29 April 2015

ECB: The banking union and financial integration

Speech by Danièle Nouy, Chair of the Supervisory Board of the Single Supervisory Mechanism at the Joint conference of the European Commission and European Central Bank on “European Financial Integration and Stability”, 27 April 2015, Brussels.

An incomplete construction of the EMU

The rapid fragmentation of financial markets can be traced back to the fact that the framework for financial governance in Europe was not equipped to address the financial imbalances stemming from cross-border banking activity. Although there was a common monetary policy, responsibility for banking supervision, as well as resolution powers, remained at the national level. This “home bias” of national supervision created an environment which allowed jurisdictions to promote “national champions” and to support local banking models. In addition, it may have led them to take a less strict stance regarding the risk behaviour of banks. 

One of the main ways in which the integration of banking markets ought to be beneficial is through improvements in the allocation of capital. Competition from foreign banks is likely to increase the distance between the shareholders and management of a bank, and the special interest of stakeholders located where the bank operates. This should help to prevent lending to less efficient activities. However, because foreign banks had only a limited presence, these benefits did not materialise in the euro area. On the contrary, financial integration in interbank markets had destabilising effects, as it created distorted incentives for risk-taking, arising from lower financing costs. There was instead a consequent increase in the leveraged positions of domestic financial intermediaries, with increasing exposure, particularly to certain economic sectors, such as real estate. Risk became even more concentrated rather than diversified.

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How do we expect the banking union to have beneficial effects on financial integration?

The first stage of the banking union, the SSM, comprises a uniform supervisory framework for financial institutions in the euro area. It is an independent institution which has the right incentives and the necessary tools to act. This set-up should break the bank-sovereign nexus that I have described. Within the euro area there are no longer any borders to supervision, therefore, the promotion of national policies is no longer a factor: the SSM safeguards the stability of the European banking system as a whole. This will bring several positive effects.

First, a single approach to supervision will be applied, with a homogeneous set of rules and methodologies. There will no longer be any distinction between home and host supervisors for banks operating across borders. Instead, there will be a single supervisory model and cross-border banking groups will be able to report at the consolidated level.

Second, the possibility of “national bias” playing a part in supervision will be eliminated. Under the old supervisory system, situations may have occurred in which supervisory agencies treated national and foreign institutions differently. This allowed for behaviours such as the promotion of national champions and the ring-fencing of capital, which clearly distorted the functioning of free financial markets and created de facto barriers to the single European market.

These two positive effects should enable banks to achieve their optimal size and thus reap all the benefits that can be extracted from economies of scale. In addition, the single supervisory model of the SSM and the single European rulebook should also lower compliance costs, as regulatory compliance functions no longer need to be duplicated in different euro area countries.

Third, on the demand side, we should expect households and non-financial corporations to overcome any mistrust that they might have had regarding the soundness of foreign institutions. Previously, a branch of a foreign credit institution was supervised by the supervisory agency of the institution’s home country, and the nationals of the branch’s host country would probably not have been aware of the supervisory practices and deposit protection arrangements of the home country. Now, if the head of consolidation of the bank is located within the SSM, this will no longer be the case for the activities of its branches and subsidiaries located within the SSM. 

Finally, with the establishment of the SSM, the ECB also gained responsibilities for macro-prudential supervision. From now on, the ECB will coordinate with the relevant national authorities the implementation of these policies and it will have a wide variety of tools at its disposal to strengthen the resilience of the financial system and prevent the build-up of imbalances which could result in increased systemic risk. We will now be in a much better position to avoid episodes such as those we have witnessed in recent years.

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Conclusion: Building a Capital Markets Union

The establishment of a capital markets union (CMU) is key to completing the Single Market for all 28 Member States and a welcome step towards developing and integrating the EU financial markets. This, in turn, should support growth and competitiveness in the long run. 

If comprehensive and well-defined, CMU can contribute to enhancing financial integration in several ways. First, it can help to further reduce the bank-sovereign link and therefore improve the allocation of capital throughout the EU economy. Second, it can create deeper cross-border markets with increased risk-sharing across the EU, thereby enhancing capital markets’ ability to cushion shocks. Third, CMU can help to overcome market fragmentation along national lines, which would also facilitate cross-border supervision of banks. We would reach this goal via several channels: (i) more harmonised accounting standards and tax laws for banks would simplify supervisory tasks by improving comparability and reduce opportunities for arbitrage; (ii) harmonised national practices and rules (such as for credit registers, insolvency and tax law, accounting standards and SME scoring) would facilitate the development of cross-border bank lending business; and (iii) more generally, less fragmented markets would also be beneficial to banks for funding purposes. 

Overall, CMU can increase the resilience of the financial system by generating alternative sources of funding for the economy and reducing the dependence of the non-financial sector on bank funding, which is particularly detrimental in periods of bank deleveraging.

In this context, it is important to stress that as the European financial structure evolves over time, the supervisory framework should be assessed and improved to match changing needs, including those arising from the development of CMU.

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