of national sovereignty to the European Union (EU) level since the creation of EMU. The euro area sovereign debt crisis revealed that the banking systems of EU Member States were fragile, that the close link between domestic banks and the respective Member States reinforced financial risks, and that crises of domestic banking systems had contagious effects on other Member States, especially those of the Euro system. EBU constituted the EU’s response to this problem. “Banking Union” is a widely used term to refer to the project of transferring banking-sector policy instruments from the national to the European level, but there is no official or legal definition of what it is or should be. It includes three pillars: The Single Supervisory Mechanism (SSM), the Single Resolution Mechanism (SRM) and common backstop, and the European Deposit Insurance Scheme (EDIS).

At the beginning of the global financial crisis in 2008, the European Commission’s decision to allow national solutions to stability and growth reinforced national responsibility for bank recapitalization, namely public intervention and deposit insurance (Donnelly, 2013, p. 11). National governments remained the only actors that could function as a lender of last resort. However, Member States did not have all the necessary instruments to manage the crisis at the national level, nor had arrangements been set up at the euro area level (Howarth & Quaglia, 2016, pp. 44–46). The potential default of the Greek state in April 2010 threatened the financial stability of the country’s banks, which held large amounts of sovereign debt (Howarth & Quaglia, 2016, p. 36). As market tensions persisted and threats of contagion extended to the periphery of the euro area, Member States agreed to set up the European Financial Stability Facility (EFSF), a temporary entity with €440 billion, and the European Stability Mechanism (ESM), with a capacity of €500 billion, to provide financial support to troubled states. Subsequently, Greece was granted the EU-IMF financial support package with strict conditionality and an austerity reform package, which was supervised by the Troika institutions – the European Commission, the European Central Bank (ECB) and the International Monetary Fund (IMF).

A special feature of particular relevance to the euro area was the existence of a “vicious circle”, also referred to as the euro area’s “doom loop”, between sovereigns and banks (Schnabel & Véron, 2018, pp. 2–3). Banks that had become too systemic to fail (“too big to fail”) and got into trouble turned to their sovereign for financial support. The stability of the banking sector could only be guaranteed to the detriment of the public finances of the governments concerned. However, when they provided financial support to banks, they increased their own debt, which decreased the value of sovereign bonds held by banks. When financial institutions were in trouble again and requested a bailout, they triggered the “vicious circle” again.

Furthermore, inadequacies of Member States’ national banking regulations such as lax supervision due to cosy relations between bankers and politicians, different regulations across Member States, and burden shifting among Member States’ national regulatory authorities in cases of ailing cross-border banks, contributed to the euro area sovereign debt crisis. Prior to the financial crisis, the focus was on negative integration based on mutual recognition and home country control (Schimmelfennig, 2014, p. 6). Institutional choice during the euro crisis was mainly confronted by enforcement problems calling for more supranational delegation and stricter surveillance (Schimmelfennig, 2015, pp. 188–189).

During June 2012, the Eurozone financial crisis turned into a sovereign debt crisis when the Spanish and the Irish governments had to support and, if necessary, recapitalize their domestic banks badly hit by the global financial crisis. Spain found itself trapped in a “vicious circle” in which both its banking and fiscal crises became intertwined (Otero-Iglesias, Royo, & Steinberg, 2016, p. 13; Schnabel & Véron, 2018, pp. 2–3). The insolvency problems of many of its cajas and the country’s interest rate on its 10-year bond rising to 6.18 per cent were threatening the solvency of the Spanish sovereign and put the whole Eurozone at risk. There were fears that financial markets would lose trust in the Euro. Spain was not Greece; the Spanish economy was “too big to fail” and would send shockwaves throughout the euro area and globally. However, Spain was also too big to rescue (Otero-Iglesias et al., 2016, p. 41). At the 28–29 June EU summit, euro area leaders agreed, after long discussions, on the need to break the “vicious circle between banks and sovereigns” and establish the SSM involving the ECB (Euro area summit statement June 2012, 2012, p. 1).

The euro area institutional crisis in 2012 set the stage for radical reforms and unprecedented transfers of competences in banking supervision from the national to the supranational level, which Member States rejected prior to the crisis. Thus, Member States conceived EBU as a regulatory toolbox, which would collectively stabilize and build credibility in national banking systems by breaking the link between sovereigns and banks and transferring powers to the EU level. EBU undermines long-established bank-sovereign ties in Europe because it centralizes the governance of critical areas in banking regulation. EBU has a strongly supranationalized banking supervision in the ECB, thereby restricting the possibilities for national regulatory forbearance. It has also set up a Single Resolution Board (SRB), limiting national discretion over how to restructure or resolve a failing bank (Epstein & Rhodes, 2018, p. 220).

Research on EBU remains relevant in times of EMU crisis reforms, very low interest rates, high liquidity and continuing fragility in the banking sectors in Europe. In addition, key elements of EMU remain incomplete like the EBU project (Fleming, Stubbington, & Arnold, 2021). EBU remains incomplete in the context of an economic recession due to the Covid-19 pandemic that started at the beginning of 2020 with potential future implications for the banking sector.

The banking sector in Europe is today stronger and more resilient than in the period before the financial and sovereign debt crises. At the onset of the pandemic crisis, banks were able to maintain financing to the economy and, thus, protecting jobs. This has been possible by the work on the EBU since its creation in 2012. However, the Covid-19 pandemic is likely to temporarily disrupt or slow down the progress and positive trends observed over recent years (Council of the European Union, 2020). On 30 November 2020, the Eurozone finance ministers agreed to an overhaul of the ESM. The reform of the ESM treaty will also include the establishment of a common backstop to the Single Resolution Fund (SRF) in the form of a credit line from the ESM to replace the Direct Recapitalisation Instrument (DRI) (Council of the European Union, 2020). The backstop should allow the EU to deal better with systemic banking crises and to break the vicious circle that drags down the sovereign giving more credibility to Europe’s banking systems in the wake of the pandemic (Financial Times, 2020).

The next sections outline the paradox and empirical puzzle of the EBU, the goal of the book, its research design and contribution to the existing bodies of scholarly literature on banking union and the role of the traditional grand theories in European integration in explaining EMU reforms in an unprecedented euro area crisis.

The paradox and puzzle of European Banking Union

Since 2012, the establishment of the EBU is still a work in progress. It represents the highest transfer of national sovereignty to the EU level since the creation of the EMU. It was conceived as an essential complement to EMU with the main objective of strengthening financial stability in the euro area and the EU. Its aim was to restore confidence in the European banking systems and – in words of the European Council President Herman Van Rompuy (2012) – “complete” EMU, thus saving the euro and protecting it better from future shocks (Van Rompuy, 2012). More specifically, EBU was designed to tackle the sovereign-bank nexus and the enforcement problems of national regulation in an integrated financial market.

EBU comprehends two layers: a regulatory one, which includes a set of common rules, the so-called single rulebook, established to harmonize regulatory standards in the European financial sector; and an institutional one, which comprises regulatory and redistributive tools applicable to participating Member States in the EBU. The single rulebook applies to all Member States and its four main elements are the Capital Requirements Directive 4 (CRD 4), the Capital Requirements Regulation (CRR), the Deposit Guarantee Scheme Directive (DGSD) and the Bank Recovery and Resolution Directive (BRRD). The second layer of EBU consists of its three pillars, namely, the SSM, the SRM and EDIS. The present book focuses on this second layer.

The SSM became fully operational on 4 November 2014 and set up a centralized banking supervision for the euro area Member States and those non-euro countries willing to join. It supervises directly the 123 largest and most systematically relevant Eurozone banks, which account for approximately 82 per cent of the total banking assets. The ECB can also supervise directly the remaining 3,500 less significant banks when it deems necessary to guarantee the consistent application of high prudential standards (European Central Bank, 2015, pp. 48–49).

As for the SRM, a new EU agency, the Single Resolution Board (SRB), and the European Commission in cooperation with the Council of the EU are responsible for restructuring and resolving troubled banks in the Eurozone. The SRM became operational on 1 January 2016 and it includes an SRF to support resolution action. The SRF is targeted for a level of €55 billion and relies on funds financed by the national compartments of each Member State up to a period of eight years. In addition, the SRM includes a common backstop to the SRF. This backstop will be fiscally neutral and will be activated where, after imposing losses on the bank’s shareholders and creditors (“bail-in”), the SRF is temporarily short of resources for resolving the failing bank (European Commission, 2017, pp. 1–2).

The EDIS will be mandatory for deposit guarantee schemes in participating Member States and will include a Deposit Insurance Fund (DIF) to complement national deposit guarantee schemes in three phases: reinsurance, co-insurance and full insurance. The aim of EDIS will be to further break and disentangle the link between banks and sovereigns by distributing the risks associated with protecting depositors from local bank failures to the EBU (European Commission, 2015, pp. 5–6).

EBU is, on the o...