The European Banking Union

A Critical Assessment

Angelo Baglioni

• Publisher: Palgrave Macmillan
• Year: 2016
• Print ISBN:
  9781137563132
• eBook ISBN:
  9781137563149
• Topic: Business
• Subtopic: Finance
• Index: Business

Why did  European policy-makers introduce the Banking Union? Which are its main features? How does it affect banks and their customers? This book tries to answer these questions, by providing a clear description of the building blocks of the banking union, and by discussing the issues that still remain unanswered. 

© The Editor(s) (if applicable) and The Author(s) 2016

Angelo BaglioniThe European Banking UnionPalgrave Macmillan Studies in Banking and Financial Institutions10.1057/978-1-137-56314-9_1

Begin Abstract

1. Introduction

Angelo Baglioni¹ 

(1)

Milano, Dipart Economia e Finanza, Università Cattolica Sacro Cuore, Milano, Italy

 

End Abstract

1.1 The European Banking Union: A Work in Progress

When the historical decision leading to the banking union was taken at the European Council in June 2012, the declared reason was to “ensure that the supervision of banks in all EU member states is equally effective in reducing the probability of bank failures.”¹ One year later, while stressing that the completion of the banking union had become a priority among the policy objectives of European policymakers, the Council stated that “it is imperative to break the vicious circle between banks and sovereigns.”² At the origin of these statements, there are the large amounts of money spent by several European governments to bail out those banks involved in the financial crisis that started in 2007. In addition, the sovereign debt crisis, hitting the high-debt European countries since 2010, has shown that the exposure to the domestic public debt is an important source of instability for the banking sector. Therefore, it has become clear that the transfer of financial risks can go not only from banks to governments, but also the other way around, creating a two-way link between banks and sovereigns. Even more importantly, this link mainly works at the national level: on one side, governments provide financial support to their domestic banks; on the other side, the exposures of banks to the sovereign borrowers have generally a strong home bias.

The original project of a European banking union has three pillars:

• Single Supervisory Mechanism (SSM)
• Single Resolution Mechanism (SRM)
• Single European Deposit Guarantee Scheme (EDGS)

The first pillar transfers the responsibility of banking supervision from the national authorities to the European Central Bank (ECB); this is fully operational since November 2014. The second pillar includes a new set of rules governing the resolution of troubled banks (laid down in the Bank Recovery and Resolution Directive [BRRD]), and a new authority endowed with resolution powers (Single Resolution Board [SRB]), which is endowed with some financial resources pooled together across the euro area countries (Single Resolution Fund [SRF]). The new rules and the new resolution authority are in place as of January 2016; however, the SRF is going to be gradually built up through a transition period that will end in 2024. The third pillar is actually missing, since the Directive on deposit insurance approved in 2014 is still a harmonization device, and it does not introduce any common guarantee scheme across the euro area countries.

The emerging picture from the current state of play is a banking union that is still halfway. The transfer of prudential supervision to the ECB has been done, and a new set of rules to manage the banking crises have been introduced. To the contrary, the pooling of resources to support the resolution of stressed banks is still under way, and it will be very limited even at the end of the transition period, given the small size of the SRF and the lack of a common fiscal backstop behind it (apart from a limited role played by the European Stability Mechanism [ESM]). In addition, no common pool of money to repay the depositors of failed banks has been created so far.

The fact that the banking union is currently a project far from being completed derives from the political stance, prevailing in several European countries, which is adverse to any kind of cross-country risk-sharing arrangements. Thus the steps taken so far, in the implementation of the project, are those that should be able to reduce the probability of banking crises and limit their fiscal cost. The first goal has been assigned to the ECB, which is expected to preserve the financial stability by implementing a uniform and high level of supervision in the euro area. The second goal has been pursued by introducing the “bail-in” principle into the EU legislation, which imposes that a relevant contribution to the resolution of a troubled bank comes from their shareholders and creditors, thus reducing the use of taxpayers’ money. To the contrary, those steps that imply a pooling of financial means, within the euro area, to tackle the banking crises are only at an initial stage.

The consequence of this state of play is that the two-way link between banks and sovereigns is bound to be in place for the foreseeable future. On one side, the costs deriving from a banking crisis will still fall within the national borders to a large extent: they will be paid by the stakeholders of a distressed bank and by the domestic government, providing the fiscal backstop (albeit within the limits of the state aid rules). On the other side, banks will presumably continue to hold large amounts of securities issued by their domestic governments.

1.2 Why This Book?

This book has two objectives. First, it provides the reader a description of the European banking union. The introduction of the banking union into the European landscape has required the adoption of many and complex regulatory innovations, which I will try to describe in a simple and sufficiently accurate way at the same time. Of course, summarizing several legal texts, amounting to many hundreds of pages, in a rather short volume requires sacrificing many details. However, my main purpose is to provide an overview of the architecture of the banking union, together with the essential elements of the new regulatory framework. My focus is on the economic and organizational impact of the banking union; to the contrary, I do not have the skill to discuss the legal issues related to it (the interested reader will be referred to the relevant legal texts and literature).

The second objective is to provide a critical assessment of the state of play of the banking union. On the one hand, some official sources (e.g. ECB, EU Commission, EU Parliament) provide material where the essential information related to the banking union can be found. However, they always take an acritical and extremely positive view on the matter: they stress on all the achievements that have been made, without considering any of the drawbacks of the new institutional framework. On the other hand, some contributions by independent (mainly academic) scholars provide some criticisms, but they are generally focused on specific issues and they are rather technical. I will try to fill this gap, trying to assess the positive results obtained so far as well as the main open issues related to the banking union.

In a nutshell, I acknowledge that the banking union is a major achievement within the process of European integration. Actually, it is the only relevant step forward in recent years, particularly in the aftermath of the financial crisis. In other areas, like the transition to a federal budget, the introduction of Eurobonds, and the strengthening of the European political institutions, the process of integration is lagging behind. However, we should not overlook the fact that the banking union is an incomplete project, for the reasons outlined above; moreover, several critical issues emerge when we carefully examine the way in which the project is being implemented. Just to mention a few of them: (1) the responsibility of the macro-prudential supervision has been left to the national authorities, which is not satisfactory given the cross-border dimension of systemic risk, (2) the stress test carried out by the ECB in 2014 has focused on the ratio between equity and risk-weighted assets (RWAs), while also leverage should be considered, (3) the application of the bail-in rule to the retail bank customers raises problems of transparency and instability, (4) the governance of the SRM seems too complex and prone to political interference.

1.3 Plan of the Work

I will start by examining the reasons behind the introduction of the European banking union. The second chapter will document the fiscal cost of the recent financial crisis, which has been the main driver inducing the policymakers to assign the ECB the task of implementing tough and uniform standards of supervision in the euro area. The above-mentioned two-way link between banks and sovereigns will emerge by looking at the market price of risk for the two sectors.

I will then describe the new architecture of banking supervision, going into the organizational details of the SSM (Chap. 3). Some controversial issues will be discussed, like the separation between prudential supervision and monetary policy, the balance of powers between the ECB and the national authorities, the discretionary approach based on the Supervisory Review and Evaluation Process (SREP), and the lack of a single authority responsible for the macro-prudential supervision.

The first important action taken by the ECB, as banking supervisor, has been the Comprehensive Assessment of 2014, where the 130 largest banks in the euro area have been examined through an Asset Quality Review (AQR) and a Stress Test. The main features of this exercise will be described in Chap. 4. The methodology used by the ECB has raised several criticisms; some of these controversies will be addressed here.

Then I will move to the second pillar of the banking union, namely the SRM (Chap. 5). Actually, I will first outline the main regulatory innovations introduced by the BRRD, affecting all the EU countries. I will then analyze the organization and funding sources of the SRM, concerning the euro area countries. Some crucial issues will be discussed here, like the bail-in principle, the governance of the SRM, and the role that should be played by the ESM as a fiscal backstop.

Finally, I will consider the missing pillar: a European Deposit Guarantee Scheme (EDGS). Actually, some progress has been recently made in the area of deposit insurance, thanks to the Directive approved in 2014. The main innovation is the requirement that the national guarantee schemes should be funded ex ante by collecting risk-based insurance premiums. However, that Directive is still aimed at harmonizing the national deposit guarantee schemes, rather than pointing to some integration among them. Looking forward, I will argue that the best way to proceed is not by creating a new European institution, responsible for deposit insurance, but rather by expanding the scope of the SRM, thus going toward an integrated resolution and deposit insurance agency (like the Federal Deposit Insurance Corporation [FDIC] in the USA).

Footnotes

1

This statement is taken from “Towards a Genuine Economic and Monetary Union,” a report by the President of the European Council, June 2012. This report was presented at the June 2012 European Council.

 

2

Conclusions of the June 2013 European Council.

 

© The Editor(s) (if applicable) and The Author(s) 2016

Angelo BaglioniThe European Banking UnionPalgrave Macmillan Studies in Banking and Financial Institutions10.1057/978-1-137-56314-9_2

Begin Abstract

2. Three Reasons for the European Banking Union

Angelo Baglioni¹

(1)

Milano, Dipart Economia e Finanza, Università Cattolica Sacro Cuore, Milano, Italy

Keywords

Financial crisisBailoutSovereign riskSupervisory convergence

End Abstract

Introduction

Why did Europe decide to proceed toward the banking union? Three main reasons can be identified as follows:

• Reduce the fiscal cost of bank bailouts
• Break the two-way link between the financial risks in the bank and sovereign sectors
• Achieve a higher level of supervisory convergence

Some European governments have spent large amounts of money to bail out those banks involved in the financial crisis that started in 2007, thus putting the cost of stabilizing the financial sector on the shoulders of taxpayers. The sovereign debt crisis, hitting the high-debt European countries since 2010, made evident that the banking sector in some countries is vulnerable, due to its exposure to the domestic public debt. So the transfer of financial risks goes not only from banks to governments, but also the other way around, creating a vicious circle between banks and sovereigns. These arguments have been acknowledged by the policymakers, in particular in the meetings of the European Council in June 2012 and June 2013.

The expected cost faced by governments, related to the potential instability of the financial sector, can be reduced in two ways: first, by reducing the probability that some banks become financially distressed and eventually insolvent, and second, by limiting the resources committed to the bailout of those institutions that are already in trouble. The first goal can be pursued by increasing the standard of prudential supervision: the transfer of supervisory powers from the national authorities to the ECB is aimed at achieving a high level of supervision in all the eurozone countries. The second goal requires a revision of the crisis management practices and bank resolution procedures. The competent authorities should be endowed with early intervention powers so that loan losses are readily recognized and recapitalization actions are taken. They should also have the legal tools enabling them to impose a significant share of the bailout costs to the private stakeholders (shareholders and some classes of credi...

Table of contents

• Cover
• Frontmatter
• 1. Introduction
• 2. Three Reasons for the European Banking Union
• 3. The Single Supervisory Mechanism
• 4. The Comprehensive Assessment
• 5. The Single Resolution Mechanism
• 6. The Missing Pillar: A European Deposit Insurance
• 7. Summary and Conclusions
• Backmatter