07 March 2014

Nicolas Véron: Tectonic shifts - Banking Union is a long-term process that will dramatically reshape Europe's financial system

Véron explores the origins of Europe's banking problem, tracing it back to the decade before the crisis, and the genesis of the shift towards Banking Union in 2011-12. He then gives an updated assessment of the prospects for success of the ECB's AQR and further steps towards Banking Union.

This opinion was published in Finance & Development, the International Monetary Fund's quarterly magazine.

Prospects for resolution in 2014

As of early 2014, Europe’s banking problem is not resolved—but this could change in the months ahead. The EU legislation to establish an integrated bank supervisory framework, now in force, foresees the November 2014 handover to the European Central Bank of supervisory authority over most of the euro area’s banking system. It mandates in the meantime a comprehensive assessment of these banks by the European Central Bank, a process started in 2013 that is widely referred to as Asset Quality Review. In addition to the balance sheet assessment, this process includes a supervisory risk assessment and EU-wide stress test coordinated by the European Banking Authority.

The Asset Quality Review was initially seen by many as a relatively minor technical requirement; it is mandated only in a subarticle of the legislation’s final section on transitional arrangements. But its practical effect is to front-load a politically challenging process of bank triage, recapitalisation, and restructuring. The experience of past banking crises suggests that this process is essential for successful crisis resolution. Its consequences may include the revelation of more past failures by national bank supervisors; shareholders, taxpayers, and creditors taking a hit; and an end to “pretend and extend” lending to dubious borrowers, which may in turn trigger extensive restructuring of nonfinancial companies. So the review has rapidly moved up the European policy agenda and is likely to generate headlines throughout 2014.

The review process is as ambitious and risky as it is unprecedented. The European Central Bank had little prior experience supervising banks, but has devoted considerable resources to this task. It is fully aware that its credibility is on the line, as a future supervisor and more generally as an authoritative institution. But while the assessment process is in the hands of the European Central Bank, its consequences will also involve governments that must restructure banks deemed weak by the review. Restructuring may be disruptive, financially and politically, for individual countries, especially since there will be no financial risk pooling at the European level, at least as long as market conditions do not deteriorate dramatically. At this early stage of the assessment process, it is too soon to say which banks and countries are most at risk.

This suggests that the interaction of governments, national authorities that have overseen banks until now, and the European Central Bank will become increasingly tense as the review gets closer to completion. National governments will be influenced by banking nationalism and by innumerable links that tie them to their respective banking systems. In July 2011, these factors resulted in the failure of the bank stress test process, which severely undermined the credibility of the European Banking Authority. But the balance of interests is different this time. All euro area countries have a stake in the credibility of the European Central Bank as the central pillar of the euro’s sustainability.

Uncertainty, and quite possibly market volatility, will mark the review until it is completed, probably in late 2014. The coordination of the bank restructuring process will be a key aspect, including the possibility of setting up a European joint asset management vehicle, or “bad bank,” even if financial risks remain allocated to individual Member States. All things considered, it appears more likely than not that the review will broadly fulfill policymakers’ objective of restoring confidence in the European banking sector and thus resolving Europe’s short-term banking problem.

Longer-term outlook

A successful review and subsequent restructuring of banks identified as too weak would probably start a gradual healing of Europe’s banking system. If so, bank funding conditions could return to normal in the course of 2015, allowing the European Central Bank to gradually withdraw its extraordinary intervention tools applied since 2008. The review may also lead eventually to a wave of bank mergers and acquisitions, many of them on a cross-border basis, which would reshape the European banking landscape.

The review would mark neither the full separation of banks’ and governments’ balance sheets nor the completion of Banking Union. These require broader steps, including further integration of EU frameworks for fiscal policy and political accountability, often referred to as fiscal and political union. Such union would pave the way for a genuinely integrated system to resolve bank crises and a pan-European deposit insurance system that would ultimately sever the financial link between banks and governments. The timing of such steps, if they occur at all, is impossible to forecast.

Nevertheless, the single banking supervisor could trigger a number of structural transformations over the next decade, depending on future European Central Bank policy decisions. Many banks’ governance models, which are currently shaped by national or subnational political and legal contexts, may be affected. Non-European banks may enter the European retail and commercial banking market. Europe’s financial system may become more diverse and less dependent, as it now is, on banking intermediation. The geography of wholesale market activity and financial centers in Europe may change. And governments, no longer able to fund themselves by harnessing domestic banks, may have to become more disciplined.

As this tentative list illustrates, Europe has just started a long journey of discovery. Banking Union amounts to a regime change for European finance. Even as prospects for the first step are reasonably encouraging, it will be a long time before the implications for Europe’s financial stability and economic prospects can be comprehensively assessed.

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