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Opinion 27 November 2019

The Banking union: something's at play

After an impasse of several years, something’s at play at the banking union. The article by German Finance Minister Olaf Sholz in the ‘Financial Times’ on November 5th and the concomitant German “non-paper” have kicked-off a much-awaited debate about the outstanding elements required to finalize this crucial European project.

The banking union project, which was initiated in 2012, was fundamental to stemming the growing financial fragmentation that at the time threatened the continued existence of the euro. Together with Draghi’s famous declaration (“whatever it takes”), the launch of the banking union substantially reduced risk premiums between European countries. The project was founded upon three pillars: the single supervisory mechanism (SSM), the single resolution mechanism (SRM), and a deposit insurance scheme. Indisputable progress was made with respect to the first two pillars, but the European Deposit Insurance Scheme (EDIS) never materialized, owing to the significant discrepancies between northern countries (specifically Germany) and the countries in southern Europe.

An incomplete banking union is a significant risk for Europe. Everyone recognizes the serious inconsistency in the European architecture represented by the coexistence of single supervisory and resolution authorities — governed out of Frankfurt (SSM) and Brussels (SRB) — with deposit insurance schemes that are still managed at a national level. It implies that decisions made (and, as the case may be, errors committed) by European authorities could ultimately impact the taxpayers in a specific country. We cannot continue with this inconsistency: if we don’t move forward, we will slide backwards.

Germany’s change of position is therefore good news. It could break the deadlock over EDIS, even if it is true that it stems from a somewhat “stingy” initial position. The EDIS proposal is based on a reinsurance system in which national funds could be mutually protected by liquidity injections, but without a true pooling of liquid resources, or only a very limited one, thus leaving the final line of defense to the respective governments themselves.

It is important to understand that in any country in the world the solvency of deposit guarantee funds depends on its sovereign holdings because there is no ex ante fund large enough to cover a banking failure, not just for a large bank, but for even a medium-sized bank. While it is true that deposits are protected by the new bank resolution framework and the absorption of losses by creditors— which only occur in extreme circumstances — the credibility of the system continues to depend on the backing of the treasury departments.  This is why the preservation of individual national deposit insurance schemes is a permanent source of financial fragmentation across the eurozone, with the upshot being that the value of a euro will vary depending on the country where it is deposited. This is incompatible with the monetary union.

The complete mutualization of deposit insurance schemes should be an indisputable objective. While its implementation may occur gradually with ample transition periods defined, the final goal should be clear from the outset, in order to limit the potential destabilizing impact from potential bank failures or in-country crises during this transition period.

The German proposal contains a quid pro quo: to move forward with EDIS in exchange for additional risk reduction measures, addressing non-performing loans and a more prudential treatment of sovereign debt. There is another important and positive change in the German position: as opposed to a sequential approach (first risk reduction, then risk sharing), the Germans now agree to move forward with both in parallel.

The German change of position can be partly explained by the fact that significant strides have been made in the area of risk reduction: with respect to non-performing loans, the rate in the EU has fallen from 6.6 percent in 2013 to 3 percent in 2019; Spain has seen a drop from 8.9 percent to 3.5 percent in the same time frame.

The sovereign debt issue is more complex. The prudential treatment of sovereign debt recognizes it as a risk-free asset, which is why it receives a zero weighting in capital requirements. The German authorities have misgivings about this approach, arguing that it does not square with certain cases, such as Greece, where sovereign debt has been restructured. Although this charge has merit, it can also be argued that it is an exception, and that eliminating the risk-free asset status for public debt would open a Pandora’s box with untold consequences. The Basel Committee on Banking Supervision (BCBS) reviewed this topic a couple of years ago, but strong disagreement between members left the matter in deadlock. What does make sense (and is included in the German proposal) is to establish incentives for the diversification (or inversely, penalties for failing to diversify) of European loan portfolios, in such a way as to eliminate — or at a minimum, temper — the so-called “domestic bias” whereby banks tend to concentrate their assets in sovereign holdings.

Although it is a highly sensitive topic where an abrupt change could unleash serious tensions in the financial markets, it makes sense to study feasible proposals with reasonable metrics and long-term implementation periods. The incorporation of another aspect of the German proposal is more complicated: it proposes to combine this with a type of sovereign rating.

The German non-paper also contains proposals to reduce fragmentation. One such proposal is the harmonization of bank insolvency regimes, which is essential in order to ensure consistency in the resolution framework. It would be advisable to go even further and define a single banking insolvency regime, but this is perhaps too ambitious an objective and would only be feasible in the long term. Measures have also been proposed to address fragmentation and to encourage coordination between national supervisory authorities of origin and destination countries where banks operate with cross-border subsidiaries within the eurozone. The persistence of this concept itself — “origin” and “destination” country within the eurozone —  reveals a serious fragmentation issue in and of itself. The recommendations raised by Germany in response to this topic are reasonable and support the advancement of EDIS: a common deposit insurance scheme is the answer to fragmentation.

Two important elements of the banking union architecture are missing in the German proposal: a mechanism to address liquidity in resolution and a European safe asset. With respect to liquidity in resolution, Europe is in the unique position of being the only monetary area in the world that lacks a lender of last resort, an essential function at the very heart of why central banks were conceived. Emergency Liquidity Assistance (ELA) is available but is limited to solvent entities. When a bank enters resolution, in theory the ECB cannot continue its lending. Thus a paradoxical circumstance may arise: an entity whose resolution process is being led by a European authority like the SRB may find itself deprived of the liquidity it needs from another European authority (the ECB) at the most delicate time, just when said entity has presumably lost access to market capital. Access to liquidity in these circumstances depends on the availability of collateral, which is likely limited in the case of a bank in resolution.

The SRB and the European Stability Mechanism (ESM) can help provide the collateral required to access liquidity from the ECB, a subject currently under study by different European working groups.

The possibility of the private sector itself establishing a “self-insurance” liquidity delivery mechanism has been raised in some of these discussions. It is difficult to draw conclusions about proposals for which the details are not known, but from the onset a mechanism of this type is a complex proposition. International experience teaches us that the only player in a liquidity crisis that can avail itself of the necessary artillery to take firm and credible action is a central bank.

As to the European safe asset, it is all the more necessary the more likely it is that there is a modification to the status quo’s treatment of sovereign risk. The present situation, in which German debt acts as the ersatz European risk-free asset is itself a source of fragmentation that heightens financial market tensions during times of crisis. There have been various proposals on this topic, from eurobonds to the so-called “safe asset” and the ESBies, none of which seem to satisfy the required technical and political feasibility criteria. European authorities must forge ahead because the monetary and banking union project remains incomplete while the financial markets lack a standard that is not linked to a specific country.

In short, the German proposal is a positive step because it could break the embedded deadlock. It raises a number of elements around which a balanced recommendation should be reached. Other elements, like resolution financing and a European safe asset should be incorporated into the ensuing recommendation. All these elements constitute a much-needed institutional framework, but let’s not forget that a true banking union will only see the light of day once residents can work with banks in any country in the European Union, irrespective of where its headquarters may be. A comparison with the United States gives us an indication of just how far we have to go. The sooner we get started, the sooner we’ll get there.

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