“Financial Risk and Crisis Management after
the Global Financial Crisis” Series No.5 (2/2016)

Financial Crisis Management
andthe Development of the Banking Union
in the EU 1

Yuri Sasaki i

Professor, Faculty of Economics, Meiji Gakuin University

1 This document is an English translation of the original Japanese, whichappears in the Feb. 2016 edition of The Japan Economic Research InstituteMonthly Report, published by The Japan Economic Research Institute.

1．Introduction
Since World War II, Europe has pursued economic integration in
many different forms. That pursuit has led to unification in the formof currency market arrangements, market integration, and theintroduction of a common currency. However, the problems caused byintegration, particularly those arising from the introduction of acommon currency, have come to the fore since the financial crisisand the Eurozone crisis. To resolve these problems, Europe
abandoned home country-based financial supervision regulations,which often led to disagreement, and established a banking unionthat unified these regulations within the euro area.
This study seeks to explain this banking union by examining thedevelopments that led to the banking union’s creation, including theorigin of the EU, the financial crisis, and its after-effects. We also
clarify the reasons for the delay in unifying financial regulations
and provide observations on the costs of unification.
Section 2 opens with a synopsis on how the unification of the EU’s
markets and currencies has progressed and describes the unificationof financial regulations. Section 3 describes the development andeffects of the 2008 global financial crisis and the subsequentEurozone crisis. Section 4 discusses the banking union in detail, andSection 5 concludes with observations on the costs of economic
integration.

2．Economic Integration and Financial Crisis Managementin the EU
2.1 A Modern History of Integration in Europe 2
In this section, before we describe Europe’s banking union in its
final unified regulatory form, let us first take a quick look at thepath that economic integration has taken in post-World War II
Europe.
The European Community originated with the establishment of
the European Coal and Steel Community (ECSC) in 1952. The ECSC
was proposed by France as a way for France and Germany to stop2 This article references EU MAG (2013), Chapter 1 of Kawamura (2015), andthe European Commission website.

warring with each other. Therefore, it was determined that going
forward, France and Germany would jointly administer the coal andsteel resources that had been deeply intertwined with their war
efforts. The beginnings of economic integration in the EU may thus
be said to originate from the desire to prevent war within Europe
and allow Europe to function as an economic group. When the ECSC
was established in 1952, Belgium, Italy, Luxembourg, and theNetherlands joined in addition to France and Germany. Those six
nations became the European Community (EC) in 1967. Initially,
there was an attempt to include the United Kingdom, but thenegotiations broke down and the community was establishedwithout the UK. Afterward, the UK, Ireland, and Denmark joined in
1973; Greece joined in 1981, and Spain and Portugal joined in 1986.
Within that time frame, exchange rate and currency integration
gradually progressed. Up until World War I, the British pound was
the key currency, and Great Britain was the global economic power.
In the inter-war period, the two great superpowers, the U.S. andEurope, divided the world between themselves. After World War II,
the U.S. became the global economic power and the U.S. dollar
became the key international currency. To counter the U.S. economic
hegemony and build up the European economy so as to regain theeconomic upper hand, an increasing number of people believed thatinstead of remaining separated countries, it would be necessary toseek an integration of all of Europe’s economies. The first proposal
for a common currency was made by the European Commission in
1962; however, no specific proposal for an exchange rate
arrangement was made until the Bretton Woods system collapsed.
When U.S. President Richard Nixon took the U.S. dollar off thegold standard in 1971, major nations shifted to a floating currency
regime one after the other. During this time, the European nations
vowed in 1972 to keep their exchange rates floating within 2.25% ofeach other. This resulted in an exchange rate system in which
exchange rates among European currencies could only fluctuate
within a band of 2.25% while European currencies’ exchange rates
vis-à-vis non-European currencies could float freely. This system
was called the “snake in the tunnel” after the shape it made whenplotted on a graph. However, as participating nations with drew,
rejoined, withdrew again, and so on and as the central rate wasrevised repeatedly, the system eventually became nothing but aformality.
After that, however, momentum resumed toward the adoption of acommon currency for Europe. This led to the establishment of theEuropean Monetary System (EMS) in 1979. The EMS was notablefor creating the European Currency Unit (ECU, pronounced “ekyu”),
predecessor to the present-day euro, and establishing the Exchange
Rate Mechanism (ERM). Because the ECU was not a real currency
but instead a unit of account, member-nation currency weightings
were used to determine exchange rates vis-a-vis the ECU’s value. In
the ERM, a ±2.25% band (±6% for some currencies) was set up
around a central rate. However, the British poun d did notparticipate in this system until 1990.
Europe subsequently experienced a surge of integration in various
forms under the banner of the “1992 Single Market” initiative. The
European Council started discussing an Economic and Monetary
Union (EMU, which would include the adoption of a common
currency) in 1988. The Delors Report of 1989 adopted plans forliberalizing capital movements, coordinating monetary policy, andintroducing a common currency. The Maastricht Treaty of 1991
specifically provided for the establishment of the EMU. However, theERM crisis (also called the pound crisis) struck in 1992, just as
Europe was poised to actively embark on this path of market
integration and introduction of a single currency. Seeing Denmark’s
failure to ratify the Maastricht Treaty as an opportunity, hedge
funds exploited the requirement that ERM-participating nations
continue intervening when their currencies exceeded the permitted
bands of fluctuation, and they launched a series of sell -off attacks on
various currencies. Although the currency authorities under attack
continued intervening to prop up their own nations’ currencies, theeffect of these interventions was limited. Therefore, the UK and
Italy had no choice but to withdraw from the ERM. A number ofother countries also revalued their currencies vis-à-vis the central
rate.
However, market integration progressed, and the European
Monetary Institute (EMI) was established in 1994, which set up theframework for today’s European Central Bank (ECB). The e conomic
convergence criteria were also clarified and the common currency,
the euro, was implemented by 1999. That being said, many weredoubtful at the time about whether a common currency would, infact, make its debut. Defying these doubts, a common curr ency wasrealized with the introduction of the euro in 1999.
2.2
Unification of Financial Regulations in Europe
As discussed in Section 2.1, Europe’s economic integration was
intended to prevent war within Europe and allow Europe to act as a
unified region in terms of market, currency, and exchange rate
integration. However, the regulations were unified only as and whennecessary and not proactively. Serious regulatory unification would
not happen until the global financial crisis and Eurozone debt cr isis.
To understand the movement toward unifying financial
regulations, let us briefly review the original setup of European
financial regulations, primarily focusing on France and Germany.
Germany has traditionally focused on indirect finance, where thebanks have played a crucial role. Germany’s post-war banking
supervision took shape with the Banking Act of 1961. Under this law,
the Federal Financial Supervisory Authority was responsible forregulating the banks’ capital, large loans, and liquidity, and if abank was not in compliance with the regulations, it could be barredor limited from providing credit or barred from making investments.
Interest rates were liberalized in 1967, bringing on a further
expansion in regulations. Because this liberalizatio n occurred
relatively early, the relevant regulations tended to be strict. In
France, the system had been centralized for some time, with theprimary doctrine being one of state control. However, financial
reforms progressed as France entered the 1980s, an d monetary
policy shifted from one of regulating credit to one of manipulatinginterest rates. In addition, foreign exchange regulations were
relaxed. Financial deregulation and the integration of the EC caused
France’s state-control doctrine to wither away.
According to Fujita (2015), European nations diverge widely intheir attitudes toward regulation when it comes to financial
legislation. The legal codes can be largely divided into civil law andcommon law. Civil law, which has its roots in Roman law, d eveloped
mainly on the European continent. It is characterized by anemphasis on statutory law, and such law is shaped primarily byuniversity professors and other academics. Examples of nations thatbased their legal codes on civil law include Germany, France, Italy,
and Japan. Common law developed mainly in England and spreadthroughout England’s colonies. Common law emphasizes precedent
as set by court judges and senior attorneys. Great Britain, theUnited States, Canada, and others based their legal sys tems oncommon law. We may then say that these different legal systems
also influence regulations and even the development of finance.
In nations with civil law systems, bureaucrats usually consult
academics when proposing new laws, but it is difficult to flexibly
respond to the financial industry through legislation when thatindustry is always discovering and using new loopholes on a daily
basis. Common law is considered to be more flexible and appropriate
for free competition. The trade-off for this freedom is more stringent
sanctions against financial crimes and more emphasis on
shareholder protection. 3
Differences between civil law and common law also extend to
regulatory discussions; that is, whether regulations should be
principle-based or rule-based. Japan’s Financial System Council
held this discussion shortly before the bankruptcy of Lehman
Brothers. 4 As financial technology developed, more loopholes would
be found, no matter how many rule-based regulations were put inplace to deal with the new technology, and as these new technologies
needed to be dealt with, regulations became increasingly complex
and bloated. At that point, some consideration had been given to atleast a partial introduction of regulations that would lay out clear
principles to enable a flexible response. The UK regulatory system
was held up as an example in discussions at the tim e. In other words,
rule-based regulations are more similar to regulations based on civil
law, whereas principle-based regulations are more similar toregulations based on common law. 5
In Europe, regulations in the UK and France/Germany wereoriginally based on different concepts. Therefore, Europe adopted ahome-country regulatory system that would supervise the financial
industry in a way that would consider the origins of each nation’s
3 The first chapter of Fujita (2015) provides an in-depth discussion aboutcommon law and civil law.
4 This is brought up in the Financial Services Agency (2007) as discussions on“better regulation.”
5 As for the debate in Japan after this point, the financial crisis deepened in2008 with the Lehman bankruptcy, and there were few developments becauseinternational implementation of the Basel Accords began many countries
started to strengthen their rule-based regulations.

regulations and the circumstances of its financial institutions,rather than forcing divergent regulations.
Specifically, the 1989 Second Banking Directive of the EU
approved the principle of universal banking based on a single
passport system, whereby approval gained in any one country would
then apply in the other member countries, and the principle bywhich the home country that granted the said approval would be
responsible for monitoring the institution receiving that approval.
The Basel Accords were later introduced, which provided for global
regulation of banks’ capital adequacy ratios. The EU held
discussions about how best to implement these in the Eurozone, andthe Basel Accords have been phased into the Eurozone as capitalrequirement regulations.

3．The Financial Crisis and Euro Crisis and Their Effects
3.1
The Global Financial Crisis and Euro Crisis
As markets and currencies were consolidating in Europe, so were
the banks, which continued to merge. Major mergers include Dexia’s
1999 merger with the Banque Internationale à Luxembourg,
Bayerische Hypo- und Vereinsbank’s 2000 merger with Bank Austria
Creditanstalt, HSBC’s 2000 acquisition of Credit Commercial deFrance, and Barclays Bank’s 2003 acquisition of Banco Zaragozano.
At the same time, cross-border banking transactions were growing
as well. Blank and Buch (2007) used data from ten nations tocompare transaction volumes before and after the euro’s
introduction. They found that the euro’s introduction led to greater
cross-border financial integration. Regardless, the home country
system prevented any progress toward regulatory integration.
Despite more intertwined cross-border relationships, the homecountry system permeated all financial regulations, including
regulatory supervision as well as all rules concerning bankruptcy
proceedings. This constituted a downside to the system when chaos
reigned over the response to the euro crisis.

Figure 1. Nominal Economic Growth Rate in the Euro Area (%)

1996Q1
1997Q1
1998Q1
1999Q1
2000Q1
2001Q1
2002Q1
2003Q1
2004Q1
2005Q1
2006Q1
2007Q1
2008Q1
2009Q1
2010Q1
2011Q1
2012Q1
2013Q1
2014Q1
2015Q1Euro Crisis

Financial Crisis

6
4
2
0
-2
-4
-6

Source: Prepared by the author based on European Central Bank data.
Figure 2. Unemployment Rates in the Euro Area (%)
14
12
10

2
0

1998Apr1998May
1999Jan
2000Apr
2000May
2001Jan
2002Apr
2002May
2003Jan
2004Apr
2004May
2005Jan
2006Apr2006May
2007Jan
2008Apr2008May
2009Jan
2010Apr2010May
2011Jan
2012Apr2012May
2013Jan
2014Apr2014May
2015Jul

4

Financial Crisis

6Euro Crisis

8

Source: Prepared by the author based on European Central Bank data.

The financial crisis that broke out in 2008 imposed grave effects
not only on banks in the U.S. but also on banks in Europe. One
reason for this is that Europe’s universal banks had developed
enormous securities businesses. In the aftermath of the crisis, both
U.S. and European financial institutions were bailed out, and fiscal
policies were quickly eased. In Europe, however, a sovereign crisis
then emerged, known as the Eurozone crisis. When a new
government came into power in Greece in 2009, it was revealed thatthe old government had been manipulating the country’s financial
metrics. This information was widely reported in 2010, triggering
the Greek debt crisis. This crisis spread to other nations insituations similar to Greece. Although the background varied in eachcase, sovereign debt crises occurred in Ireland in the fall of 2010, in
Portugal in 2011, and in Cyprus in 2013, producing a spike in long term interest rates and throwing these nations’ fiscal regimes into
turmoil. The countries were subsequently bailed out, primarily bynations in the EU. Spain also received support in 2013.
The 2008 financial crisis and the ensuing Eurozone crisis inflicteddamage on every European nation. Looking at movements innominal GDP in the Eurozone as shown in Figure 1, we see that
GDP sank following the Lehman bankruptcy and fell again around2012 as a result of the Eurozone crisis. Looking at Figure 2, we seethat unemployment also jumped twice, once because of the financial
crisis and once because of the Eurozone crisis.
3.2
Effects of the Crises
The onset of the financial crisis boosted the amount of nonperforming loan held by financial institutions. Figure 3 shows
movement of non-performing loan over time. We see that Greece,
Ireland, and Italy were holding particularly large amounts of nonperforming loan. Spain also had a considerable amount of nonperforming loan. As of December 2015, the total amount of nonperforming loan in Europe was still approximately one trillion euros,
and the European Banking Authority (EBA) has indicated thatbanks’ earnings are under pressure.
The EBA also conducts stress tests and asset reviews tocomprehensively determine bank health. The EBA’s stress test
results published in 2014 showed that 25 (out of 123) banks had
capital shortages and that in the adverse scenario, core capitalratios were potentially 4%, below the 8% hurdle rate specified byregulators. What became clear from the final results was that theamount of fund raising that the Italian banks needed had ballooned.
This spurred the unification of regulations, expedited the resolutionof bankruptcies, and stimulated the development of plans to preventthe next crisis.

Figure 3. Non-Performing Loan as a Percentage of Loans

Source: Prepared by the author based on World Bank data.

4．Development of the Banking Union
After the financial crisis, Europe overhauled its system offinancial supervision (see Fig. 4). However, because microprudential
supervision was only concerned with cash flow for dealing withcrises, these changes were largely characterized by the introductionof new macroprudential supervision, so no drastic reforms were put
into place.
As the effects of the Eurozone crisis, which started with the Greek
crisis, propagated and spread throughout Europe, the sovereign debt
crisis worsened so much that it became critical to separate thefinancial crisis from the sovereign debt crisis. During the 2013
Cyprus debt crisis, observers also began to see the limits of adopting
a home country supervision system for those countries that wereusing the euro as a common currency. This led to the fi rst real steps
toward a banking union framework.
Figure 4. Financial Supervision System in Europe, Post-Financial Crisis

4.1
Background of the Banking Union Framework
A problem that arose after the financial crisis (and particularly
after the Eurozone crisis) was the phenomenon whereby a banking
crisis would cause the government bond prices to collapse, which
would then lead to a currency crisis for the euro, in turn ha rming
the balance sheets of banks in the Eurozone (which held a lot of
euro-denominated debt), which would then cause further
depreciation of the value of euro-denominated debt issued by othercountries. Another problem was a vicious circle of financial an d
fiscal crises. As shown in Figure 5, in the event of a financial crisis,
the government will use public funds to rescue problem banks, thus
worsening the nation’s fiscal stability and leading to a vicious circle
in which government bond prices collapse and long-term interest
rates spike (i.e., a sovereign debt crisis), which further damages

banks and exacerbates the crisis. Not only do publicly funded bankbailouts aggravate the crisis, but the taxpayers providing thesefunds consider this an unwelcome proposition, thereby creating amajor issue.
Figure 5. Post-Financial Crisis Vicious Circle

CrisisworsensBankbalancesheetsdeteriorate

Long-terminterest
rates go up /refinancing
costs
increaseBanksrequirepublicbailout

Countries'
fiscalsituations
deteriorate

Source: Prepared by the author based on charts from the European Commission website.

The banking union framework originally proposed in May 2012 by
the then-European Commission President, José Manuel Barroso,
clearly specified that this would break the vicious circle between
banks and sovereign debt. This framework also aims to prevent
potential crises, to rapidly respond to problems as they arise, and toprotect not only depositors but also taxpayers in an attempt tomaintain the health and stability of Eurozone banks.
The framework for the banking union was approved at the EUsummit in June 2012, and the unification of banking regulations andsupervision plus a rulebook on handling bank failures were proposedby the Economic and Financial Affairs Council (ECOFIN) in
September 2012. It was thereby determined that the ECB wouldsupervise all Eurozone banks. This was because of the dire need tounify a supervisory authority over banks so that the European
Stability Mechanism (ESM) would be able to inject funds directly.

4.2
The Banking Union Mechanism
Figure 6 is a broad representation of the banking union
framework. 6 The first aspect is the Single Supervisory Mechanism(SSM), which ECOFIN agreed to in December 2012. This mechanism
concentrates all bank supervisory authorities in the euro area in theEuropean Central Bank (ECB). The SSM’s supervision encompasses
all EU member-nation banks. Although banks from countries outside
the Eurozone will be supervised directly by authorities in theirrespective jurisdictions, they can also fall under the SSM’s
supervision if they choose. Joining the SSM thus allows banks toreceive bailout funds from the ESM, which do not have a time limit
like those from the ESFS. The SSM began operations in November
2014.
Next is the Single Resolution Mechanism (SRM), a unified
mechanism to resolve bank failures established in the EU in
January 2015. It is led by the Single Resolution Board (SRB) andadministers a Single Resolution Fund (SRF). The SRB began partial
operations in January 2015 and is fully functional as of January
2016. It not only deals with bankruptcy resolution but also preventsbank failures through early intervention.
Figure 6. The Banking Union Mechanism

6 Sasaki (2013) already described this in some detail, so this study will only

describe the concept briefly.

The European Deposit Insurance Scheme was announced in
November 2015 and will insure deposits of up to €100,000 until 2024.
Because this deposit insurance was one of the last measures to be
implemented within the banking union framework, we can now
consider the structure of the banking union to be more or lesscomplete. There are two ways to handle a financial crisis. One is th e
traditional bailout, in which public monies are injected into anailing financial institution, making the bailout a taxpayers’ burden.
The other is the bail-in, in which depositors, creditors, andshareholders share the losses by taking a haircut on the value of
their deposits, forgiving debt, making concessions on repayment,
and so on. Japan, the U.S., and Europe have followed the traditional
way of thinking that because financial institutions have a public
purpose, they exert a broad influence over the economy as a whole
and, therefore, tax proceeds should be used to rescue troubled
institutions. However, criticism from taxpayers often makes it
difficult to inject funds quickly. Further, the bail-in method wasintroduced at the time of crisis in Cyprus, when large depositors had
to provide funding because it was not possible to increase the public
deficit. This bail-in concept has been fairly well-received in Europe.
Although it has so far been difficult to reach an agreement on
deposit insurance, it seems the spread of this kind of bail-in concept
has led to smoother proceedings.

5．Conclusion
Before the global financial crisis and the Eurozone crisis,
financial regulations in the Eurozone were primarily based on theprinciple of home-country supervision. For that reason, although
there were some unified international regulations, such as the Basel
Accords, each nation would respond separately and carry out its own
regulatory supervision vis-à-vis such regulations as the Basel
Accords, even if these regulations applied to a number of countries.
This is because each nation’s financial sector and financial
regulations differ, in addition to other issues like country -specificpolitical problems. However, the breakout of the crisis meant thatthe use of a single currency, the euro, forced governments to provide
public funds, and as sovereign risk spread, the need for a unified
regulatory regime grew. This accelerated efforts to establish abanking union.
The difference in the areas covered by the Eurozone and E U
complicated matters regarding the scope of the unification. Other
obstacles cropped up as well, including the difficulty for somenations to maintain a uniform level of supervision, to obtain fundingfor deposit insurance, and so on. When the euro was introduced as
the common currency, or when the idea of an optimum currency area
was being considered, not much thought seems to have been given to
the costs that might be incurred as a result of unifying such
regulations or that might be incurred by not unif ying such
regulations. However, it is now clear that the costs of not unifying
regulations are significant; therefore, the regulations should be
unified. Going forward, further thought should be given to the issueof supervisory regulations as well as the pluses and minuses ofmarket and currency integration.
Buch and DeLong (2004) analyzed cross-border bank mergers.
According to them, although the number of bank mergers is
relatively small compared with mergers in other industries, this isdue to the difficulty in obtaining information and the differences inregulations. Therefore, as the banking union advances and thecapital markets become more integrated, it is likely to facilitate
more bank mergers in the EU and enable more restructuring of thebanking sector. In a broader sense, a pairing of currency unification
with regulatory unification could conceivably promote more cross border activities. We should consider these points in future debatesover optimum currency areas and/or regional currencies.

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i [Profile: Yuri Sasaki]

Professor, Faculty of Economics, Meiji Gakuin University (Financial Theory,
International Financial Theory)
Born in Tokyo. Received her Ph.D. in Commerce from the Faculty ofCommerce and Management at Hitotsubashi University. Assistant at
Hitotsubashi University, Lecturer and Associate Professor at Takachiho
University, and Associate Professor in the Faculty of Economics at Me iji
Gakuin University. Has held her current position since April 2007. Visiting
scholar at the University of Washington in 2006-2007 and 2015-2016.
(Major Works)“Yuro ni okeru kinyu kisei to yuro kiki no eikyo” [Financial Regulations in
Europe and Effects of the Euro Crisis], ed. Eiji Ogawa, Yuro ken kiki to sekai
keizai—Shinnin kaifuku no tame no hosaku to ajia he no eikyo [The Euro
Zone Crisis and the World Economy: Measures to recover credibility and theireffect on Asia], University of Tokyo Press, pp. 45-68, 2015.
“The Disclosure of Non-Performing Loan Prevented Banks’ Evergreening
Policy?: Lessons from Japanese Banks’ Experiences,”Keizai KenkyuEconomic
Studies (Meiji Gakuin University), #147, 2014.
“Automobile Exports: Export Price and Retail Price,” with Yushi Yoshida,
Discussion Papers 15-E-024, Research Institute of Economy, Trade andIndustry (RIETI), 2015.