17 December 2020

Vox: Two proposals to resurrect the Banking Union: The Safe Portfolio Approach and SRB+

This column provides a politically and economically viable solution based on first, creating a model ‘Safe Portfolio’ and, through a reform of the regulatory treatment of sovereign exposures, incentivising banks to move towards it; and second, reforming the resolution framework to empower the Single Resolution Board while simultaneously setting up, within it, a European deposit insurance based on the emerging consensus around a ‘hybrid model’.

A few days ago, the Eurogroup agreed to a reform of the European Stability Mechanism (ESM) and to accelerate the establishment of the ESM as backstop to the Single Resolution Fund. This is excellent news for Europe, as these reforms are essential to ensure a credible crisis management framework, particularly given the enormous economic impact of the Covid-19 pandemic and the likelihood of a banking crises once the unprecedented support measures are withdrawn. 

But these measures are not sufficient. The Banking Union is incomplete – its second ‘pillar (resolution) does not really work, and the third ‘pillar’ (deposit insurance) does not exist. As a result, the banking market is more fragmented now than at the inception of the Banking Union. Mergers only seem to happen within member states, and home and host regulators continue to fight to ensure sufficient capital and liquidity in each national market in which a bank might operate. Without completion of the Banking Union, our Economic and Monetary Union will continue to be fragile and exposed to the return of the doom loop. What needs to be done? 

In a recent CEPR Policy Insight (Garicano 2020), I seek to provide a politically and economically viable answer. This path rests on two legs. The first is creating a model ‘Safe Portfolio’ and, through a reform of the regulatory treatment of sovereign exposures, incentivising banks to move towards it. The second is reforming the resolution framework to empower the Single Resolution Board while simultaneously setting up, within it, a European deposit insurance based on the emerging consensus around a ‘hybrid model’.

Both of these legs are economically necessary as they break both aspects of the doom loop – deposit insurance cuts contagion from banks to sovereigns, while the Safe Portfolio approach, by diversifying bank balance sheets, cuts the link from sovereigns to banks. Politically, both legs are complementary: Northern countries insist against any risk sharing through a common deposit insurance unless there is also risk reduction through the diversification of bank’s sovereign exposures; Southern countries and their treasuries do not want to give up their reliance on their own banks without having a true third pillar of the banking union in place.

A European Safe Portfolio

The usual proposals to induce a diversification of bank sovereign debt portfolios revolve around either credit risk-based requirements (eliminating the 0% risk weight) or quantitative limits on sovereign exposures, as proposed by the German Council of Economic Experts (2015). Such proposals are lacking both political and economically. Politically, because highly indebted member states will never accept an asymmetric treatment of their debt that may endanger their ability to fund themselves. Economically, ratings-based risk weights have been found to be unreliable due to the arbitrariness of the whole rating system, and hard concentration limits are even less effective as banks would be able to arbitrage within the caps to increase their risky (and profitable) exposures (Alogoskoufis and Langfield 2019).

In October of 2019, the German Finance Minister Olaf Scholz proposed that a reform of regulatory treatment of sovereign exposures by establishing a “Safe Portfolio” – a portfolio of sovereign bonds deemed safe – and incentivising banks to move toward it (Scholz 2019). However, he left this Safe Portfolio largely undefined; with my proposal, I try to build on this idea. I propose that we define the Safe Portfolio as a portfolio of sovereign bonds with shares matching the capital contribution key of the ECB – Germany constituting 26%, France constituting 20%, Italy 17%, and so on – and that we set capital (or ‘concentration’) requirements, based on how far the sovereign debt portfolio of a bank is from this Safe Portfolio.

To calculate ‘how far’ the portfolio is from the Safe Portfolio, I would suggest a distance metric (perhaps using the vector difference between the ECB’s capital key and the bank’s portfolio). Thus, banks would be subject to marginal risk weight add-ons that would increase along with this distance. As illustrated below, the marginal penalty could be graduated to start small and increase over a transition period (see Garicano 2020 for details). ....

Full paper: here

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