FACULTY OF BUSINESS AND ECONOMICS

A closer look at the European banking union

Wim Nullens Masters Project Financial Economics: Seminar Series Topic 5: Recent evolutions in financial markets Msc in Financial Economics December 20, 2012

Msc Financial Economics Wim Nullens

Introduction The Eurozone crisis has gone through its fair share of buzzwords fiscal compact, growth compact, Big Bazooka, etc. The latest kid on the block is the banking union (Beck, 2012). The subject was introduced by Mr. G. Wolf during a lecture of recent evolutions in the financial markets and will be further explored in this paper. Banking regulation and supervision is currently a hot topic in Europe. While it was discussed by economists even before the 2007 crisis, it has moved up to the top of the Eurozone agenda. At their June 2012 summit, the heads of state of Eurozone have decided upon policy measures that aim at breaking the vicious circle between banks and sovereigns. The summit declaration aims at the establishment of a single supervisory mechanism involving the European Central Bank (Buch & Weigert, 2012). As we are speaking, the European leaders are still discussing the foundations and key issues of this banking union. However, the road to such a European banking union is beset with many obstacles, not least political intransigence. First, we explain why there is a need for European banking supervision. Next, we ask ourselves the question for which countries this bank union is the most appropriate. Thereafter, we discuss whether the European Central Bank should take the leading role as bank supervisor or not. Finally, we shed some light on the recent developments concerning this bank union.

Why there is a need for a European banking supervision? During the financial crisis, large banks had to be rescued by the government of their home country when they ran into trouble. Gros (2012) argues that this was partly caused by national supervisors who always have a tendency to minimize problems on their own turf. In the case of large banking groups, the instinct (and the bureaucratic self-interest) of the home country supervisors is to defend their national champion abroad. But the resistance of national supervisors to recognize any general problem at home is even stronger. The author further states that given this predictable tendency of national supervisors not to recognize problems at home, it seemed natural that the cost of cleaning up insolvent banks should also be borne at the national level. At first sight it thus made sense that even in the euro area banking supervision remained largely national, with only some loose coordination at the EU level. A European Banking Authority (EBA) was recently created, but it has only very limited powers over national supervisors whose daily work remains guided by national considerations. However, recent developments have shown that this approach, i.e. national problem and hence national responsibility for cleaning up, is not tenable. The problems might arise at the national level, but they quickly spread out and start to threaten the stability of the entire Euro system The need to rectify this situation has now finally been recognized by Europes leaders who decided at their summit in June 2012 that the responsibility for banking supervision in the euro area should be transferred to the European Central Bank. Therefore, the European Commission has proposed that the European Central Bank should have broad authority over all banks within the supervisory mechanism (Veron, 2012). It is so important because a Eurozone-based banking union could be crucial for the survival of the Eurozone and its future stability. It would help sever the much-feared

Msc Financial Economics Wim Nullens

death loop between sovereigns that are exposed to losses in their national banking systems and banking systems directly and indirectly exposed to sovereigns (Zettelmeyer, Berglf and de Haas, 2012). Moreover, Gros (2012) argues that the European Central Bank is already de facto responsible for the stability of the euro areas banking system. But at present it has to lend massive amounts to banks without being able to judge their solidity because all the detailed information about the health of the banks is still in the hands of national authorities who guard this information jealously and have every tendency to pretend that there is no problem until it is too late. The European Central Bank already de facto started to assume some supervisory power in a little-noticed step when it announced that government guaranteed bank bonds would be accepted as collateral for new lending only if the bank draws up a funding plan indicating how it will be able to finance its operations without excessive recourse to the European Central Bank.

Banking Union for whom? One critical question is whether the banking union should be just for the Eurozone or for the whole European Union. Beck (2012) argues that the need for a banking union is stronger within a currency union, as it is here where the close link between monetary and financial stability plays out strongest and where the link between government and banking fragility is exacerbated as national governments lack policy tools that countries with an independent monetary policy have available. On the other hand, Zettelmeyer, Berglf and de Haas (2012), argue that non-Eurozone countries should be allowed to opt into the banking union but, if they do so, they must be given a say in the governance and access to euro liquidity through swap lines with the European Central Bank. Apart from full membership, intermediate options could be considered which would extend some but not all benefits and obligations of membership to all financially integrated European countries including countries outside the European Union. While initial proposals posited a banking union only for large, cross-border banks, several authors stress the need to include all banks, including smaller ones. Garicano (2012) argues that, it may be the small institutions that play the role of the canary in the mine in anticipating the systemic problems. Furthermore, Wyplosz (2012) suggests that if the European Central Bank is to fulfill its role of lender of last resort to all banks, it also needs the authority to supervise and resolve all banks. Recent developments show that France is a proponent of the first view, while Germany favors the latter. This will be discussed later on in this paper.

Why the European Central Bank? Why not? Moving the bank regulation and supervision at a European level does not necessarily imply moving it to the European Central Bank. Why the European Central Bank? As very succinctly put by Wyplosz (2012) in a recent opinion piece borrowing from Bagehot (1873): every banking system needs a lender of last resort and a central bank is the only institution that can fulfill this role given the large amount of money that needs to be mobilized in a very short period of time, especially in the new interconnected world that we live in today. For a central bank, however, to be able to act

Msc Financial Economics Wim Nullens

appropriately it must have intimate knowledge of the exact situation of the banks for which it is supposed to act as a lender of last resort in real time, which requires supervisory responsibilities. (Ioannidou, 2012). Under this argument the European Central Bank the Eurozones ultimate central bank and lender of last resort should have the responsibility of supervising the Eurozones banks as it is ultimately responsible for maintaining the stability of the financial system and of the euro itself. As Wyplosz (2012) further points out, this logic was deliberately ignored when the single currency was created, giving in to pressures from both banks and national supervisors. The Commissions proposal essentially aims at correcting this birth defect. Ioannidou (2012) argues that there is also one important concern of hosting monetary policy and bank supervision under the same institution. This has to do with the potentially conflicting goals of the two tasks (see, for example, Goodhart and Schoenmaker 1992). Monetary policy is usually countercyclical, while the effects of regulation and supervision tend to be procyclical, offsetting to some extent the objectives of monetary policy. In particular, during periods of economic slowdown, the financial condition of banks deteriorates and supervisors step in and apply pressure on the institutions to improve their condition. However, the implementation of these requirements will typically result in tighter credit, reinforcing the recession. If we following this line of argument, we might expect that a central bank may go easier on supervision to support monetary policy objectives. Supervision could also influence the conduct of monetary policy. It is often argued that interest rates may be kept lower than otherwise because of concerns about the banking sector, resulting in worse performance with respect to price stability. Because of such conflicts, it is often argued that monetary policy and bank supervision should be kept separate, and when hosted under the same institution, Chinese walls should be erected between the two functions. The European Commissions proposal seems to share these concerns as it proposes a segregation of activities between monetary policy and bank supervision within the European Central Bank. Carmassi et al (2012) and Beck & Gros (2012) argue that separation seems hardly guaranteed under the proposed set-up and that the effect of this Chinese wall will be very small or even neglectable. Giving supervisory responsibilities to a central bank could also have some important positive effects. Peek et al. (1999) argued that information obtained from bank supervision could improve the accuracy of economic forecasting, and thus help the central bank to conduct monetary policy more effectively. Problems in the banking sector may serve as an early indicator of deteriorating macroeconomic conditions.

Recent developments After the summit in June 2012 -were Eurozone countries ratified common supervisory of their banks by involving the European Central Bank- the European politicians have not been idle. In this section we will shed some light on the recent developments concerning the European Banking Union. On 10 September 2012, the Financial Times states that putting the principles into practices has proved pretty hard. The first and easiest step was giving supervision responsibilities to the

Msc Financial Economics Wim Nullens

European Central Bank. The original deadline for agreement was the end of the year. Even this represented a loss of national control that some countries are struggling to accept. Moreover, the battle over the bank unions responsibilities is now heating up. At this point, the most vocal concerns are voiced by Germany. While backing a single supervisor, Berlin has fundamental concerns over the commissions proposal: the wide scope of banks covered the high degree of centralization and the quick pace and sequence of implementation. More than two months later Germany and France are still disagree about the European Central Banks remit over small banks (Financial Times, 4 Dec 2012). France, Brussels and the European Central Bank are adamant that the supervisor must be ultimately responsible for all banks. Germany says it must focus only on big ones, and leave the small German savings banks to national authorities. On top of this lie the objections of non-Euro countries. Sweden and Poland are clear about their demands: equal say in supervision decisions, if they join the banking union. Furthermore, London could still emerge as a stumbling block. It enjoys the support of the other outs in demanding reforms at the European Banking Authority, so the European central Bank cannot dominate decision-making on technical standards. Eventually, last week the Europe took its firsts big step towards a banking union, as the Eurozone finance ministers agreed a plan to cede to a common bank supervisor in Frankfurt (Financial Times, 13 Dec 2012). After almost four months of fraught diplomacy that laid bare deep Franco-German divisions, finance ministers brokered terms for the European Central Bank to begin direct supervision of up to 200 Eurozone lenders from 1 march 2014. The Financial Times further argues that the reform required governments to surrender jealously guarded control over national banks, in the most concerted financial integration project since the creation of the single currency. At the same time, Britain, Sweden and other non-Eurozone countries outside the banking union won coveted safeguards to check the power of the European Central Bank and maintain some influence over technical standards applying to all EU banks. De Standaard (14 Dec 2013) states that all the major banks in Belgium fall under this supervision. However, the concrete implementation of the duties of the central bank supervisor is not yet complete.

Conclusion The Eurozone crisis is as much a banking as it is a sovereign debt crisis. Foremost, however, it is a crisis of governance structures and political constraints. The crisis has been exacerbated by halfbaked approaches and unsustainable policies. Political inaction has put greater responsibility and stress on the ECB, expanding its realm far beyond monetary stability and its democratically assigned responsibilities, and forcing it to go for second- or third-best solutions. If the Eurozone countries are not to be caught in the downward spiral of a failed currency union, it is time to act now. Let us hope that the European banking union will help to restore the confidence in the Euro and the banking sector. At least Mario Draghi is confided that the agreement of last week will lead to a stable economic and monetary union, and last but not least, to further European integration.

Msc Financial Economics Wim Nullens

References Barker, A. (2012). EU divided over banking union. Financial Times, 4 Dec, electronically available at: 00144feabdc0.html#axzz2FQ7JzNaa] Barker, A. (2012). Eurozone agrees common bank supervisor. Financial Times, 13 Dec, electronically available at: [http://www.ft.com/intl/cms/s/0/2946cbfe-44d4-11e2-8fd700144feabdc0.html#axzz2FQ7JzNaa] Beck, T. (2012). Banking union for Europe: risk and challenges. Centre for Economic Policy Research, London, pp. 11-18 Beck, T. & Gros, D. (2012). Monetary Policy and Banking Supervision: coordination instead of separation. Ceps policy Brief, European parliament. Buch, C.M. & Weigert, B. (2012). Legacy problems in transition to a banking union Centre for Economic Policy Research, London, pp. 22-35 Carmassi, J., Di Noia, C. & Micossi, S. (2012), Banking Union: A federal model for the European Union with prompt corrective action, CEPS Policy Brief, 282. De Standaard. (2012). Alle grote banken in Belgi onder toezicht. 14 Dec 2012, pp. 34-35. Garicano, L. (2012). Five lessons from the Spanish cajas debacle for a new euro-wide supervisor. Centre for Economic Policy Research, London, pp. 79-86. Goodhart, C. A. E. & Schoenmaker, D. (1992). Institutional Separation between Supervisory and Monetary Agencies, Giornale degli Economisti e Annali di Economia 9-12, 353-439. Gros, D. (2012) An incomplete step towards a banking union. Ceps commentary, Centre for European Policy Studies, 5 July Ioannidou, V. (2012). A first step towards a banking union. Centre for Economic Policy Research, London, pp.85-94 Peek, J., Rosengren, E. and Tootell, G. (1999). Is Bank Supervision Central to Central Banking? Quarterly Journal of Economics Vol. 114, pp. 629-653 Steen, M. (2012). Berlin pressed on banking union plan. Financial Times, 10 Sept, electronically available at: [http://www.ft.com/intl/cms/s/0/cc55f4d2-3241-11e2-b89100144feabdc0.html#axzz2FQ7JzNaa] Veron, N. (2012). Europes Single Supervisory Mechanism and the Long Journey Towards Banking Union. Bruegel Policy Contribution, Vol. 16 Wyplosz, C. (2012). Banking union as a crisis-management tool. Centre for Economic Policy Research, London, pp. 17-23 [http://www.ft.com/intl/cms/s/0/bbaa0976-3e2a-11e2-829d-

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Zettelmeyer, J., Berglf, E. & de Haas, R. (2012). Banking union: the view from emerging Europe. Centre for Economic Policy Research, London, pp. 65-75

Msc Financial Economics Wim Nullens