The Single Market for banking services was first introduced in the early 1990s with a view to spurring greater competition in a sector characterised by extreme market segmentation along product and regional lines.
For a long time, financial integration was being heralded
unequivocally as a driver of prosperity. Not only was it considered a
key driver of growth, it was also supposed to distribute risk to those
best equipped to bear it. The Single Market for banking services was
first introduced in the early 1990s with a view to spurring greater
competition in a sector characterised by extreme market segmentation
along product and regional lines. The idea that banks could freely open
branches and provide services across the EU through a single passport
was expected to bring tangible benefits for banking customers, while the
implementation of the Basel standards was deemed to ensure that
adequate prudential safeguards were put in place. The introduction of
the euro further strengthened the process: the disappearance of foreign
exchange risk within the euro area and the establishment of a common
framework to access central bank liquidity represented a leap forward in
banking market integration, especially on the wholesale banking side.
Then,
the great financial crisis struck. The distribution of risk turned into
a channel of contagion. The search for yield, the overextension of
credit and the mispricing of risk had led to the creation of a bubble.
Once this bubble burst in the wake of the Lehman crisis, banks abruptly
reversed the previous trend. Cross-border loans and sources of liquidity
dried up in times of need, and the integrated banking sector served to
amplify the shock.
As
the safety net for banks had remained completely national, the policy
response resulted in banking markets segmenting once more along national
lines: cross-border banking groups were broken down and their crises
were managed under local regulations, ring-fencing measures were
introduced to prevent local establishments from importing risks from
other group entities and to ensure they remained viable on a standalone
basis, and banks supported by government funds were asked to refocus
their business on domestic households and corporates. The drop in
cross-border banking within the euro area was the main driver of the
fall in financial integration at the global level.
While the
excesses of the pre-crisis period required correction, the real,
longer-term question facing us is whether or not an integrated, euro
area banking sector would become less of a channel of contagion, and
instead become an effective mechanism to absorb the shocks that hit one
part of the Union.
From channel of contagion to shock absorber
The
US experience shows that an integrated banking sector can provide an
important element of stability. In the United States, about 20% of an
economic shock is smoothed via credit markets.
Several mechanisms are at work: banks with assets well diversified
across states are better able to withstand idiosyncratic shocks hitting
any one of those states, thus offsetting losses in one region with
profits earned in others. Furthermore, when banks in one state enter
into a crisis because of a local shock, their assets and liabilities can
be transferred to buyers from other states, thus minimising the impact
on local customers and avoiding a credit crunch that would exacerbate
the crisis.
Depending on its features, an integrated banking
market can be either a shock absorber or a channel of contagion. With
banking union, the aim was to prevent the latter and bring about the
former. The key ingredients for such a shift are common, effective and
fully unified supervision to prevent an excess build-up of risk and a
more integrated response to shocks through the use of a common
resolution framework and a more unified safety net. As we all know, we
have not yet reached the finishing line as far as the institutional
set-up for banking union is concerned. The third pillar thereof, the
European deposit insurance scheme, which should complement the Single
Supervisory Mechanism and the Single Resolution Mechanism, is not yet in
place. In its absence, the legislative framework remains peppered with
options and national discretions that prevent cross-border groups from
operating seamlessly at the euro area level and from treating the
banking union as their domestic market.
The coronavirus (COVID-19)
pandemic has proved to be a litmus test for the progress achieved in
the area of banking union, and the first results are promising.
While
one ECB composite indicator of financial integration pointed towards a
significant increase in financial fragmentation after the first wave of
the pandemic, its level remained above those witnessed during the great
financial crisis and ensuing sovereign debt crisis.
What is
remarkable, however, is that the indicator for banking market
integration has remained almost completely stable in stark contrast to
the steep decline seen during the great financial and sovereign debt
crises. This indicator captures the dispersion in comparable bank
lending rates across the euro area: the lower the dispersion, the higher
the level of integration.
The financial reforms implemented
after the great financial crisis have created a stronger and more
unified rulebook, leaving little room for competition of laxity. The
swift and fully unified supervisory response to the shock caused by the
pandemic is an important change compared with the past. The fact that
such a response was fully coordinated and consistent with the powerful
stimulus provided by the monetary and fiscal measures taken, also at
European level, is another sign that a fundamental paradigm shift has
occurred.
These findings point to the possibility that banking
union is indeed transforming the European banking market from a shock
amplifier into a shock absorber. But we are not quite there yet. There
is still a risk that in the event of a major systemic shock, European
banking groups may be prevented from functioning as shock absorbers
since their capital and liquidity remain largely segmented in local
pools in individual Member States.
As long as deposit insurance
schemes remain at national level only, Member States will have an
incentive to ring-fence their banking sectors. Completing the banking
union by establishing EDIS would be the most direct route to foster
integration, as any argument to justify the remaining regulatory
provisions in European and national legislation that trap capital and
liquidity within national borders would fade away
A fully-fledged
European deposit insurance scheme must continue to be our goal. But it
is also clear that it will take some time to materialise. Until then, we
as supervisors can take steps to try and counter ring-fencing as much
as possible.
The importance of cross-border banking groups
Currently,
liquidity requirements applied at the individual bank level may prevent
parent companies from efficiently managing their liquidity resources
within the group, even within the banking union. To ensure compliance
with the liquidity coverage ratio at the individual level, around €200
billion of high-quality liquid assets sitting with the cross-border
subsidiaries of significant credit institutions are not transferable.
This clearly makes centralised liquidity management less effective;
liquidity is not allowed to flow freely. Not only can this can
exacerbate a crisis, as funds may not be able to go where they are
needed, but it hampers an efficient allocation of resources overall.
But
we have to acknowledge that in the absence of a fully integrated
deposit guarantee scheme at the European level, there need to be
safeguards that prevent parent companies from behaving like free riders
and opting to enjoy the benefits of resources generated in local markets
in good times but failing to protect local franchises in times of
stress. How can we combine both a broader pooling of liquid resources
and, ideally, of capital, with safeguards for national stakeholders if
and when banks start to see signs of a deterioration in their financial
positions?
Linking group financial support agreements to recovery plans
Banking
union has eliminated the distinction between a parent company’s home
supervisory authority and its subsidiaries’ host supervisory
authorities. We now have European supervisory and resolution authorities
that take a truly integrated, area-wide approach. For example, let’s
look at how prudential requirements are set for entire banking groups:
if a local risk is not diversified away or netted out in consolidation,
it needs to be captured in group requirements. This might help to limit
the risk at the national level and reduce the need for ring-fencing.
We
can deal with cross-border banks that encounter difficulties in a
similar fashion. For these banks, group recovery and resolution plans
should play an essential role. As intended by international
standard-setters and European legislators, advance planning by banks
under the scrutiny and guidance of their supervisory and resolution
authorities should ensure that a cooperative approach prevails when a
situation starts to deteriorate or develops into an outright crisis. If
we want to strengthen confidence in crisis management at the European
level, the best way forward is to strengthen the role of group recovery
and resolution plans, as well as their practical implementation. The
focus should be on recovery plans, because the options outlined in these
plans can potentially be activated at an early stage, and can therefore
offer a clear opportunity to act before a crisis actually occurs.
When
it comes to the coverage and credibility of banks’ recovery plans, ECB
Banking Supervision has already made considerable progress, notably by
conducting an annual review and ensuring there is a follow-up
supervisory dialogue. We will continue to strengthen the usability of
these plans. One additional step would be to offer banking groups the
option of having subsidiaries and parent companies formally agree to
provide each other with liquidity support, and to link this support to
their group recovery plans. This would not only help to explicitly map
out how group entities could support each other when difficulties arise,
taking into account local needs and restrictions, but it would also
enable the setting of appropriate triggers for providing contractually
agreed support at an early stage. This would also ensure that
supervisors would be involved in the process, since recovery plans are
assessed by the relevant competent authority. For significant euro area
banking groups, this would be the ECB.
The provision of financial
support by the parent entity would therefore be linked to internal
recovery indicators at the level of the subsidiary. It would be up to
the banking group – in close cooperation with supervisory authorities –
to identify the most appropriate liquidity indicators for group support
to be activated. These indicators would need to be tailored to the
characteristics of each group and be consistent with the group’s
internal liquidity management policy.
This would also make it possible for group support to be activated
early enough for it to be effective. Safeguards could be established and
included in recovery plans to also address the concern that
subsidiaries could be drained of liquidity in the event of their parent
company experiencing difficulties in funding markets. For example, a
separate vehicle to manage all pooled liquid resources could be
established under the parent company’s responsibility, with the precise
rules of engagement outlined in the event of difficulties experienced at
any level of the group.
But creating a stronger link between
group support and recovery plans would not necessarily mean that the
provision of support would be triggered automatically. The bank’s
management body could still refrain from taking an action foreseen in
its recovery plan if it did not find said action appropriate in the
particular circumstances. Once recovery indicators were breached,
however, the management body would have to assess the overall situation
and decide whether to activate a recovery plan option or refrain from
taking action. At the same time, the supervisor would be made aware of
the breach of indicators and the management body’s decision about
whether or not to activate the group financial support agreement, and
could be granted early intervention powers to take action on the basis
of the group financial support agreement.
This stronger link with
the group recovery plan could provide additional reassurance regarding
application of the group financial support agreement, whether at the
parent or subsidiary level. And confidence in its application could be
strengthened further if EU legislation were to empower the supervisor to
enforce the agreement included in the group’s recovery plan.
This
solution would be more agile and effective than the group financial
support agreements currently envisaged in the Bank Recovery and
Resolution Directive. Safeguards would be triggered at an earlier stage
and would require less stringent conditions, due to the power of
enforcement that could be assigned to the supervisor.
Introducing adequate incentives and safeguards to enter into group financial support agreements
For
this proposal to work, we need to give banks adequate incentives to
enter into group financial support agreements. This could be achieved,
for example, by linking the granting of cross-border liquidity waivers
to the inclusion of adequate intragroup financial support agreements in
the recovery plans. In addition, the decision to grant a cross-border
liquidity waiver could underpin the enforceability of these intragroup
agreements. For example, a clear link could be established between the
effectiveness of financial support agreements and the granting of the
waiver itself. A link of this kind, and the possibility to reassess it,
could provide significant incentives for banks to comply with financial
support agreements.
Obtaining an independent legal opinion on the
enforceability of the group financial support agreement would help to
ensure adequate safeguards for a receiving group. This could also be
reinforced by encouraging certain group parent entities to issue public
statements about their commitment to provide group support in the event
of a crisis. In future, the enforceability of group financial support
agreements outlined in banking groups’ recovery plans could be enhanced
by introducing statutory safeguards in the European legal framework.
This
move towards greater cross-border integration would ideally be combined
with a broader harmonisation of the European crisis management
framework. In particular, the mechanisms suggested here do not aim for
or require any substantial change in national laws relating to
insolvency, corporate or contract law, as they build only on what is a
generally recognised principle in the European legal system: that a
parent company may have a legitimate interest in providing support to a
subsidiary to facilitate its operations and possibly benefit from the
recognition of that support by the supervisor. Similarly, subsidiaries,
as separate legal entities, have a legitimate interest in protecting
their creditors and ensuring the timely payment of their obligations in
times of stress, and should have their claims on the common pool of
liquid assets safeguarded within an overall, commonly agreed group
policy.
A pragmatic approach to the integration of the operations
of cross-border groups within the banking union could also remove
existing – or perceived – obstacles to consolidation across Member
States. Moreover the possibility now offered by the Capital Requirements
Directive (CRD5) to treat the banking union as a single geographical
area in the G-SII buffer methodology removed an important disincentive
to cross-border consolidation: while in the past the increase in
international business could have led to higher buffer requirements, a
cross-border merger within the banking union would now have exactly the
same impact as a domestic one.
Conclusion
Let me conclude.
Through
banking union, we have made great strides towards transforming the
European banking sector from a shock amplifier into a shock absorber.
Unlike in previous crises, lending rates have not diverged substantially
across the euro area since the outbreak of the pandemic. But for the
banking union to be a truly domestic market, we need a European deposit
insurance scheme. While we are working towards this, we can take steps
in our role as supervisor to improve the cross-border integration of
banking groups to not only bolster their ability to deploy their
resources in a flexible and efficient manner in response to shocks, but
also to improve the overall allocation of resources, and in this way
contribute to an efficient financing of the European economy.
SSM
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