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The banking union negotiations in the Eurozone have been stuck ever since, in the Ecofin Council of June 2016, the Italian government managed to assemble a blocking minority opposing any further discussions on proposals to reduce legacy risks in banks’ balance sheets. Completing the banking union should now again be given priority, because the current half-baked banking union – lacking a common system of (cross-border) deposit insurance (European Commission 2015) – leaves the Eurozone exposed to idiosyncratic financial shocks capable of endangering its survival.
The request that banks’ balance sheets be cleared of legacy risks, before moving to the full mutualisation of losses with the European deposit insurance scheme (EDIS), is legitimate and should be heeded. Legacy risks mainly arise from the large stocks of non-performing loans (NPLs) and banks’ exposures to their national sovereigns.
New policies to address the NPLs issue have been adopted by the Supervisory Board of the Single Supervisory Mechanism (SSM) and the Ecofin Council. Last March, the SSM issued its comprehensive Guidance to banks on non-performing loans (ECB 2017a); banks’ performance in managing NPLs will be part of the SSM Pillar Two supervisory evaluations which, if considered unsatisfactory, may lead to additional bank-specific prudential requirements, possibly including the request to raise capital. These measures are already leading to an acceleration in the disposal of NPLs.
An even more important legacy risk is banks’ heavy exposure to their sovereign. The EBA 2016 transparency exercise has shown that some three-quarters of total sovereign exposure is vis-à-vis the home sovereign; and bank holdings of their national sovereign typically are on average around 140% of Tier1 capital, with some countries hovering around 200% (e.g. Belgium, Germany, and Italy). This situation raises the possibility of a re-emergence of the doom loop between sovereign distress and banking crisis, in the event investors lose confidence in the sustainability of the sovereign debt of one Eurozone member state.
ESRB (2015) identified two main options to address the problem:
Integrated credit and asset markets within EMU would make it possible to hedge against country-specific sources of risk through capital markets. More importantly, EMU should be resilient – i.e. it should not unravel and become per se a source of instability – in the face of large financial and economic shocks (ECB 2017b).
However, without EDIS, market fragmentation is likely to persist. This seems to reflect to an important extent the uncertainty generated by political events calling into question the future of the monetary union. As has been established by solid academic research, following the seminal paper by De Grauwe (2011), this happens because of a special externality created by the combination of a common currency managed by an independent central bank, and fiscal and economic policies managed at the national level. When the latter diverge, doubts are likely to arise on the sustainability of the sovereign debts of some countries, since the liquidity for their orderly roll-over depends on the willingness of the ECB to intervene as lender of last resort for distressed sovereigns – an intervention that persistent divergence in economic fundamentals makes highly controversial within the ECB Governing Council and official policy circles.
The European Commission (2017) has now aired the idea that in an initial phase of EDIS, the system would only provide a liquidity line to cover any liquidity shortfall of national deposit guaranty schemes (DGSs). The rest would be covered by national DGSs, if needed by charging additional ex post contributions on the banks in that country. In addition, the transition to subsequent phases where national banking losses would be progressively mutualised, would be subject to a targeted asset quality review (AQR) to verify progress in the reduction of NPLs and sovereign exposures.
EDIS could move forward immediately by providing in its early phase that the ESM would offer a liquidity line to national DGSs that had exhausted their funds, with no sharing of losses. Meanwhile, risk reduction would accelerate through the stronger policies already established by the SSM for the reduction of NPLs and a fresh approach to the reduction of banks’ sovereign exposures, based on a modified version of the large exposure prudential policy.