The Banking Union: What will the future hold?

The recent events that impacted the Banking Union and insight into the future perspective of the Banking Union.

Just Formanoy, Jort Van der Horst, Bob Van Alphen

December 2017

Introduction

The debt crisis demonstrated that the European financial system is insufficiently robust to overcome a debt crisis. Collapsing banks had to be bailed out with government money, hence taxpayer’s money, which resulted in refinancing struggles for several countries who lost access to international money and capital markets. In order to ensure a safer and more reliable banking sector in the euro area, the Banking Union was implemented at the height of the sovereign debt crisis in 2012 as an EU-level banking supervision and resolution system. Thereby the goal was to break the European doom loop, lower financial fragmentation and unify regulatory and supervisory standards within the Eurozone. (Acharya & Sascha, 2017)

The doom loop constitutes to the fact that domestic banks purchase government bonds, most likely due to ‘moral suasion’. Hereby in times of financial distress, the sovereign prompts domestic banks to purchase domestic sovereign bonds because market demand is low. (Ongena, 2016) Banks become dependent on the good performance of their government and vice versa the government dependents on the to purchase their bonds. In the case such as Greece that the government has to default on its debt, the banks that it tried to support are hit the hardest. (Wallace, 2016) Before the financial crisis, financial integration had led money to be spend across the border in the periphery. But at the height of the sovereign debt crisis home bias ensued that capital flowed back to the core countries leaving the periphery without access to money. Different national banking measures to the financial crisis and different accounting standards led to fragmentation of the single market in financial services. (Angeloni, 2016)

The Banking Union was formed as a measure to counter national interest and to enforce the financial stability of the euro area. The European Banking Union thereby has three pillars to its exposure: (Angeloni, 2016)

1. the Single Supervisory Mechanism (SSM)

2. the Single Resolution Mechanism (SRM)

3. the European Deposit Insurance Scheme (EDIS), has yet to be implemented.

By transferring supervisory power to a supra-national institution, supervisory coordination failure between countries could be prevented since national regulators now had to adhere to EU-wide principles. The alignment of these regulatory reforms was intended to make the banking system safer and more robust against future crises. (Acharya & Sascha, 2017) (Angeloni, 2016)

The SRM is implemented as a system for the effective and efficient resolutions of non-viable financial institutions. Through SRM, bank failure can be resolved according to EU-wide principles thereby breaking with the sovereign-nexus. Sovereigns will be less able to support failing banks and this will lead to a separation of bank risk and sovereign risk. (Acharya & Sascha, 2017) (Angeloni, 2016)

For the SRM to be successfully implemented, the EDIS has to be accepted by all the member-states of the euro area. All countries in the euro area will have to deposit money which enables the ECB to bailout banks where needed in the Eurozone. This could for instance entail the German taxpayers’ money is used to bailout an Italian bank. This is in conflict with the interests at a national level, but is in line with the ultimate goal of the European Banking Union of risk-sharing on an European level. Thereby the greatest challenge for the ECB will be to convince all the European countries to give up on domestic interest for the benefit of a stronger euro area. In today’s society with national and popular sentiment on the rise in several European countries, this will be particularly challenging. (Acharya & Sascha, 2017) (Angeloni, 2016)

Historic events which led to the introduction of the Banking Union

As briefly mentioned above, the importance of creating a more solid and stable monetary union by introducing a Banking Union became much larger after some events in recent history. Prior to the crisis there was a more “traditional view of banking”, which implies that the liabilities of banks are almost risk free, because they hold a well-diversified portfolio of loans and risk-free government bonds, there is insurance for depositors provided by governments to prevent bank runs and there are regulations making sure that banks are capitalized enough. These factors of the traditional view contributed to the rise of the interbank market prior to the crisis. (Elliott, 2012)

As we now know, banks are not risk free and the shortcomings of the ‘traditional view were revealed. Spillovers from the US subprime mortgage-loan crisis affected the European banking sector and threatened to intensify into a true systemic crisis in Europe. In the summer of 2007, the fear of counterparty risk started liquidity hoarding in the banking system which resulted in a liquidity crisis. Banks in Italy and Portugal had liquidity surpluses and countries like Germany had liquidity shortages. Than this situation shifted.

In the third quarter of 2008, the dysfunctional interbank system resulted in insolvency for banks in Greece, Ireland and Portugal. Therefore, European governments had to bailout a great part of their banking sectors. Due to these large liabilities in combination with low growth, investors started doubting the repayment capacity of sovereigns. As the balance sheets of banks were stuffed with government bonds, the decrease in sovereign bond prices further increased insolvency risk of other Eurozone banks. The “doom-loop”, as mentioned above, continued and fragmentation became larger. In 2012, also Spain and Italy surfaced insolvency, which resulted in the height of the sovereign debt crisis. At this point, the Banking Union was introduced as an attempt to break the doom-loop, lower financial fragmentation and unify regulation and supervision across the Eurozone. (Acharya & Sascha, 2017) Figure 1 gives a visual display of shifts in liquidity surpluses and shortages from the beginning of 2008 until summer 2012.

Arguments for and against the current performance of the Banking Union.

In the summer of 2012, the President of the ECB Mario Draghi stated that they will do “Whatever it takes”. (Knot, Modesty in times of uncertainty, 2017) Shortly after, the ECB announced its Outright Monetary Transactions (OMT) program. As a result markets came at ease, in the knowledge that the ECB would step in if needed. So, on the one hand, it already shows changes after the introduction. Yields on government bonds came at ease after introduction of the Banking Union, as shown in figure 2. (Angeloni, 2016)

Figure 2: this chart shows ten year government bond yields, monthly averages. Source: De Nederlandsche Bank (The Dutch Central Bank), (Knot, The European sovereign debt crisis, the monetary policy response and the way forward, 2017)

Besides the improvement of financing conditions in de the euro area, the financial fragmentation has been reduced as well, due the Asset Purchasing Program the ECB started. It is also noticeable that we now have experience twelve consecutive quarters of reflationary growth, as shown in figure 3, and deflation risk is of the radar. (Knot, The European sovereign debt crisis, the monetary policy response and the way forward, 2017)

Figure 3: Euro area GDP growth. Source: De Nederlandsche Bank (The Dutch Central Bank), (Knot, Modesty in times of uncertainty, 2017)

On the other hand, hence all these positive results of the Banking Union so far, in order to ensure a stable financial sector; sufficient capitalization, cross-border regulation and supervision, a M&A friendly environment and a solid structure to diminish non-performing organizations are key-essentials for a Banking Union. These essentials show the importance of a reliable and well-structured system of regulation, supervision and resolution for the EU banking sector. Unfortunately, the Banking Union has only accomplished these steps partially. Despite the changes in supervisory and regulatory mandates, currently there are still shortcomings in the Banking Union. For example, there are still insufficient capitalization levels in the banking sector, the level of non-performing loans on banks’ balance sheets is only slowly declining and if banks continue to expect that interventions by governments or the ECB will save them from the downside risk of distress, excessively risk taking will persist. (Acharya & Sascha, 2017)

Despite these shortcomings in current days, the Banking Union is still ‘young’. First steps are constructed, and have proved to be effective in creating a more stable financial environment. The Banking Union should now focus more on the political alignment between members of the union, because not all European leaders seem to have political interests in completing the deposit insurance part of the Banking Union. When this part could also be completed maybe a more fiscal union can be pursued which will result in a more mature, sustainable Capital Markets Union. (Elliott, 2012)

What will the future hold for Banking Union?

The future of the European Banking Union for a large part depends on the ability of the ECB to get member-states to agree with the risk-trading on an European level. This would entail 6

suppressing national sentiments, a phenomenon which has been on the rise in many European countries. A good example of popular sentiments forcing for drastic consequences has been the Brexit. The exit of the UK from the EU meant that the future for Europe’s financial heart in London has become uncertain. Already several of the big banks have advocated that they will be moving their headquarters to mainland Europe, especially to Frankfurt. This can have big consequences for the UK, but also for the EU. A similar exit from another European member-state would greatly jeopardize the prospects of a well-functioning Banking Union. The distrust amongst countries would grow making it increasingly more difficult to accept euro wide principles. (Springford & Whyte, 2014) (Elliott, 2012)

The biggest danger facing the European Banking Union therefore would be the populistic trend in which nationalistic sentiments outweigh the sentiments for an united Europe. For cross-border financing it is of importance that distrust between European countries remain low and preferably disappear. The Banking Union was installed to prevent further bail-outs of banks with the money of taxpayers. Following the “Geithner principle” creditors of large financial institutions should not suffer any losses and bank resolution should be paid for by bondholders, shareholders and in a last resort large depositors. (Rouanet, 2017) (Elliott, 2012)

Figure 3: After the Italian bailout the European banking stocks saw a significant rise. Source: (Rouanet, 2017)

Unfortunately, the Italian government decided to bail out two Italian banks, Veneto Banca and Banca Popolare di Vicenza, thereby using 17 billion euros of taxpayer money. This undermines the principle at the core of the Banking Union that taxpayers´ money would no longer be used to bail out banks in distress. The fact that the European Commission hardly disapproved this bail out signaled to the markets that the big banks do not have to fear bankruptcy. This is illustrated in figure 3 where stock prices of European banks quickly rose after the news. (Rouanet, 2017)

Conclusion

In order for the Capital Markets Union to succeed, the Banking Union will have to function correctly. Progress has been made on the Banking Union and the fist steps have been taken. The Single Supervisory Mechanism and Single Resolution Mechanism have been implemented, but there is still resistance against the European Deposit Insurance Scheme (EDIS). At this point in time European leaders do not seem to have the political will to make further progress on the EDIS or the Banking Union, as a whole. Moreover, the recent event within the euro area has only made the segmentation between Euro countries greater. (Acharya & Sascha, 2017)

The European Central Bank will play a very important role within the ongoing progress of the Banking Union. The ECB introduced several different programs to help the integration among Eurozone countries, with the goal to converge the sovereign yields. This will reduce the segmentation between Euro countries and is an important step for the Capital Markets Union. However, it is uncertain if the arrangements from ECB will create a viable, long-term solution. Therefore, there will still be debate about the feasibility of the Banking Union as a whole. (Acharya & Sascha, 2017)

The recent events, like Brexit and the Italian banking crisis, have not helped the progress of the full implementation of the Banking Union. The Brexit has questioned if the prospects of a well function Banking Union is viable and has made the distrust amongst Euro countries grow. The Italian banking crisis reinforced the fact that taxpayer money can and will be used to provided bail outs. Therefore, in order for the Banking Union to succeed policy makers and political leaders need to step up and make further concrete progress. Adopting policy within certain Euro countries, that not necessarily include all the Euro countries, will be the only way to insure that progress will be made. (Springford & Whyte, 2014) (Rouanet, 2017) (Elliott, 2012)


References

  • Acharya, V. V., & Sascha, S (2017). The Importance of a Banking Union and Fiscal Union for a Capital Markets Union. European Commission Economic and Financial Affairs, 5-30
  • Angeloni, I (2016). European banks and the Banking Union. European Central Bank Banking Supervision
  • Elliott, D. J (2012). Key Issues on European Banking Union. Global Economy & Development, 1-54
  • Knot, K (2017). Modesty in times of uncertainty. Business Economists’ Annual Dinner (pp. 1-10). London: De Nederlandsche Bank (The Dutch Central Bank)
  • Knot, K (2017). The European sovereign debt crisis, the monetary policy response and the way forward. VU Amsterdam Guest Lecture (pp. 1-25). Amsterdam: De Nederlandsche Bank (The Dutch Central Bank)
  • Ongena, S. P (2016). The Invisible Hand of the Government:'Moral Suasion' During the European Sovereign Debt Crisis
  • Rouanet, L (2017). The Death of the European Banking Union. Mises Institute Austrian Economics, Freedom and Peace
  • Springford, J., & Whyte, P (2014). The consequences of Brexit for the City of London. Centre of European Reform, 1-10
  • Wallace, T (2016). The doom loop is back: Europe’s banks are still buying more of their own governments’ debts. The Telegraph

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Just Formanoy

MSc Finance at Vrije Universiteit Amsterdam

Jort Van der Horst

MSc Finance at Vrije Universiteit Amsterdam

Bob Van Alphen

MSc Finance at Vrije Universiteit Amsterdam