Blog Post

Organising bank supervision and resolution in Europe

The Euro Summit has decided to create common supervision and allow for direct capital injections into banks by the European Stability Mechanism (ESM). This is an important step towards breaking the negative feed-back loop between banks and their feeble sovereigns and will therefore contribute to the stability of the euro area.  Two issues on the […]

By: Date: July 5, 2012 Topic: Macroeconomic policy

The Euro Summit has decided to create common supervision and allow for direct capital injections into banks by the European Stability Mechanism (ESM). This is an important step towards breaking the negative feed-back loop between banks and their feeble sovereigns and will therefore contribute to the stability of the euro area.  Two issues on the road to a banking union will prove particularly contentious: the organisation of common financial supervision, which is an explicit part of the summit agreement and the creation of a resolution authority, which is not really covered in the summit statement. The fact that the summit document is silent on resolution shows how contentious the issue is.

Organising common supervision is also not an easy task. The Council has not specified which banks would be covered and what would be the relationship between the national and the common supervisor. Should national supervision be discontinued? Should national supervisory authorities be put under the administrative control of the new European supervisor? To be most effective, a system covering a large set of banks is desirable. The crisis has revealed that problems often arise in small to medium-sized banks and that these problems are too large to be handled by national fiscal and administrative capacities alone without causing contagion. However, this would imply a radical transformation of the European supervisory landscape in which national supervisors would lose their status and would have to become agents of the common European supervisor. This would also imply major changes in the respective national legislations underpinning supervision. If that route were to be chosen, I would expect the transformation period to last at least one year if very strong commitment is there.

 Alternatively, a narrower solution would consist of European supervisory power  being limited to large banks only. The national supervisors could then either keep their supervisory powers over these same banks so that supervision would be dual, or their supervisory authority would be restricted to smaller banks. While this option may be easier to implement in practical and political terms, one should bear in mind that only a broad solution will be effective in overcoming the negative feed-back between banks and sovereigns. It will therefore be of central importance that the ECB, the European Commission and the presidents of the European Council and the Eurogroup make a concerted effort to achieve as far as possible a solution that changes the supervisory landscape in a meaningful way.  

The Council conclusions are surprisingly silent on bank resolution. While there is political agreement to allow for direct capital injections into banks by the ESM, nothing is said about how this could be achieved and who would take the necessary decisions. Indeed, bank resolution authority involves significant choices about the distribution of costs between shareholders, creditors, uninsured depositors, taxpayers, and/or surviving banks, as well as about ownership and competition in the sector as a whole.

One possible way of organising bank resolution would be to require national authorities to act once the European supervisor detects a significant capital shortfall in a bank. The decision by the European supervisor would then be legally binding on the national authorities to find a solution. As long as national fiscal resources are sufficient, the national authorities would be fully in charge of making the decisions on the restructuring and the burden-sharing. However, they would have to keep the European supervisor fully informed and they would obviously have to comply with state aid rules to avoid competitive distortions.

In case national tax resources are too limited and ESM funds were to be directly channeled into banks as equity injections, national resolution powers would have to be significantly reduced. In Greece in particular, the difficulty of retaining resolution power at national level while finance is given from abroad has become particularly apparent. In fact, the restructuring process can become protracted and banks may be kept alive on emergency liquidity assistance despite their negative capital. It is thus advisable to render direct capital injections into banks conditional on the passing of national emergency legislation empowering the European level with the resolution authority.

An even more radical option would be to give the actual resolution authority for all banks to the European level  upfront. The European authority would be empowered to take the decisions on the distribution of costs and the re-organisation of banks in Europe following a decision by the European supervisory authority.

It is clear that the more far reaching the transfer of authority to the European level is, the more pressing is the issue of political and democratic legitimacy of the decision-making process. A model where the essential decisions on resolution are taken by national authorities requires only limited further enhancement of legitimacy at the European level. However, if resolution authority is fully moved to the European level, Europe would have to agree on a new way of legitimising such decisions. This would require a significant step towards more political integration.

Ultimately, resolution and supervision authority should be organised at a European level covering as many banks as possible. Only broad coverage will allow an effective banking union to be built in which the capacity to absorb shocks will also be moved to the European level. In other words, only broad European coverage will permit  the vicious circle between banks and sovereigns that characterises the current crisis so much to be broken. To come to quick and effective decisions on resolution more resolution authority would , also need to be moved to the European level. Such a solution would require clear rules, on the model of state aid rules, to avoid bank resolution leading to major distortions in the competitive environment of banking. The task set by Europe’s leaders is daunting. Europe will need to act fast and avoid getting trapped in minimalist solutions.


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