The Banking Union was identified as the second cornerstone for EU policy-making of the new leadership. With publication of the results of its Comprehensive Assessment at the end of October 2014, the European Central Bank has set the standard for its new mandate as supervisor. But this was only the beginning. The heavy work started in early November, with the day-to-day supervision of the 120 most significant banks in the eurozone under the Single Supervisory Mechanism. The centralisation of the supervision in the eurozone will pose a number of challenges for the ECB in the coming months and years ahead.

To achieve this third objective, policy-makers embarked on a policy agenda to end “too big to fail” conundrum and improve the ability to resolve global systemically important financial institutions (G-SIFIs). The aim was to create a regime in which financial institutions, especially global systemically important banks (G-SIBs), could ‘fail’ without significant adverse effects on financial markets or the economy at large and without cost to the taxpayer.

Now that this regime is largely in place, attention must turn to implementation. This report outlines, principally with respect to the EU, key steps that authorities, banks and financial market infrastructures (FMIs) should take to make resolution effective. Particular emphasis is placed on how the bail-in tool should be employed, as this tool is most likely to feature prominently in the resolution plans for significant banking institutions in the EU.

The global standards for bank capital requirements will once again be revised. The package that forms the completion of Basel III, but are sometimes also labelled Basel IV, were discussed during the High-Level Seminar co-organised by CEPS and IRCCF HEC Montreal in the European Parliament. This timely seminar, which gathered together policy-makers, supervisors, bankers, researchers and other experts, took place just days after the European Commission launched a banking reform package and on the eve of the meeting of the Basel Committee on Banking Supervision in Santiago (Chile) to agree on the revisions of the global standards. Some of the revisions, namely those concerning market risk requirements and the treatment of securitisation, were already expected. The Basel III accord, agreed in the midst of the global financial crisis in 2010, contained certain quick-fixes that were less sophisticated than the remainder of the standard.

These anticipated revisions are complimented by measures that try to address the large divergence in internal models that banks may use to calibrate the capital requirements. On the one hand, supervisors want to make the simpler standardised approach a more credible alternative to the internal models based approach, on the other hand it tries to reduce the differences between the models with a more restrictive capital floor. The revisions could have considerable consequences for banks’ capital requirements. They are therefore sometimes referred to as ‘Basel IV’.

The High-Level Seminar discussed the recent proposals and outstanding reforms of the Basel Committee, and considered the following questions: Do the proposals address the right issues and do they go far enough, or even too far?; How will they impact Europe’s banks, economy, and society?; How will they be transposed in the EU, and if so, will the Basel standards be applied to all banks, or only to the globally significant banks for which they have been designed?

All the participants underlined the need for revisions, although there were divergent views expressed on how the capital requirements should be revised. The revisions currently debated include measures to change both the standardised and internal ratingsbased approach for credit and operational risks as well as surcharges on the leverage ratio of global systemically important banks.

Looking at the motives behind the revisions, the supervisors want to make the simpler standardised approach a more credible alternative to the internal models-based approach and reduce the differences between the models with a more restrictive capital floor. Bankers fear that in particular the capital floors will lead to higher-than-necessary capital requirements, which will restrict banks in lending to the real economy. In their view, the revisions should take into account national specificities. For example, they argue, pointing to research of the supervisors, that their own models can better determine the risk weights for exposures, for which they have collected vast amounts of historical data on the default probabilities and losses (e.g. Danish and Dutch residential mortgages).

Researchers from IRCCF, CEPS and OECD emphasised the need for more stringent backup requirement in the form of a higher leverage ratio. They showed empirically that the enhanced use of internal models has eroded the average capital requirements. In particular, the average risk weights of banks with more market-oriented activities such as derivative exposures had decreased in the aftermath of the crisis. The researchers argued that a more explicit adjustment for business models in the capital requirements should be considered. Moreover, the leverage ratio has in general been a better predictor of bank distress, with banks showing leverage ratios above 5% being unlikely to fail. The average leverage ratio of European banks is already above this level, but many primarily larger banks would have to increase their capital to reach this level.

The regulators argue that European banks have sufficiently improved their capital in recent years, with higher and better quality capital. The revisions should therefore not lead to significant increases in the capital requirements, but only change the distribution across banks.

In September 2012, CEPS also concluded that the banking union project has triggered highly polarising debates across the EU, tearing the union apart into many disparate and unexpected camps. This result is indicative of the enormous complexity of EU governance. Whereas the debates in the first half of September were fairly sanguine about the project’s prospects, the assessments have become grimmer in the second half of the month. Navigating the dossier through the convoluted and multi-levelled route to approval before the end of the year will require strong leadership and imagination. With all that this may entail, a successful completion is not guaranteed.

• Article 127.6 of the Treaty on the Functioning of the EU, which allows leaders to confer “specific” supervisory tasks on the European Central Bank, requires unanimity of the Ecofin Council, but only advice from the European Parliament. However, since the European Commission also proposed to amend the voting rules contained in the Regulation establishing the European Banking Authority, which came into being in 2011, the Parliament now insists on co-decision for the entire dossier.

• Three member states, and not the most expected ones at that – Sweden, Poland and Hungary – have already voiced substantial reservations on banking union, primarily on the grounds that they would not be part of the decision-making structure when opting into ECB supervision.

• German Sparkassen and other smaller banks – which constitute Germany’s biggest sub-sector in the banking industry and account for 45% of the country’s deposits – do not want to be part of the banking union, and even less of an eventual eurozone-wide deposit guarantee scheme.

• The UK, on the other hand, continues to be strongly supportive of the project, but has expressed reservations about the single rulebook for banks, which is an intrinsic part of the proposed bank union.

By supporting banks not by the government can prevent larger debt and that they will become deeper involved into trouble when they save their banks. If so, this leads to higher interest rates on the bond-market. Such a downward spiral is one of the reasons why the euro crisis continues.

In the recent drafted report 'Completing the Euro', in the chapter on 'Banking and the financial sector' a euro area banking union is pledged. Financial market stability has been neglected by the architecture of the Maastricht Treaty. Despite an increasingly integrated EU financial market, with the volume of cross-border banking growing substantially in the 2000s, financial supervision remained a prerogative of Member States, with only a modest degree of supranational coordination. This dichotomy prevented, prior to the crisis, both the detection of the development, in some EU countries, of excessive private sector imbalances and the identification of cross-country and cross-sector interlinkages, which therefore went unaddressed. In addition to these banking supervision deficiencies, the EU faced the financial crisis with no banking crisis management capacity.

The lack of a European framework for banking supervision and crisis resolution is, at least partly due to the fact that, until the crisis, the interdependency between national banking systems in the EMU was underestimated. The crisis has highlighted the fact that, given the increased financial integration spurred by the common currency, the financial instability faced by one Member State is a threat for the EMU as a whole. Furthermore, the crisis exposed a fragility of the euro area, which is the interconnection between the banking crisis and the sovereign crisis that weaken both sovereigns and banks and the whole monetary union as a consequence.

As the failure of financial markets is at the heart of the crisis, a comprehensive framework for financial stability is a crucial piece in the EMU (Economic Monetary Union) puzzle. This implies moving towards a banking union addressing the financial system deficiencies revealed by the crisis

We therefore call upon the euro area to take the lead in the setting up of a true banking union. We are aware that it could be a delicate issue to achieve the right rules for financial stability in the euro area without endangering the functioning of the single financial market. But it must be possible to ensure that the banking union within the euro area do not entail distortions to competition between the EU-27 within the single market for financial services and the euro area.

The recent reforms in EU financial market supervision are not sufficient. Following the crisis, the EU supervisory framework already underwent a comprehensive reform, aimed at ensuring a stable, reliable and robust single market for financial services. The new architecture consists of two mutually reinforcing European pillars. On the one hand, a micro-prudential pillar, with the establishment of three European Supervisory Authorities (ESAs) for banking (EBA), securities (ESMA) and insurance and pension funds (EIOPA). The specific powers granted to the three ESAs have been designed to improve the quality and consistency of supervision, reinforce the supervision of cross-border groups, strengthen crisis prevention and management across the EU, and establish a set of common standards applicable to all financial institutions. On the other hand, a macro-prudential pillar, with the creation of the European Systemic Risk Board (ESRB) with a mandate to prevent and mitigate the build-up of risks to financial stability in the EU financial system and to contribute to the smooth functioning of the internal market.

This new framework for financial supervision is a step in the right direction. However, the design as a coordination framework means that national authorities will ultimately retain competence for most decisions. Indeed, the new supervisory agencies have limited powers and resources. The EBA does not have the power and capacity to conduct deep and far-reaching bank stress tests. It still has to rely on information provided by national supervisors, who ultimately have the authority to intervene.

The EBA is thus not yet a true European supervisor, and even less a euro area supervisor. The limited supervisory role of the EBA is, of course, related to the absence of financial means at EU level to support banks in difficulty. Taxpayers’ resources remain firmly in the hands of national governments and parliaments, and logically therefore Member States have the main responsibility for banking supervision.

We need to move towards a more European solution for both banking supervision and crisis resolution at the EMU level. In designing the EMU banking union, it is vitally important that future arrangements for supervision and crisis resolution of cross-border banks are dealt with jointly as a package and not in isolation, as the solutions in these two areas are totally intertwined. We cannot separate the supervision from the resolution in the sense that supervision is the preventive arm and even if we prevent crises they will still occur and then we will need the corrective arm.

A BANKING UNION FOR THE EURO AREA

The euro area banking union should in the first place include a fully integrated banking supervision for the euro area. This would include having a euro area supervisory institution being responsible for micro prudential supervision with investigation powers. Creating an integrated euro area banking supervisory authority instead of 17 autonomous national supervisors would have obvious advantages compared with the status quo. With integrated supervision, all relevant microeconomic data for euro area banks would be made available to a single institution. This would allow the supervisor to identify all financial links between the Member States, as well as concentrations of lending to specific borrowers, sectors and regions. A euro area institution would be much more independent of national interest groups and politicians than a national supervisor. Thus, the problem of “regulatory capture” could be avoided or at least dramatically reduced.

This euro area banking supervisory institution should either be built up within the ECB or closely cooperate with the ECB.

Overall, the group considers that supervision of banks should, as a general rule, be consistent with the EU internal market rules and seek to avoid regulatory arbitrage between different levels. A pan-EU supervisory authority in a position of hierarchical superiority vis-à-vis national layers of supervision would be the most desirable approach. The exact design would have to be determined politically, in particular with regard to the relationship of euro area countries to the EU-27 28

A EURO AREA DEPOSIT INSURANCE SCHEME

In parallel to an enhanced supervision structure, there should also be the setting up of a crisis resolution framework at the euro area level. The euro area should aim at creating a framework inspired by the Federal Deposit Insurance Corporation in the US (FDIC), combining the function of a banking resolution agency and a deposit guarantee scheme. A European FDIC-style agency would have to become involved at an early stage in the resolution of a cross-border banking crisis, assuming a role in negotiating the resolution path, alongside the relevant national authorities. This could include the adoption of ex-ante burden sharing arrangements. This agency could also supply funds needed to facilitate the resolution of a cross-border banking group, provided this was less costly than paying out deposits in liquidation. The euro area-wide bank deposit guarantee scheme, which would serve as a “pay-out box” in case of deposit losses, would be easier to implement and less controversial, as public guarantees on bank deposit across the EU are partially harmonized and less discretionary.

The costs of a European FDIC-style agency could be based on an insurance fee raised from the banks, but would clearly have to be complemented with pay-ins from national budgets. As a system of euro area-wide guarantees as a backstop would be necessary for both households and non financial corporates deposits, the amounts involved would possibly be very large. The intervention capacity would therefore have to be financed and backed up by all euro area governments. In order to reduce the moral hazard associated with the potential use of public money, deposit authority should be assigned some “prompt corrective action mandate” (as the FDIC in the US). One option to discuss could be to provide the European deposit/resolution authority with the power to monitor the “recovery and resolution” plans submitted by banks to their primary supervisor. Moreover, there should be clear rules for the resolution authority to impose losses to creditors (bail-in instruments).