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9. Towards a European Banking Union

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1 9. Towards a European Banking Union
1. What is the problem with banks, and what could be done to enhance a more stable banking system? 3. The problem of cross-border spillovers 4. Building blocks of a banking union 5. Can a proper banking union be set up in Europe?

2 1. What is the problem with banks?
Banks have a bias towards excessive risk taking, i.e. they take more risks than is socially optimal (appropriate from the point of view of society as a whole). Reasons for this include: - banks are mostly stock companies with limited liability; owners cannot loose more than their equity while there is no ceiling on the upside (banks were much more prudent in the days when they were private partnerships) - banks benefit from explicit and implicit government guarantees (mostly at no or little cost): deposit insurance, funding guarantees, recapitalization if need be… - banks benefit from favourable tax treatment (tax deductibility of borrowing, no VAT on most banking activity) - central banks may support banks through lender-of-last resort actions and monetary accomodation (providing banks with cheap money to ease stress) - many banks are perceived to be ”too big to fail” and can realistically count on public rescue operations in case of need, which reduces the cost of funding - banks (like their customers) are prone to periods of euphoria and herd behaviour - reward systems for management is mostly based on relatively recent performance and is asymmetric (”head I win; tail, somebody else looses, I may quit”)

3 (cont.) The bias to excessive risk taking takes the form, notably, of high leverage, i.e. of too much lending or other assets being financed by borrowing rather than equity. NB that the return on equity is much bigger for highly leveraged investments (using a lot of borrowed money) than for less leveraged investments IF the return on assets is higher than the rate paid on borrowed money. NB also that the investor, if a company (such as a bank), cannot loose more than the equity put into the company. This asymmetry (no ceiling on upside, only on downside) encourages risk-taking. A company with equity E invests into assets A. At a later point in time the value of the assets has doubled (risen by G); the profit is P, and the rate of return on equity is P/E. Another company borrows L and invests both E and L in the assets A, the value of which again doubles (G); however, the rate of return on equity (P/E) is now twice as high. Leverage increases the rate of return on equity in success, but it also increases the size of loss if the return on assets is lower than the interest rate on borrowing. Yet, E is maximum loss. A A G E E P A G L E P

4 5.4 Banking and financial stability: the problem of high leverage
Assume that the economy has been developing favourably for a number of years, that confidence is high and risk premia and interest rates are low. The balance sheet of the representative investor is A = K + L, A = total assets, K = equity, L = debt The return on equity of the portfolio is rE = (rAA - rLL)/K = (rA(K + L) - rLL)/K = rA + (rA – rL)(L/K), where rE is the return on equity, rA the return on total assets, rL the rate on interest on debt and L/K the degree of leverage. Obviously, with optimistic expectations w.r.t. the return on investment and/or a low rate of interest on debt, the expected return on equity can be improved by increasing leverage. However, this is at the expense of higher risk or a higher variance of the rate of return: V(rE) = (1 + (L/K))2 V(rA) with V denoting variance (assuming no uncertainty for the interest rate. Obviously, the risk or variance of the return is an increasing function of the degree of leverage.

5 (cont.) (iii) The costs to society of the financial crises (associated with or at least made worse by the vulnerability of banks) are large: - the subsidies given to banks in various forms - the costs of financial distress and of the severe recessions following upon financial crises - the banking crisis may also trigger a negative feedback-loop, where the weakness of the banks undermines confidence in the sovereign and vice versa. (iv) Some of the reasons or causes of excessive risk-taking cannot be eliminated (in practice): - deposit insurance (up to some amount) is needed to prevent bank runs - it is difficult to do away with ”too big to fail banks”; authorities may ex ante claim that ”no bailout” will prevail, but in acute situation (ex post) bailout may still seem the less risky solution. (v) Damage limitation therefore calls for regulation and supervision by various means: - setting appropriate premia for banks to finance deposit insurance, - requirement for lending/assets to be sufficiently diversified, - separation of commercial or retail from investment banking, building firewalls between more and less risky bank activities, - requiring banks to set up ”living wills” to facilitate their winding down in case of need - setting up of resolution authorities with instruments and power to ”bail in” owners and creditors of banks in trouble - imposing sufficiently high capital requirements on banks and supervising that they are respected etc etc

6 2. The problem of cross-border spillovers
The EU’s single market, including the market for financial services, is based on free movement in combination with the principles of - minimum harmonization (of national legislation), - mutual recognition (of different standards as long as they comply with minimum harmonization) and - home country control. Home country control means that supervision of a bank is the responsibility of the home country of the bank also for branch offices located in other countries. Foreign subsidiaries, by contrast, are supervised by the authorities of the host country (the country of location), i.e. the country which has given the banking license. The lack of correspondence between the area of the activity of the bank and the area of bank regulation and supervision can be highly problematic: - there are a number of channels of contagion between banks (they are interconnected directly and indirectly) - authorities may not have full information about the situation of many banks - banks may exploit regulatory differences between countries to their advantage - countries may have incentives to engage in regulatory competition (to favour activies of domestic banks) - in a crisis situation they may want domestic banks to withdraw funds from their foreign branch offices - in case of bank failure or the need for bailout it may be very difficult to agree on the burden sharing as between authorities of the countries in which the bank is operating - governments in weak countries may not be able to handle the consequences of a banking crisis, in which case tax payers from other countries may be called upon to shoulder the consequences of excessive risk- taking by banks in countries with lax regulation and/or supervision of banking

7 Cross-border linkeages
Country A Country B Government debt situation Government debt situation Banking system Banking system

8 3. Building Blocks of a Banking Union
There is no agreed definition of a banking union, but it may include at least the following aspects: A unified framework for regulation and a coherent framework for bank supervision A lender of last resort for banks (a function which the ECB is already de facto fulfilling) An authority with power to undertake resolution of banks in difficulties and equipped with a bank resolution fund to provide financing if need be A coordinated or common deposit insurance system Conceivably a minimum fiscal backstop to provide financing for handling a banking crisis (if the bank resolution fund an central bank lending to banks does not suffice) An appropriate framework of committees and framework for macroprudential supervision The aim of setting up a banking union is to eliminate or alleviate the significance of cross-border spillovers: Distressed banks may cause contagion to banks in other countries (which purely domestic arrangements do not necessarily give sufficient attention to) Banking problems may undermine the credibility of sovereigns, the bonds of which are held also by foreign investors Government debt problems may threaten the banking system and vice versa, a negative feedback mechanism that national authorities may find difficult to break etc. One important source of inspiration for the Banking Union is the USA, where banking is mostly a comptence of the federal authorities. California may be on the verge of bankruptcy, but nobody is concerned about the health of Californian banks or repercussions from California to the rest of the USA via the financial system. The main explanation seems to be the existence of the American banking union. The Commission has proposed the first steps towards a BU for the euro area with opt-in possibility for others.

9 Banking union: building blocks
+ lender of last resort (ECB) to prevent runs on banks (if solvent) + ex ante levies on banks (deposit insurance and resolution fund) + possibly ex post levies if government money has to be used Bank regulation mainly EU also national Bank supervision SSM ECB (also ESRB) national Deposit insurance national euro area? Bank resolution -national - euro area Bank resolution fund national euro area Minimum fiscal backstop (= ESM?)

10 Elements of a banking union
Regulation The regulatory aspect w.r.t. the financial system refers to defining the rules to be followed. It is already by and large a Community competence and takes place through Community legislation (though often in the form of directives rather than regulations). The Commission proposes to have a ”single rulebook for banking regulation” concerning, i.a., capital requirements of banks and prudential supervision. The regulatory set-up is harmonized through Community legal acts: the Capital Requirements Regulation and the Capital Requirements Directive IV (soon to be adopted and enter inro force over the next years). These acts are based on the Basel III agreement. Some scope for national flexibility is foreseen though. Supervision Already years ago the EU set up a European system of financial supervision, though with limited powers, consisting of certain committees and three European Supervisory Authorities: - the European Banking Authority (EBA, London) - the European Securities and Markets Authority (ESMA, Paris) - the European Insurance and Occupational Pensions Authority (EIOPA, Frankfurt). These authorities try to enhance information and coordination with a view to ensuring that implementation of regulation and supervision is reasonably harmonized within the EU. Also, supervisory colleges have been set up to improve collaboration between host and home country authorities. There is also the European Systemic Risk Board (ESRB), chaired by the ECB and having responsibility for macroprudential supervision of the euro area (i.e. supervision geared towards stability of the overall financial system rather than of individual institutions). More recently, the euro area decision makers have agreed to set up a single supervisory mechanism (SSM). The SSM is to operate as part of the ECB. It will focus on supervision of the ”Sifis” (systematically important financial insitutions) but has ultimate responsibility for the supervision of any or all banks (6 000 in the euro area) if it so decides. In any case, it should supervise banks receiving financial support from authorities. It will work in close collaboration with national supervisory authorities. The SSM will gradually become operative (at the latest in 2014).

11 (cont.) The details of the governanvce of the SSM are not entirely clear. In particular: - How to ensure that supervision does not influence monetary policy, or the lender of last resort-function, in an inappropriate way and vice versa? Is there a risk that monetary policy will be eased when banks are strained at the risk of higher inflation? On the other hand, the ECB will have improved information to function as lender of last resort when managing the SSM (with better access to information about the solvency of banks). - How to ensure that the ECB is fully accountable for its activity wthin the SSM (presumably to the European Parliament)? - Also, how does the SSM relate to non-participating member states and notably the UK, an important matter given the importance of the City of London? Some sort of joint colleges, but with what decision making? Resolution Many countries still rely on general corporate insolvency proceedings to deal with bank failures, which raises many legal and practical difficulties. Some member states have recently given their banking authorities or the government special resolution powers to facititate a quick resolution of failing banks. There is now a Directive on bank recovery and resolution, which seeks to ensure that national authorities have strong preventative and early intervention or resolution powers in the face of banking difficulties (giving authorities power to require actions to retain profits, raise capital, restrict certain activities, implement recovery plans, set up bridge banks in the context of asset separation, override shareholders’ rights, write down or ”bail in” debt). Member states are also required gradually to set up resolution funds with a target ratio of 1 % of total liabilities (less equity). Also, banks could be burdened with ex post levies (if funds are insufficient and government support is needed). Furthermore, resolution funds of various member states might, in case of need, lend to each other. There could also be a credit line from the central bank. There is also preliminary agreement on a single European resolution authority and a single resolution fund. This would imply a new supranational authority with very wide-ranging powers to decide on the fate of banks in difficulties. A single resolution mechanism can be seen as a necessary complemen to the SSM: one without the other makes no sense.

12 (cont.) This mechanism, including the resolution fund, should be financed by contributions of the financial institutions covered. There should be a possibility to use taxpayers’ money in case of need, conceivably from the ESM, but such support should be recouped ex post from the financial institutions. There is also a need for a clear ex ante agreement between member states on the burden sharing of supporting banks with cross-border activities. There might still be also national resolution authorities and funds for the purpose of dealing with banks, the activities of which have mainly a national scope. Deposit insurance. The Commission proposes that all member states should have deposit insurance schemes with a target fund of 1,5 % of eligible deposits, i.e. deposits below euro per depositor per bank. Insurance payments should also apply to cross-border deposits. There could be a possibility of cross-border borrowing across national schemes in case of need (and with some safequards). It is unclear wether the Commission will also propose a single deposity insurance system and fund for the euro area, as is the case in the US, where the federal deposit insurance system is a central part of the banking union. It would also be possible to combine national deposit insurance and euro area reinsurance. The role of the national deposit insurance would be to deal with more limited and mainly national banking crises. National deposit insurance authorities could be obliged to also purchase reinsurance from an euro area deposit insurance authority. This would pay out in case of ”large” crises surpassing the capacity of the indiviudal member state.

13 (cont.) Insurance premia should in all cases be differentiated according to risks: National authorities would assess the risks of individual banks and set premia accordingly. The euro area insurance authority would assess the size of national reinsurance premia in the light of the riskiness of banking systems in member states and also on the basis of how member state performs w.r.t. fiscal policy and/or the excessive imbalance procedure. The intention would not be to create a transfer system but rather a genuine insurance mechanism (beneficial to all, at least ex ante). However, this is politically a step which presently has very little backing. Lender of last resort and macroprudential supervision The ECB is the lender of last resort of banks in the euro area, which should help avoid excessive difficulties due to pure liquidity problems. Also, there is the ESRB with responsibilities for macroprudential supervision. Minimum fiscal backstop There may, in the case of banking problems, be need for financial support in the context of setting up a ”bad” bank or protecting depositors or recapitalization. It will take a lot of time to build up national or euro area wide deposit and/or resolution funds. Thus, it cannot be excluded that there will be a need for funding without an obvious source. This could be handled by the ESM, if it has the required lending capacity. The other alternative is funding by member states, based on previuosly agreed formulas for burden sharing of cross-border bank problems. (This assumes that all member states concerned are fiscally capable of bearing their part of the burden; if not, the ESM is the remaining option.) Conceivably, the cost of bank resque and the need for a fiscal backstop could be limited if 1) the SSM is tough and if 2) the resolution authorities act early and strongly and 3) have power and use it to enforce bail-in of owners and all creditors except depositors below euro (and collateralized creditors).

14 Safeguarding banking: who does what (or could conceivably do)?
REGULATION SUPERVISION RESOLUTION DEPOSIT INSURANCE BIS (Basel) and Partly BIS, Some involvment GLOBAL to some extent G20 and of the IMF LEVEL G20 (negotiations) IMF (cf. e.g. Cyprus) Community legislation SSM (ECB) and a euro-area wide conceivably a euro EU/EA by the Commission, ESRB and work of bank resolution area deposit insurance LEVEL Council and the EP, EBA as well as other authority plus or reinsurance fund Regulations, Directives committees resolution fund and authority NATIONAL Legislative action by national financial national national deposit LEVEL national governments supervision by resolution funds insurance and parliaments specific authorities and mechanisms systems and funds

15 4. Can a banking union be set up in the euro area: questions and concerns?
Nota bene: presently existing losses in balance sheets of banks inherited from the past, or so called ”legacy costs”, will remain at the responsibility of the national authorities of the banks. Thus, banking union is a solution, if at all, to future crises, not to the current one. Is it conceivable that all member states, including Germany and France, would accept politically to surrender national sovereignty over their banking systems, given also the links between the big banks and big corporations as well as links between banks and politicians? Is it conceivable that citizens in Northern Europe would accept mutualization of risks, including common funding obligatons for bank resques and deposit protection, in the way that a banking union of the American type would require? Will the Commission make sufficiently ”courageous” proposals? Will the outcome of the negotiations requiring unanimity be a coherent and credible legislative package? Can it be safely assumed that all member states will implement agreements in an appropriate manner? Will the banking union be an insurance mechanism benfiting all or a transfer mechanism causing moral hazard? Is it safe to assume that the banking union, with mutualization, would have democratic legitimacy for citizens? What are the ultimate consequences for the functioning of the internal market (with ins and outs)? Is it possible to have a banking union without a fiscal union and, in the end, a political union?

16 Questions Why are banks a potential source of economic instability?
Why could there be cross-border spillovers related to banking? What are the main building blocks of a banking union? Who is responsible for banking supervision in the euro area? What is meant by bank resolution? Will there be a role for the union level in bank resolution?

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