Claudia Buch: Completing the Banking and Capital Markets Union -
where do we stand?
Statement by Prof Claudia Buch, Deputy President of the Deutsche Bundesbank, at the
SUERF-Deutsche Bundesbank-IMFS Conference on "SSM at 1", Frankfurt am Main,
4 February 2016.
* * *
The financial crisis and the ensuing sovereign debt crisis have revealed weaknesses in the
European financial architecture. Although capital market integration in Europe intensified prior
to the crisis, it took place mostly via debt capital markets. This form of financial integration
turned out to be vulnerable at the outbreak of the financial crisis. Many European countries
experienced a reversal of capital flows and a "sudden stop" as investors moved their funds into
safe havens. Fragmentation of European capital markets increased, and a mutually reinforcing
feedback loop between risks of banks and sovereigns (the "sovereign-bank nexus") emerged.
After the crisis, several policy initiatives have been launched which strengthen the institutional
framework in Europe (Deutsche Bundesbank 2015a). The enhanced Stability and Growth Pact
strengthens incentives to follow prudent fiscal policy while retaining decentralised responsibility
for fiscal policy. The European Stability Mechanism (ESM) introduces a crisis resolution
mechanism with elements of risk-sharing under well-defined conditions. Collective Action
Clauses in sovereign debt contracts complement these new rules. The Banking Union, which
has become effective in November 2014, has been a key step in terms of transferring
supervisory power to the European level with the aim to improve both, the monitoring of risks
and mechanisms of dealing with distress in the banking sector (Buch 2014). This note
discusses the scope of reforms in the financial sector with a focus on open issues to be
addressed in future reforms.
Completing the Banking Union
The Banking Union rests on two main pillars: The Single Supervisory Mechanism (SSM) has
given the ECB responsibility for supervising the significant banks in the euro zone and the
ability to assume direct supervision over smaller institutions. In cooperation with national
supervisors, the ECB is now able to apply a uniform set of prudential standards and
supervisory culture across the European banking sector. The second pillar of the Banking
Union is the Single Resolution Mechanism (SRM), which started in January 2016, and builds
on the Bank Recovery and Resolution Directive (BRRD). The implementation of resolution
powers, in particular the bail-in-instrument, and the creation of the Single Resolution Fund
(SRF), are at the core of the SRM.
Taken together, these reforms reduce the probability of bank distress and improve the ability
to deal with distress events through improved private sector risk sharing mechanisms. Public
bail outs become less likely. In this sense, the Banking Union addresses the
sovereign-banknexus by reducing the probability that distressed banks negatively affect sovereign risk. At the
same time, additional reforms can contribute to further increase the resilience of the European
financial system and to enhance the consistency of the new institutional framework (Deutsche
Bundesbank 2014a):
Limiting banks' exposures to sovereign risk: The Banking Union has no direct implications
for the prudential regulations of banks. Most importantly, it does not address the regulatory
treatment of banks' exposure to sovereign risk. Under current prudential regulations, sovereign
debt is treated as risk-free when calculating banks' capital requirements, and large exposure
limits do not apply. This creates incentives for banks to hold exposures vis-à-vis governments
with potential negative implications for private sector lending and financial stability. Abolishing
this preferential treatment of sovereign debt in prudential regulation would thus be an important
complement to the institutional reforms that are already under way (Deutsche Bundesbank
2014b).
Completing the macroprudential toolbox: The ECB has also been given macroprudential
powers. The main responsibility for the implementation of macroprudential measures still lies
with national authorities. In the German case, some key macroprudential instruments are still
missing. In 2015, the German Financial Stability Council has thus issued a recommendation
to create the legal basis for macroprudential instruments addressing potential systemic risks
in the market for mortgage loans.1 Many other European countries have instruments available
to set minimum standards for loan-to-value ratios, debt-service to income ratios, or minimum
amortization requirements. In addition to the recommendation to create the necessary legal
instruments in Germany, the recommendation of the Council also refers to the additional
statistical requirements. Current reporting systems for banks in Germany do not allow
monitoring risks resulting from mortgage lending and in particular possible changes in lending
standards.
Ensure sufficient loss-absorbing capacity and limit exemptions from bail in: Improved
regulations and supervision reduce the probability of bank distress, but they do not eliminate
these risks. Banks thus need to have sufficient loss-absorbing capacity to successfully prevent
the use of public funds in case when a resolution becomes necessary. Internationally,
standards for Total Loss-Absorbing Capacity (TLAC) for global systemically important banks
(G-SIBs) have been agreed upon last year. In Europe, Minimum Requirement for Eligible
Liabilities (MREL) apply. Some discretionary scope in the use of the bail-in instrument, as
granted by the BRRD and the rules on state aid, may be necessary to prevent systemic
contagion. But this flexibility opens a door to political influence and may threaten the credibility
of the instrument. Discretionary exceptions should, therefore, be made only under rare and
strictly defined circumstances. A statuory "systemic risk exemption" that would require, for
instance, a strong majority among relevant stakeholders such as finance ministers for any
deviation from a bail-in in could be an appropriate institutional hurdle.
Reform complex decision-making in the SSM and SRM: The current institutional set up of
the Banking Union has been shaped by limitations of what is currently permitted within the
boundaries of European primary law. As a result, decision-making procedures within the SSM
and the SRM are overly complex and can lead to possible conflicts of interest. The ECB's
Governing Council, for instance, is the ultimate decision making body for both, monetary policy
and supervisory decisions. A clear separation of the ECB's responsibilities for banking
supervision and monetary policy would be desirable. Also, rules governing the participation of
the European Commission and the Council in the decision-making procedures of the SRM
could be streamlined. Both changes, however, would require amendments to primary union
law.
A common deposit guarantee scheme as a third pillar?
The European Commission has recently presented a proposal for a European Deposit
Insurance Scheme (EDIS) as a potential third pillar for the Banking Union. Presently, national
deposit guarantee schemes (DGS) are being harmonised through the Depositor Guarantee
Scheme Directive (DGSD) which was decided upon in 2014, but which has not fully been
implemented by all member states. In the long-run, a common deposit insurance system
would, in principle, be consistent with centralized supervision. It could enhance financial
stability because risk would be spread more widely and the pool of available resources would
be larger. However, integrating deposit insurance systems now would be premature because
necessary preconditions are not met (Buch 2015).
As with fiscal reforms, risk-sharing mechanisms should be established only if powers to control
risk-taking have been delegated to the European level as well. Hence, a de-risking of banks is
necessary before further steps towards a further mutualisation of liability in the form of a
common DGS can be taken. As regards policies that contribute to mitigate risks in the banking
sector, regulatory reforms that limit banks' exposure to sovereign risk are crucial. Therefore,
reforms of the current regulatory treatment of sovereign risk should be a pre-condition for
further risk-sharing mechanisms. Because sovereign debt is not per se a risk-free asset,
regulation should address both, credit risk and concentration risk of sovereign exposures of
banks. Otherwise, effects of sovereign distress would be mutualised under the common
deposit insurance system via the direct effects on its national banks.
In addition, there are many national and economic policy measures which, directly or indirectly,
affect the risk profiles and thus the solvency of banks. For instance, differences in national
insolvency laws have direct consequences for the valuation of banks' assets and the burden
that creditors must bear in the event of insolvency. Hence, reforms need to strike a balance
between retaining national discretion over domestic policies while, at the same time,
preventing national sovereignty from risk-shifting to the European level through (changes in)
regulations affecting bank solvency.
The preconditions for a common deposit insurance scheme will not be met before these issues
have been resolved.
The capital markets union: enhancing channels for private sector risk-sharing
The focus of the Banking Union has been on markets for debt capital. The Capital Market
Union can complement the Banking Union by supporting the development and integration of
European capital markets beyond the banking sector, and by creating additional channels for
private sector risk sharing. Developing and integrating markets for equity capital through the
removal of impediments to efficient, non-distorted market outcomes can play an important role
in this regard (Deutsche Bundesbank 2015b).
Integrated capital markets contribute to risk sharing among investors, which can generate
welfare gains. In integrated markets, local risks are shared amongst investors from different
regions. Individual investors can safeguard themselves against local income risks by
diversifying their equity and debt-financed investment across borders. As the nominal
exchange rate cannot adjust in a currency union, cross-border risk sharing plays an important
role in balancing asynchronous business cycles and thus in supporting the stability of the
currency union. It is therefore all the more important that capital markets function as channels
for risk sharing within the European monetary union.
Yet, cross-border risk sharing is constrained if the integration of capital markets is concentrated
on financial instruments with payout streams that are not contingent on an enterprise's
business situation such as debt instruments. Equity investors, in contrast, directly participate
in gains and losses. This serves as a buffer against losses and as a private sector risk sharing
mechanism.
While stock markets in the EU are already well integrated, there are other market segments in
which reforms could be beneficial.
For instance, removing institutional barriers to mergers and acquisitions could spur
crossborder equity investments. This may include limiting discretionary power in the implementation
of the European Takeover Directive or legal options available to national governments to block
M&A transactions. It may also include reviewing to what extent corporate governance rules
affect incentives for M&As.
As regards European venture capital markets, the review of the European Venture Capital
Funds regulation can be a step towards more developed and integrated European equity
markets. Regulation of venture capital markets should aim at creating a level playing field
across Member States by limiting discretion at the national level, for instance in terms of own
funds requirements and the methodology used to determine the sufficiency of own funds.
Beyond equity markets, the revitalisation of European markets for securitisations via rules for
simple, transparent and standardised securitisations can strengthen European and
international private sector risk-sharing.
In addition to short-term projects, the implementation of long-term goals is decisive for the
success of the Capital Markets Union. Tax systems affect the choice between debt capital and
equity capital, often creating incentives towards using debt finance. Assessing ways to
establish an equal tax treatment of different sources of funding could thus be an important step
forward. Moreover, distortions of investors' decision making emerge from heterogeneous and
in some countries inefficient national insolvency laws.
Obviously, any such reform should take risks to financial stability and the potential for
regulatory arbitrage into account.
Further reading
Buch, Claudia M. (2015). Stellungnahme anlässlich der öffentlichen Anhörung des
Ausschusses für die Angelegenheiten der Europäischen Union des Deutschen Bundestags
zum Fünf-Präsidenten-Bericht zur Vollendung der Wirtschafts- und Währungsunion,
2. November 2015.
Buch, Claudia M. (2014). The banking union - setting the course for better integrated and more
stable financial markets in Europe? Speech at the Handelsblatt Annual Conference, Frankfurt
am Main, 4 September 2014.
Deutsche Bundesbank (2014a), Financial Stability Review 2014: Implications of the banking
union for financial stability, pp- 69-88.
Deutsche Bundesbank (2014b), Annual Report 2014, Reducing the privileged regulatory
treatment of sovereign exposures, pp 23-40.
Deutsche Bundesbank (2015a). Bundesbank Monthly Report March 2015: Approaches to
strengthening the regulatory framework of European monetary union. Frankfurt a.M.
Deutsche Bundesbank (2015b). Financial Stability Report 2015: Capital markets union -
financial stability and risk sharing, pp. 85-94, Frankfurt a.M.