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The European Banking Union (1/2)

In recent months, the European Banking Union has been one of the hottest topics of the financial services industry in Europe. Benoît Coeuré, a member of the ECB Executive Board even called it "the most important event in the European integration since the creation of the euro, and maybe even more important than the euro itself". Even though it might be clear for everyone that this banking union is important, necessary and should be put in place in the near future, the content and the propositions that are currently on the table might not be that clear at all.

Sia Partners thereby provides you with an in depth analysis of what the banking union in Europe is going to be. In this first part, the focus will be made on mains the reasons why we need a banking union, its perimeter and the most important constraints to its construction.

The vicious circle between banks and sovereigns

After the fall of Lehman Brothers in the United States in 2008, the well-known Subprime Crisis arrived quickly in Europe and many European banks were shaking to their foundations. The European states, who were willing to avoid a systemic banking crisis in Europe at all cost, tried to help out the troubled banks with several recapitalization projects and rescue plans. Doing this, governments indebted themselves for billions of euros in risky banks, which finally resulted in a downgrade of their sovereign credit ratings by the influential Credit Rating Agencies (see Sia Partners' analysis). The banks, already holding a major stock of government debt, were hit by another devaluation of their balance sheet due to the lower credit rating of their governments, increasing again banks' Risk of Default. As presented in the figure below, the creditworthiness of governments and banks are directly linked and cause a poisonous vicious circle.

Since regulation and supervision is mainly organized on a national level, it failed to predict and even more to resolve this situation. Besides, the regulation in place was way too permissive, relatively easy to bypass and cooperation between different regulatory bodies was almost non-existent. Even though the Basel principles and other banking regulation have been put in place to address some of the issues and to regulate banks more strictly, the current regulation and supervision is still not sufficient to prevent new and dangerous shocks to the financial system in Europe. In this context, the European Parliament agreed to set the foundation of a so-called banking union, which would complement the monetary union already in place in the euro area and the political union towards which many members strive.

The European Banking Union Bases

Since the link between banks and governments was one of the main reasons why Europe's Financial System has been in crisis for the past few years, one of the most important objectives of the European Banking Union is to break this dangerous link. Meanwhile, the member states want to improve the safety of the banking system in Europe and strengthen convergence on a supra-national level. Even though the euro-crisis and the financial crisis are calling for an urgent implementation of this new Banking Union, it will be important to take into account the pros and cons of each possibility in order to take well-balanced decisions.

In an optimal solution, the entire European Union (28 countries) would be integrated in this banking union. Unfortunately, political impracticalities - especially with the UK - do not currently make it possible to integrate all of European member states. Therefore, the current structure includes all Eurozone members (17 countries) and gives other EU countries the possibility to opt in now or later on. This method paves the way to include the entire EU in a later stage.

Taking into account this perimeter and the difficult constraints mentioned above, the European Institutions created a general proposition consisting of 3 important pillars aiming to address as many issues as possible:

  1. Single Supervisory Mechanism: Common regulation and supervision of the banking system.
  2. Single Resolution Mechanism: Common management of the resolution process for troubled banks.
  3. Deposit Guarantee System: Common deposit guarantee fund or a fund that backstops national guarantee funds.

Even though they are not perfect yet, all these propositions should lead to a more solid, more efficient and more coherent banking system in Europe.

The second part of this article will present each of these three pillars in more detail

Sia Partners

"Could ESM and a European Banking Union break the link between sovereign and bank creditworthiness?", Stefan Best & Frank Gill, RatingsDirect, Standard & Poor's Rating Services

"Key issues on European Banking Union", Douglas J. Elliot, Global Economy and Development at Brookings

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