ATTILA MARJÁN – LORINA BUDA

Banking Union –Achievements and Concerns

HIIA Papers T-2014/6

HIIA PAPERSSeries of the Hungarian Institute of International Affairs

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© Attila Marján, Lorina Buda, 2014© Hungarian Institute of International Affairs, 2014

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Attila Marján - Lorina Buda Banking Union

The aim of this study is to present the ongoing procedure of creating the banking union and to construe the arising problems in connection with the negotiations. The first steps of the banking union have been taken, ECOFIN has agreed to SRM (Single Resolution Mechanism) in March 2014. Nevertheless it is evident that the EU is still far away from the full-fledged “banking union” deemed necessary to underpin financial markets and help sustain the stability of the Eurozone.

The Way To The Banking Union

More than 5 years have passed since the outbreak of the financial crisis. Many institutional changes and reforms have been undertaken since then. One of these measures is the banking union, which is meant to be the recipe for banking

sector shocks. The US subprime mortgage market crisis has hit the financial sector of the EU. The need to save the ailing banking sector has damaged government budgets in Europe, while weak government balance sheets undermined the banking sector1 – the financial vicious circle.

Figure 1: Toxic Interactions between Banks & Their Sovereigns2

The crisis brought to light serious shortcomings in the existing framework of the European financial market supervision. It was obvious that the existing EU-level micro and macro prudential supervision system (European Systemic Risk Board, ESRB), the European Banking Authority (EBA), the European Insurance and Occupational Pensions

1 Eurozone banks hold about 1.75 trillion euros of government debt, equivalent to 5.7 percent of their assets and the highest relative exposure since 2006. “European States Seek Backing for Banking Union Reform”. Reuters, http://www.reuters.com/article/2014/03/11/us-eu-banks-idUSBREA2A10A20140311, 11 March 2014.

2 Source: Richard J. Herring: “The Danger of Building a Banking Union on a One-Legged Stool”. In: Political, Fiscal and Banking Union in the Eurozone? E-book: CEPS, http://www.ceps.eu/book/political-fiscal-and-banking-union-eurozone, 18 December 2013. p. 12.

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(EIOPA), the European Securities and Markets Authority (ESMA), and the European System of Financial Supervision (ESFS) were not efficient enough.

In several Member States, banking groups with their headquarters established in another Member State hold a significant market share, and credit institutions have geographically diversified their business. The present crisis has shown quite well that the integrity of the internal market may be threatened by the fragmentation of the financial sector. The integration of the banking markets in the Union brought close to collapse. But financial stability – including a healthy banking sector, and restoring lending to the economy, maintaining and deepening the internal market for banking services – is key for sustaining the economic recovery.

Nevertheless, up until now, supervision of cross-border banks has been carried out by national supervisors. Under EU law the home supervisor and the host supervisors of other Member States where the bank establishes branches or subsidiaries or provides cross-border services have to coordinate their action. Therefore, in June 2012, as part of a longer-term vision for economic and fiscal integration, the European Commission3 called for a banking union to restore confidence in banks and the euro. Countries of the euro area would create a single supervisory mechanism for banks. Such an integrated supervision is necessary to make sure that all euro countries can have full confidence in the quality and impartiality of banking supervision.

According to the envisaged road map, the banking union has three major elements plus one:

0. single rulebook for the European financial market;1. Single Supervisory Mechanism (SSM);2. Single Resolution Mechanism (SRM), ideally supported by a Single Resolution

Fund (SRF) and a fiscal backstop;3. Deposit Guarantee Schemes (DGS).

The single rulebook for financial services is the base of the banking union. EBA has the competence to develop it and monitor its implementation. The banking union was launched by creating the single rulebook and the single supervisory mechanism.

The first block of the banking union is SSM, which was created4 in 2013 led by the European Central Bank (ECB). Legal work was finalised in November 2013 and the supervisor will become fully operational in late 2014. The establishment of the SSM in autumn 2014 will be an important milestone towards banking union.

One of the advantages of the SSM is that it will draw on a broader and better basis of information across the Eurozone, making it possible to reveal undesirable developments more quickly.

Euro area countries participate automatically in the single supervisory, but it is also potentially open to other Member States willing to be integrated in the system (through

3 “Building Blocks for Deeper Integration”. European Commission, http://ec.europa.eu/commission_2010-2014/president/pdf/integration/index.html. Last accessed: 15 March 2014.

4 “Commission Proposes New ECB Powers for Banking Supervision as Part of Banking Union. Europe.eu, http://europa.eu/rapid/press-release_IP-12-953_en.htm?locale=en. Last accessed: 15 March 2014.

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close cooperation between their competent authorities and the ECB). The European Central Bank will directly supervise banks with assets of more than 30 billion euros, or which constitute at least 20 percent of their home country’s GDP, or which have requested or received direct public financial assistance from the ESM. (130 banks under the direct supervision of the ECB and now under review have about 25,000 billion euros of assets and only about 1,000 billion euros of capital [about 4 percent of assets].5)

On 15 October 2013,6 the EU Council adopted a regulation on the Single Supervisory Mechanism, which creates a uniform single supervisory mechanism, which is the primary pillar of the banking union. Under the regulation, non-participating Member States should conclude a memorandum of understanding describing in general terms how they will cooperate with one another in the performance of their supervisory tasks under Union law in relation to the financial institutions. As there are remaining Member States from the single supervision, the parent companies of the Member States participating in the mechanism may have subsidiaries in those countries. Therefore it is strictly necessary that those countries also agreed about a framework for cooperation in the case of a crisis.

With the creation of the SSM, many supervisory tasks in the euro area Member States will be carried out by the ECB for all Member States concerned. “As the euro area’s central bank with extensive expertise in macroeconomic and financial stability issues, the ECB is well placed to carry out clearly defined supervisory tasks with a focus on protecting the stability of the financial system of the Union.”7 Nevertheless, central banks are already responsible for banking supervision in many Member States. The SSM, after all, is designed in such a manner that the quality and expertise of national supervisors will continue to be the decisive factor.

As far as the European Central Bank’s role is concerned, it will:8

• authorise and withdraw the authorisation of all credit institutions in the euro area;• assess acquisition and disposal of holdings in banks;• ensure compliance with all prudential requirements laid down in EU banking rules

and set, where necessary, higher prudential requirements for banks, for example for macro-prudential reasons to protect financial stability under the conditions provided by EU law;

• carry out supervisory stress tests to support the supervisory review, and carry out supervision on a consolidated basis – such stress tests are a supervisory tool also

5 Silvia Merler – Guntram B. Wolff: “2014 Financial Odyssey”. Bruegel, http://www.bruegel.org/nc/blog/detail/article/1226-2014-financial-odyssey/. Last accessed: 15 March 2014; Daniel Gros: “The Asset Quality Review and Capital Needs: Why Re-Capitalise Banks with Public Money?”. CEPS, http://www.ceps.eu/book/asset-quality-review-and-capital-needs-why-re-capitalise-banks-public-money. Last accessed: 15 March 2014.

6 “Council Regulation (EU) No 1024/2013”. Official Journal of the European Union, 29 October 2013. p. I. 287/63. Electronic version: http://eur-lex.europa.eu/LexUriServ/LexUriServ.do?uri=OJ:L:2013:287:0063:0089:EN:PDF.

7 “Report on the Proposal for a Council Regulation Conferring Specific Tasks on European Central Bank Concerning Policies Relating to the Prudential Supervision of Credit Institutions”. European Parliament, http://www.europarl.europa.eu/sides/getDoc.do?type=REPORT&reference=A7-2012-0392&language=EN. Last accessed: 15 March 2014.

8 “Council Regulation (EU) No 1024/2013”.

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used by national authorities to assess the stability of individual banks; they will not replace the stress tests carried out by the EBA with a view to assessing the soundness of the banking sector in the single market as a whole;

• impose capital buffers and exercise other macro-prudential powers;• carry out supplementary supervision over credit institutions in a financial

conglomerate;• apply requirements for credit institutions to have in place robust governance

arrangements, processes, and mechanisms and effective internal capital adequacy assessment processes;

• carry out supervisory tasks in relation to early intervention when risks to the viability of a bank exist, in coordination with the relevant resolution authorities;

• carry out, in coordination with the Commission, assessments for possible public recapitalisations;

• coordinate a common position of representatives from competent authorities of the participating Member States in the Board of Supervisors and the Management Board of the EBA, for topics relating to the above-mentioned tasks.

The European Central Bank will have two units – the new bank supervisor and its financial stability directorate. It is very important to provide clarity on who is going to do what, draw a clear line between the monetary and supervisory functions. This “conflict” of aims can threaten the ECB’s internal independence. The ECB shall be accountable for its tasks to the European Parliament (EP) and to the Council/the Eurogroup.

Before the European Central Bank takes over banking supervision in November, it will conduct9 a comprehensive assessment of the Eurozone’s largest banks. If any of the participating banks failed the assessment they could be wound down, and merging them in order to save them would not be a solution.

According to the design of the banking union, the single supervisor should be matched by a single resolution authority to restructure or shut troubled banks and a single resolution fund to deal with any resulting costs. The Single Resolution Mechanism (SRM) will ensure that – not withstanding stronger supervision – if a bank, subject to the SSM faces serious difficulties, its resolution can be managed efficiently. In case of cross-border failures, it will be much more efficient than a network of national resolution authorities and avoid risks of contagion.

The bail-in mechanism will stabilise a failing institution so that it can continue to provide essential services, without the need for bailout by public funds. With this measure it can be prevented that in the future public finances and banking problems spread to each other causing a worse economic situation.10 According to the policy expectations, it should break the link between indebted states and the banks that buy their debt. Recapitalisation through the write-down of liabilities and/or their conversion to equity will allow the

9 “Factbox: The Road ahead for Europe’s New Banking Watchdog”. Reuters, http://linkis.com/buff.ly/aljSK. Last accessed: 15 March 2014.

10 Attila Marján: “Bankunió és fiskális paktum − célok, kilátások, kétségek” [Banking Union and Fiscal Pact – Aims, Perspectives, Doubts]. MKI-tanulmányok, No. 21. (2013). http://www.hiia.hu/pub/displ.asp?id=WULWYJ. Last accessed: 15 March 2014.

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institution to continue as a going concern, avoid the disruption to the financial system that would be caused by stopping or interrupting its critical services. The regulation of SRM is based on article 114 of the Treaty on the Functioning of the European Union. The resolution and restructuring of a bank supervised directly by the ECB requires common instruments and procedures. A complication is that cross-border banks operate not only in Eurozone countries, but also in other EU countries. So this second stage involves a two-step process.11 First, harmonise the rules on resolution and deposit guarantees across the 28 members of the EU. Then merge the systems of the 18 countries of the Eurozone (and any others that want to join12).

The single resolution fund would be financed by bank levies raised at national level. It would initially consist of national compartments that would be gradually merged over 10 years until it hits the 55-billion-euro target funding level by 2026. During this period, mutualisation between national compartments would progressively increase. In the interim, Eurozone countries would contribute cash into national pots that would remain segregated within the broader European fund. During the transition period the ESM could be a credible fiscal backstop. It is already recognised by the market and trusted by the ECB and the Member States.13

As far as timing is concerned, SRM was adopted in March 2014 and will enter into force on 1 January 2015. Bail-in and resolution functions would apply from 1 January 2016.14 The SRM agreement will enter into force once ratified by Member States participating in the SSM/SRM that represent 80 percent of the contributions to the Single Resolution Fund.15

A joint asset management vehicle is a basic element of any European banking system stabilisation arrangement. As Nicolas Véron says,16 “The coordination of the bank restructuring process will be a key aspect, including the possibility of setting up a European joint asset management vehicle, or ‘bad bank,’ even if financial risks remain allocated to individual member states.”

The proposal on the SRM17 was adopted on 20 March 2014. According to the deal, the 55-billion-euro fund will be built up in over eight years, by 2024. In the beginning, 40 percent of the fund will be shared among countries and 3 years later 70 percent. And the decision-making process was greatly streamlined. Centralised decision-making

11 “Banking on a New Union”. The Economist, http://www.economist.com/news/europe/21591634-promises-and-pitfalls-euro-zones-next-big-idea-banking-new-union. Last accessed: 15 March 2014.

12 Member States outside the Eurozone, which join the SSM, will also join the SRM.13 Olivier Marty: “Banking Union and Fiscal Capacity: the Case for the ESM as a Fiscal Backstop”.

In: Banking Union and Beyond. Brussels: Bruegel, 2014. Electronic version: http://www.bruegel.org/publications/publication-detail/publication/808-banking-union-and-beyond-discussion-papers-for-brussels-think-tank-dialogue/.

14 “Council Agrees General Approach on Single Resolution Mechanism”. Council of the European Union, http://www.consilium.europa.eu/uedocs/cms_data/docs/pressdata/en/ecofin/140190.pdf. Last accessed: 15 March 2014.

15 Ibid.16 Nicolas Véron: “Tectonic Shifts”. Finance & Development. March 2014. p. 19.17 “Parliament Negotiators Rescue Seriously Damaged Bank Resolution System”. European Parliament,

http://www.europarl.europa.eu/news/en/news-room/content/20140319IPR39310/html/Parliament-negotiators-rescue-seriously-damaged-bank-resolution-system. Last accessed: 22 March 2014.

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would be built around a strong Single Resolution Board and would involve permanent members as well as the Commission, the Council, the ECB, and the national resolution authorities. It was very important to make resolution centralised in the sense of credibility and effectiveness of the supervisor. The ECB could lend banks, but does not have the institutional responsibility. Thus this centralised and exclusive decision-making authority for all banks covered by the SSM was an important step. It is a mixture of board committee and delegation from home country’s authority. This Board can take high-risk decisions under intense pressure and be accountable in a European level. A resolution scheme could be approved within a weekend.

According to the Bruegel Institute,18 two crucial steps still remain to be taken. First, the backstop to the Single Resolution Fund is not yet settled. The fund will be able to borrow against future bank levies but will not be able to rely on the Eurozone bailout fund to raise credit. “A resolution mechanism still absolutely needs some form of public backstop to be fully credible and ensure that confidence is preserved.” Second, the scope of the SRM must also be made more unequivocal. It is not clear whether the Board would have a say in the resolution of cross-border banks. “In a proper Banking Union should have no segmentation between central and national level in the management of resolution function.”19

The other key aspect remains the same: which member state will have to pay? While Member States consider the banking union as a step towards sharing bank risks with each other and advancing towards a common cost of borrowing across the Eurozone, Germany places greater emphasis on imposing losses on the creditors of banks. However, the long-term benefits might be higher for Germany than for countries with weak public finances, because those countries would gain the most from delegating bank resolution to an independent EU agency, where the cost of public funds are the lowest and where the countries have the closest links between the banking sector and the political class.20 The main aim of the banking union was to break the ‘doom loop.’21 Although several measures have been taken so far, it still exists. The key components, according to Véron,22 are the followings: bail-in criterion cannot be left at national authorities, and credible and explicit commitment must be made by the ECB after the handover. The bail-in may help reduce public cost, but the parameters should not depend on nationality. The banking union should include a more centralised management setup for banking crises. It is not envisaged to equip the banking union with a single supranational deposit guarantee scheme at this

18 Silvia Merler – Guntram B. Wolff: “The European Parliament Improves Banking Union”. Bruegel, http://www.bruegel.org/nc/blog/detail/article/1282-the-european-parliament-improves-banking-union/?utm_source=Bruegel+Update&utm_campaign=9f752b88d6-Bruegel+Update_Week_12_2014&utm_medium=email&utm_term=0_cb17b0383e-9f752b88d6-276083913. Last accessed: 22 March 2014.

19 Ibid.20 Daniel Gros: “The SRM and the Dream to Resolve Banks without Public Money”. CEPS, http://www.

ceps.eu/book/srm-and-dream-resolve-banks-without-public-money. Last accessed: 22 March 2014.21 Which is a vicious circle between banks and sovereigns.22 Nicolas Véron: “A Realistic Bridge towards European Banking Union”. Bruegel, http://www.bruegel.

org/publications/publication-detail/publication/783-a-realistic-bridge-towards-european-banking-union/. Last accessed: 22 March 2014.

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stage. The proposal on the DGS – recently agreed upon – will ensure that every Member State has a deposit guarantee fund which is correctly funded. A well-financed Eurozone-wide deposit insurance system would stop savers from panicking.

In 2010 the Commission adopted a legislative proposal for the DGS.23 This scheme was supposed to prevent depositors from making panic withdrawals from their bank, thereby preventing severe economic consequences. After more than three years of stop-start negotiations, in December 2013,24 the European Parliament and the Member States agreed on the new rules of the DGS.25 The Directive will strengthen the existing system of the national DGS. The changes are harmonised with the recommendations of the IMF.26 It was another important step towards completing the single rulebook on crisis management for credit institutions in the EU. Key elements of the agreement27 are the following:

1. A universal guarantee of deposits up to 100,000 euros. The new Directive preserves the harmonised coverage level of 100,000 euros per depositor and per bank. The guarantee will continue to be offered in the form of repayment in case of a bank’s liquidation where deposits would become unavailable.

2. Easier and faster access to repayment. Repayment deadlines will be gradually reduced from the current 20 working days to 7 working days.

3. A robust financing regime. The recast confirms the fundamental principle underpinning the DGS whereby it is the banks that finance deposit guarantee schemes, and not the taxpayers.

4. Better information for depositors. The new Directive will require better information to be provided to depositors to ensure that they are aware of how their deposits are protected by the guarantee schemes.

FUrTher STepS

In order to become law, the Commission’s proposal about the SRM needs to be adopted jointly by the European Parliament and by the EU Member States in the Council. It is expected that the European Parliament will vote this legislation in plenary in April,

while the Council will formally adopt it subsequently.Nevertheless, further steps are still needed to reach a well-functioning banking union.

However the current framework of the banking union is based on intergovernmental

23 “Directive 94/19/EC of the European Parliament and of the Council of 30 May 1994 on Deposit-Guarantee Scheme”. Official Journal of the European Communities, 31 May 1994. Electronic version: http://eur-lex.europa.eu/LexUriServ/LexUriServ.do?uri=CELEX:31994L0019:EN:HTML.

24 “Commissioner Barnier Welcomes Agreement between the European Parliament and Member States on Deposit Guarantee Schemes”. European Commission, http://europa.eu/rapid/press-release_MEMO-13-1176_en.htm. Last accessed: 15 March 2014.

25 The EP and the Commission have to confirm the agreement.26 “European Union: Publication of Financial Sector Assessment Program Documentation –Technical

Note on Deposit Insurance”. IMF, http://www.imf.org/external/pubs/ft/scr/2013/cr1366.pdf, March 2013.

27 “Commissioner Barnier Welcomes Agreement…”.

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treaties, treaty changes are inescapable steps and require ordinary revision28 procedure. Only the ordinary revision procedure can prove a ‘steady-state’ banking union. “This is because of the need for resolution, insolvency need fiscal policy to be subject to adequate judicial review and political scrutiny.”29 But before treaty changes the key point is the handover of the direct supervision by the ECB, which is launched in 2014. A sustainable banking union requires European fiscal capacity, European insolvency regime for banks, and a European Resolution Authority, which cannot be reached in the current legal framework as it stands today. Completing the transportation of the Bank Recovery and Resolution Directive (BRRD) in the Member States and accomplish logistical tasks are also of key importance. Last, a comprehensive Treaty overhaul to allow for a better functioning economic union is also on the to-do-list in the medium to long-term.

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28 Which requires intergovernmental conference or a Convention.29 Véron: “A Realistic Bridge…”. p. 6.

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