The European Banking Union (2/2)
In recent months, the European Banking Union has been one of the hottest topics of the financial services industry in Europe. Sia Partners provides you with an in depth analysis of what the banking union in Europe is going to be. In this second part, the focus will be made on the three pillars of the future union: supervisory mechanism, resolution mechanism and the deposit guarantee system.
Single Supervisory Mechanism
For the first and currently most developed pillar of the European Banking Union, the Council of the European Union is establishing a single supervisory mechanism (SSM). It will confer specific tasks on the European Central Bank concerning policies related to the prudential supervision of credit institutions on the basis of Article 127(6) of the Treaty on the Functioning of the European Union (TFEU).
The objectives of the SSM is to help breaking the negative feedback loops between sovereign ratings and banks and thereby to address the so-called "financial trilemma". This trilemma can be defined as the impossibility of achieving financial stability and financial integration while maintaining national financial policies in an integrated financial market. In a monetary union with a high degree of interconnectedness between financial institutions and markets, problems in one country's financial system can spread rapidly. Such problems can best be assessed and addressed by a central supervisory authority who has a bird's eye view of the entire union banking sector rather than through cooperation between national ones.
To undertake this task, the SSM -which should be fully operational by the Autumn of 2014 -will be composed of two regulatory bodies:
- ECB who will be responsible for the overall functioning of the SSM
- National competent authorities of the Monetary Union.
The main reason why the ECB was chosen over the EBA (who functions as a guardian of the EU-wide single market with a pure focus on bank supervision) is probably that the ECB is central to the Eurozone and crucially important to manage the euro-crisis. Nevertheless, the ECB will use a so-called "single supervisory handbook", created by the EBA.
Since direct supervision over all banks in Europe is impossible, the ECB will opt for a system in which they directly supervise bank that meet one of the following conditions:
- Present more than € 30 billion of asset
- Weight more than 20% of the Gross Domestic Product of the member state in which it is located and present assets of more than €5 billion.
- is among the three most significant banks of the member state in which it is located.
- has large cross-border activities.
- receives aid coming from a eurozone program.
Others will remain under the control of National Central Banks. However, the ECB will have a "right of evocation" enabling it to attract these other institutions under his direct control if it deems it necessary.
Single Resolution Mechanism
The second pillar has as main objective to recapitalize or restructure distressed financial institutions directly with a so-called Single Resolution Mechanism. Organizing the rescue at supranational level should reduce the risk of complacency that national authorities could have for the banks of their own country.
At the origin of this SRM lie the European Financial Stability Funds (EFSF) and the European Financial Stability Mechanism (EFSM), which had the objective to bail out member states in financial difficulties. In June 2012, the European leaders sought to create a similar system to help banks in difficulties. This proposition has been validated in June 2013 by the 17 finance ministers of the Eurozone and is awaiting a long and difficult legal path before entering into force, which will be in the second semester of 2014 at the earliest.
The proposition as it is now, describes when and how the SRM can be solicited in five steps, which are presented in the figure below:
In short the objective is to let the shareholders and priority debt holders pay with the so-called bail-in and do away with the practice where governments bail-out troubled banks. To say it with the words of Executive Board Member Jörg Asmussen: "Bail-outs out! Bail-ins in!"
This uniform process of troubled bank situation's resolution will give more visibility to investors and will limit the risk for complacency that national authorities could have. Also, since the Commission is the only one who has to decide on resolution matters, decision times will be lower and the restructuration process will be faster. Moreover, funds needed to bail banks should be financed ex ante and funds of the member states will progressively be replaced by the funds of the banking sector.
Deposit Guarantee System
The third and least advanced pillar of the banking union is the deposit guarantee system. This pillar aims at protecting deposits while simplifying and harmonizing the current national systems of guarantee funds. The system especially focuses on small depositors and small enterprises that don't really have the means to evaluate the structure of their bank. In fact, the main objective is to improve the confidence of these economic actors in the safety of their deposits, which will eventually reduce the risk of bank-runs. In the long term about 95% of eligible deposits should be covered.
Even though this third pillar is important to create a complete banking union, it has not yet really been officially discussed in detail, mainly because the first two pillars are more important and can start functioning without the third one. Moreover, the objective of the regulators is to have a first pillar strong enough to ever using the third one. However, the main characteristics of this Deposit Guarantee System are already known: it will be based on a European dedicated fund and guarantee deposits up to €100,000 in case of default of a financial institution.
The funding of the system is still under discussion. Two possibilities are still being investigated: either base the Guarantee fund on the existing national system and complete it with a reinsurance fund on supranational level; or create a single European fund, financed ex-ante, which would be more in phase with the idea of unlinking banks and sovereigns.
Consequences and limits
We can say that the current banking system in Europe, which is suffering from a confidence problem, is more than ripe for a change. Investors are still unsure about the health of banks' balance sheets, about the rigor of supervision and about the capacity of fiscally constrained countries and of banks that are no longer viable. It is largely agreed that the three proposed pillars of the European Banking Union are thus necessary and that they each address many of the existing problems in the Eurozone. Moreover, they will be essential to restore confidence, to assure asset quality and to assure that banks that need to be wound down can be wound down and will be wound down, even those who are called "Too Big To Fail". However, the question remains if it will be enough to ensure a safe and good functional financial system in Europe. In any case, we cannot assume that the Banking Union will solve all the problems, and certainly not right away: even though preparatory works have already started, the first pillar still has to be put in place, not to mention the second and the third pillar, for which no exact timing has been decided. Apart from the timing issues, it remains to be seen how the Banking Union will be complemented by other initiatives to tackle remaining problems in the financial system in Europe. Indeed, the banking Union does not address the risk of non-bank financing, the inaccessibility of credit nor the risk of global contagion. Nevertheless, the banking union is a necessary but complex evolution that will certainly boost the recovery of the European banking system and provide an improved protection of the entire European financial system.