20 August 2012

Xavier Vives: Banking union and the financial architecture of the eurozone - A retrospective

20 years ago, Vives proposed the following architecture:

1. The ESCB (European System of Central Banks) should perform a Lender of Last Resort function if the stability of the European financial and payment system is to be preserved.
2. The Lender of Last Resort function of the ESCB needs to have associated supervisory powers, although, perhaps, the ESCB need not have them in the exclusive.
3. The concern for a potential misuse of the Lender of Last Resort facility by a ESCB with supervisory powers is legitimate but not overwhelming. Indeed:
4. A potentially optimal structure could be for the ECB to have authority in liquidity matters while another European agency has authority over solvency matters (and perhaps deposit insurance). In this arrangement both agencies would have supervisory powers but the ECB would have the primacy." (Vives 1992)

In the eurozone, the ECB has taken up in practice in the current crisis the Lender of Last Resort function of helping solvent but illiquid banks. A corollary of this function is that the ECB should have also supervisory powers but that those need not be exclusive. A possible design building on the received academic literature could be the following. The ECB should be responsible for the systemic stability of the financial system and macro-prudential regulation and supervision. It could also authorise financial institutions. A RA [Resolution Agency] with supervisory powers should be in charge of solvency matters, closure decisions, and also deposit insurance for individual institutions. This would correspond to a model close to the successful US FDIC except that the RA should be closely coordinated with the EU competition authority in charge of controlling state aid.

However, there are several further issues that need to be resolved. Should the ECB supervise all banks in the eurozone or only the systemic and cross-border ones? How should banks outside the eurozone be supervised? How to structure the financing and the ex ante burden sharing agreements backing up the RA? Who should regulate markets?

In the long term it would be better for the ECB and the FDIC to supervise all banks in the eurozone in order not to create two tiers of institutions. Recall that if many small banks correlate their strategy they may become a systemic problem. Banks outside the eurozone could be supervised by the current supra-regulator EBA with general remit to preserve and deepen the single financial market. To this the market-wide regulator in the EU could be added to build a European Financial Services Authority. In the eurozone, where there is no single treasury, the RA/DIF [Deposit Insurance Fund] should be financed with levies on banks, with a backstop agreed among the governments before a crisis strikes. Levies or insurance premia on banks should be calibrated to the perceived risk positions of institutions according to market indicators such as credit-default spreads. Flat premia would merely induce cross-subsidisation of risky banks by safe ones. Following the FDIC model, the agency should be bound by a prompt corrective-action procedure to avoid the regulatory forbearance that we have witnessed so many times in banking crises, from the savings and loan crisis in the US in the 1980s to Japan in the 1990s, with Spain as the latest example. The agency should limit taxpayers' exposure by wiping out shareholders and subordinated debt holders if needed in a restructuring procedure.

The banking union project is a long-term one and it cannot imply the ex post mutualisation of banks debts. Indeed, insurance cannot be arranged once a crisis is ongoing, because solvent countries and banks should not pay for insolvent ones except in so far this is needed to preserve systemic stability. A European DIF would address the next crisis, but not this one, while a European RA could start functioning with funds from the European Stability Mechanism (ESM).

Banking union is necessary but not sufficient for monetary union to survive. There is no European deposit insurance fund that could sustain a run on deposits in Italy if it was feared that this country would leave the eurozone. Indeed, to cope with sovereign risk a high degree of political and fiscal integration is needed.

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