Can the gap in the Europe’s internal market for banking services be bridged?

Completing banking union remains one of the European Union’s policy priorities, notwithstanding the huge economic impact of COVID-19. The rise in non-performing exposures (NPEs) as support provided by EU governments peters out in the coming months will be a major hit to bank balance sheets and could trigger renewed ring fencing, or measures to protect assets, by home and host countries.

Significant progress towards a more unified banking market has already been made. The single supervisory mechanism (SSM) was agreed in 2013, and a bank resolution framework that includes a resolution institution and fund, the Single Resolution Board (SRB) and the Single Resolution Fund (SRF), has been put in place.

However, these reforms were concentrated on the 19 EU countries that participate in the euro. The reforms thus contribute to a steadily converging banking market in the euro area, but this could create frictions with the banking markets of non-euro EU countries.

At the more granular level, sources of divergence between euro-area countries and those outside could include how and where banking groups can and should fund the loss-absorption capacity of subsidiaries, and who should decide on how far to go in separating the critical functions of banks. The banking union’s lack of a unitary decision-making structure covering both the ins and outs could exacerbate differences between the different parts of the EU’s banking market. Without a unified approach that covers also those member states outside the euro area, this will not be easily reversed.

Dealing with these challenges requires a well-designed and well-run system, but in Europe all is not well. Various factors inhibit the efficient functioning of supervision and resolution of financial institutions. The gap in the internal market for banking services between euro-area countries and those that have not yet adopted the euro could widen. Even though the non-euro-area volumes are only a fraction of the banking market in the euro area, re-introducing frictions to a smooth functioning of markets is ill advised given the economic benefits of well integrated markets especially in and for central and eastern European countries.

Home-host issues in general are at the core of the policy problems we continue to witness. Whilst still an issue within banking union, the real problems that require significant moves at the policy and political level are between ins and outs. Parent banks consider themselves to be at the mercy of arbitrary policy measures in the jurisdictions of their subsidiaries. National authorities of subsidiaries in turn fear that they might be left to pick up the mess once the parent bank has siphoned profits away from their country.

The question is how and indeed if mutual trust in the stability of framework conditions can be hardwired into the system of a fully functioning internal market for banking services in the EU. Indeed, lack of trust in (other people’s) national rules, and in the willingness of parents to pick up the costs of resolution of failing subsidiaries, are at the core of lack of progress in creating a well-functioning internal market for banking.

Ultimately, the decisive question is who pays the bill. This may depend on why a bill has to be paid: is it due to failings of the national policy framework, of management or governance problems of the banking group, or possibly due to exogenous factors.

In a unitary jurisdiction such costs, to the extent that they are not mitigated by bail-in procedures, are borne by the taxpayer. A common backstop, or a similar construction, that fulfils such functions is required in the EU in order to overcome home-host issues. This is not in sight, and would also require the European Commission and the supervisor to play a more ambitious role in judging whether national policy frameworks are not detrimental to the fiscal interests of a common backstop.

These are fairly well analysed issues between ins and outs. Less noted are divergences stemming from the issues covered by the Bank Recovery and Resolution Directive (BRRD, 2014/59/EU). This major legislative act was put in place in order to lead to convergence over time on the resolvability or winding down of credit institutions, and to deal with other features of the system (a Single Resolution Report summarises these issues).

Two issues risk making the banking market of the 27 even more fragmented in the foreseeable future by driving a further wedge between ins and outs, if not addressed carefully by European policymakers.

As of 2021, BRRD II (Directive (EU) 2019/879) will introduce options for resolution bodies for bail-in capital at the level of subsidiaries, and the SRB policies on ‘separability’ are about to be implemented.

Thus, the funding of loss-absorption capacity and the issue of who decides (and how) on the issue of separability of entities within a cross-border banking group should be approached with the aim of leading to greater market convergence in the EU instead of divergence.

In Europe there are two accepted models for handling cross-border bank resolution planning for international banking groups (codified in BRRD II): the single point of entry (SPE) and multiple point of entry (MPE), to be adopted by the respective resolution college.

One of the main distinctions is whether the holding company alone issues Minimum Requirement for own funds and Eligible Liabilities (MREL) type bonds (SPE: losses are passed up and capital is passed down), or bail-in capital needs to be raised in each separate jurisdiction (MPE: losses remain local, bailed-in investors become new owners of a separate national entity).

The financing of adequate loss absorption capacity in subsidiaries requires local MREL. However, markets in some countries that joined the EU in 2004 and after lack well-developed investor bases for locally issued subordinated debt. The greater the share of local funding in the smaller EU national markets the more easily an MPE approach can be made operational, as parent and wholesale financing from abroad decline in importance.

To make things even more complicated different national competent authorities (NCAs) reportedly favour different strategies: Poland is apparently more inclined to MPE, whilst Romania is usually mentioned as a proponent of SPE.

Whether SPE or MPE is better in any sense is neither here nor there: the point is that different requirements on such issues make cross-border banking disjointed and less efficient. Thus, it should be either up to the banking group or a European supervisor to determine which method a bank can or should apply. At present it can be presumed that the European Banking Authority (EBA) or the SRB would agree that it is up to the subsidiary (or its parent, as the case may be) to decide autonomously on its funding strategy, including the source of bail-in capital. Practice may differ, depending on the approach of the respective NCA.

The BRRD also requires banking groups to document the separability of parent and subsidiary in operational terms, a logical prerequisite if one wants to ensure containment of local or regional financial stress. Separation becomes easier with steadily developing local markets.

However, the apparently mundane issue of separability is in practice more problematic than one might think. Under BRRD and SRM legislation, banks must provide information on their separability, which was at the time mainly intended to cover ‘living wills’ (ie questions of internal organisation, continuity planning and the like).

There are quite obviously significant costs of being inseparable, but also costs of being required to be significantly separable. The more stringent the requirements imposed by NCAs are, the more the traditional model of banking groups as a genuine group is put into question. It seems logical that separability should be well documented and approved by the SRB and/or the supervisory college, taking due account of the role of the EBA. This implies that there need not be a de-facto far-reaching separation of business activities.

Thus, the issue of whether the subsidiary must be separable in operational terms, and demonstrably separable in funding terms, is core to problems in resolution planning for cross-border groups.

Without a coordinated and joint approach to these issues, the banking markets of euro outs, especially in central and eastern Europe, risk being less well integrated into the internal market for banking services, with all associated costs to growth and welfare.

Recommended citation:

Wieser, T. (2020) ‘Can the gap in the Europe’s internal market for banking services be bridged?’, Bruegel Blog, 7 December