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Banking Union and Beyond: Discussion papers for Brussels Think Tank Dialogue

The economic session of the BTTD 2014 will review the progress on banking union so far and ask what else is missing in the EMU architecture to complement and enhance the reforms on the financial side.

By: Date: January 28, 2014 Topic: European Macroeconomics & Governance

Three years have passed since the euro crisis broke out in 2010, revealing the shortcomings of the EMU architecture as it was foreseen in Maastricht. A number of reforms have been undertaken since 2010 in order to strengthen the Monetary Union, make it more adept to face the challenges of the financial integration that the euro itself created and ensure a stronger resilience to financial crises in the future. To this end, the EMU framework has been strengthened on the side of financial supervision, fiscal discipline and macroeconomic surveillance. Among the various reforms, the agreement to create a Banking Union is certainly a major one and represents probably the most important step towards integration to date. But is it enough? The economic session of the BTTD 2014 will review the progress on banking union so far and ask what else is missing in the EMU architecture to complement and enhance the reforms on the financial side.

2014 will be a year of important changes for the European financial system, and the shape of the European Banking Union is due to become clearer. The Banking Union, in the sense that the term is being used in Brussels, indicates a system of four major elements:

  1. Single rulebook for the European financial market;
  2. Single Supervisory Mechanism (SSM);
  3. Single Resolution Mechanism (SRM), ideally supported by a Single Resolution Fund (SRF) and a fiscal backstop;
  4. Harmonisation of the Deposit Guarantee Schemes (DGS).

The stated rationale behind a European Banking Union is to preserve the singleness of the European financial market, to ensure consistent high-quality supervision and to break the vicious circle between banks and sovereigns. Discussion has been on-going for a long while at the academic, as well as the political, level and agreement (or preliminary agreement) has been reached on these elements.

Borrowing conditions for sovereigns have improved markedly after the European Central Bank (ECB) introduced the new Outright Monetary transactions in September 2012, but the fragmentation of the European financial market induced by the crisis is far from being reversed. Starting in 2009 (and accelerating since 2010) Eurozone banks have been massively retrenching within domestic borders. This has led, especially in countries perceived to be weaker, to an impressive re-domestication of banks’ assets in general and of debt portfolios in particular. Doubts about the quality of banks’ balance sheets remain, still weighing on borrowing conditions for the private sector.

Credit volume has contracted by 6% in the Eurozone since early 2010, and the worsening of financing conditions seems unevenly distributed across the EMU, with borrowing costs showing diverging dynamics along the peripheral-core divide. Due to their strong reliance on the banking sector, small and medium businesses seem to pay a disproportionately high price in terms of lending conditions not only because of the economic slowdown, but also because of deleveraging undertaken by the banks.

The phase in of the SSM that will start in 2014 can help reduce uncertainty about the quality of banks’ assets and about the thoroughness of financial supervision, thus helping to address also the divergence in the private sector borrowing conditions. However, several questions remain open, which is the reason why the issue of banking union is due to remain topical in early 2014.

First, some of the central elements of the ECB’s balance sheet-assessment exercise have not yet been decided (or they have not yet been communicated). These include, in particular, the treatment of sovereign debt, the magnitude of the stress test, and the treatment of systemic risk. The choices that will be made on these issues will potentially significantly affect the results. Uncertainty should also be dispelled about the rules that will apply to bank recapitalisation, bank restructuring and bank resolution in 2014 and thereafter, including how remaining recapitalisation costs should be distributed between national taxpayers and taxpayers of other European countries.

Second, the recent deal on SRM leaves open the question of how far the present arrangements go towards achieving the stated aim of the banking union i.e. breaking the link between banks and sovereigns. The decision-making process envisioned in the proposed SRM Regulation is very complex and at least for the immediate future, no credible backstop is envisioned for resolution. The recent deal includes a commitment to establish a common backstop of 55bn by 2025 at the latest but during the transition the EU’s fund will be split into national compartments that will be merged over time. In the immediate future, the construction will not differ much from the status quo, meaning that the link between banks and their sovereigns would not be weakened and that different member states’ positions could still lead to potentially very large heterogeneity in the approach to financial sector problems

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