Peter Praet: The importance of a genuine banking union for
monetary policy
Speech by Mr Peter Praet, Member of the Executive Board of the European Central Bank, at the
EMU Forum 2016, Oesterreichische Nationalbank, Vienna, 24 November 2016.
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It was always understood that deep financial integration would be key to effective
macroeconomic stabilisation in Monetary Union. The cross-border integration of credit and
capital markets would facilitate a smooth transmission of the single monetary policy across the
union, allowing the central bank to stabilise area-wide shocks. And the risk-sharing benefits of
financial integration would help absorb local macroeconomic shocks that could not, by definition,
be addressed through monetary policy - nor, by design, through a federal euro area budget.
Indeed, financial risk-sharing would be crucial to prevent national budgets from being
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overburdened in severe local downturns.
These benefits are one reason why, 15 years ago, the topic of this conference was "The Single
Financial Market - Two Years into EMU". At that time, however, it was widely believed that the
elimination of intra-EMU currency risk, coupled with a process of broad economic and regulatory
convergence, would foster a market-led process of financial integration. And indeed, following the
launch of the euro, financial markets did steadily integrate, in particular the money market but
also bond markets. The integration of the banking sector deepened too. According to the ECB's
financial integration indicators, euro area interbank markets became almost completely
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integrated prior to the crisis.
Yet, as is well-known, the state of pre-crisis financial integration was shallow and largely
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illusory. Under stress, the euro area financial market fragmented, providing little ex post risk
sharing. This was made possible by the composition of cross-border flows - based more on
short-term debt than on equity - which limited the potential for capital-market risk-sharing. And
the integration of interbank markets was not matched by retail banking integration, hindering
consumption smoothing through credit markets. Financial fragmentation in turn disrupted both
monetary and fiscal stabilisation as public and private sector borrowers suffered the effects of
the so-called "bank-sovereign nexus".
This failure of financial integration, and its effect on shock absorption, is an important reason why
the crisis has been more protracted in the euro area than in other advanced economies. Hence a
strong policy response has been needed. First, to make the financial sector safer by
strengthening the regulatory and supervisory framework - what has been termed "risk reduction".
And second, to deepen risk-sharing by creating the institutional conditions for more robust
financial integration, which has been one key aim of the banking union. It is this latter aspect, and
why it matters for monetary policy, that I would like to focus on in my remarks today.
The main point I would like to make is that we need a more integrated banking sector in the euro
area to achieve greater macroeconomic stability. But to achieve this, private and public
risksharing have to be seen as complementary - that is, we cannot expect to have a fully integrated
banking sector that can share risks without common institutions that can also share risks,
namely for deposit insurance and bank resolution. Without such institutions, there is a real
prospect that the banking system will remain fragmented, and that is ultimately to the benefit of
no one in the euro area.
Financial integration and monetary policy transmission
Why is financial integration in the euro area, especially in the banking sector, and the resulting
degree of risk-sharing so important for monetary policy? The financial system helps smooth out
temporary fluctuations in economic conditions. Companies and households can resort to
financial intermediaries - in the euro area, typically banks - to accommodate their temporarily
higher financing needs and reduce fluctuations in spending patterns. This leads to a higher
degree of macroeconomic stabilisation. A sound financial system reduces the burden on
monetary policy, which would otherwise have to step in to stabilise the economy. While banks in
principle help to stabilise investment and consumption patterns, they can also contribute to
procyclicality by becoming shock amplifiers or even trigger financial shocks. One of the main
lessons of the crisis was that in order to effectively transmit monetary policy impulses to the real
economy, banks need to be well capitalised through the cycle and conduct maturity
transformation in a prudent manner.
The euro area consists of a diverse group of countries with different degrees of specialisation in
different economic sectors and in different segments of the value chain. Short-term fluctuations
as well as the long-term shifts in the global economy can have very different contrasting
implications for individual euro area economies. These disparities have at times been
compounded by diverging policy stances, for instance overly loose fiscal policies in countries that
were already overheating compared with their euro area peers. In addition, varying
macroeconomic dynamics are to some extent unavoidable in a currency union - and, as a
matter of fact, in any major economy composed of structurally diverse regions.
How should such differences be addressed? This is where the interplay between financial
integration and monetary policy comes in. Monetary policy is not well suited to cater for
asymmetric shocks, which affect some countries more than others.
In a monetary union, banks or other financial intermediaries may also prove unable to absorb
country-specific shocks, if they are themselves overly exposed to their respective economy.
They risk facing financing constraints at the same time as everyone else. In such a situation, the
financial system will not avert, but rather amplify, the retrenchment in the real economy. And, if
the shocks are as violent as they were, for example, during the last crisis, financial
intermediaries may face threats to their own solvency, with pernicious effects on bank-based
monetary policy transmission.
As I mentioned earlier, for an effective transmission of monetary policy, banks need to be in a
position to pass on changes in financial conditions set by the central bank, for example in money
and longer-term credit markets, to households and companies. But if solvency is their chief
concern, banks will retrench rather than generate new, or at least maintain existing, business.
This means that the central bank's efforts to stabilise the economy cannot work as effectively as
they should. So not only will banks fail in their macroeconomic stabilisation efforts, they will also
obstruct the efforts of monetary policy to play that role.
In fact, this is what we saw during the crisis. To avoid that happening again, we need a deeply
integrated financial system with well-capitalised intermediaries that are active across borders
and benefit from the risk diversification options that the economic diversity of the euro area
offers. Sound risk diversification within the euro area financial system will make the task of
monetary policy easier even when confronted with common shocks.
Public and private risk sharing
Having discussed the importance of financial integration for the transmission of monetary policy, I
would now like to turn to the issue of risk sharing. There is an ongoing debate on the broader
need for public risk sharing in monetary unions, and even on the need for fiscal capacity to
strengthen macroeconomic stabilisation at euro area level. Clearly, more private risk sharing
through the financial system should not be seen as a substitute for public risk sharing, but to be
fully effective, private risk sharing through the financial system needs not only common
supervision, regulation and resolution, but also a common fiscal backstop. In the debate about
public risk sharing in the euro area, the question of the fiscal backstop to the banking union is
essential.
Let me be clear: it is not the task of the public sector to backstop private banks' risk taking. This
would be the very definition of moral hazard. Public policy is responsible for creating the right
framework for a sound and integrated European banking system so that taxpayers do not end up
footing the bill for bank failures. In this regard, significant progress has been made over the past
four years: we have common institutions for supervision and resolution at European level, we
have a Single Rulebook and European supervisory authorities to ensure that the rules are applied
in a harmonised manner across the Single Market. However, rules and institutions are not
enough to create a genuine banking union. Let me highlight two points:
First, the present institutional architecture of the banking union is one where supervisory
responsibilities are shared, while the consequences of supervisory failures are not.
Second, the banking union appears at times more like a collection of national banking systems
than a single entity, especially when we consider banks' balance sheet exposures. As long as
this is the case, country-specific shocks cannot be absorbed via integrated markets and
procyclicality will prevail.
Barriers to cross-border banking
So what is holding back financial integration? And what are the barriers to more cross-border
banking in Europe? The answer isn't simple. A comprehensive explanation would probably need
to include not only institutional and regulatory aspects but also non-regulatory barriers, and it
would go far beyond the scope of my speech. However, one of the key reasons for the lack of
cross-border integration, on which I would like to focus now, is that capital and liquidity are not yet
fully fungible in our banking union.
Let me explain. Many aspects influencing banks' decisions to engage in cross-border activities
remain under the purview of national authorities rather than European ones. And even where this
is no longer the case in principle, national options and discretions still provide for distinct
crosscountry differences. This ranges from financial regulation and accounting to insolvency practices.
Take, for example, a banking group that operates across different countries. Where should this
group's prudential safeguards, such as capital and liquidity, be located? Should each local
subsidiary of the banking group hold a minimum of liquid assets, irrespective of whether they are
needed for its business model? Or is it sufficient to fulfil liquidity requirements at the consolidated
level? Centralised liquidity management at group level seems clearly beneficial from the
perspective of financial integration.
However, there are also risks associated with closer integration in the banking union. As
supervisor, the ECB can grant waivers for liquidity requirements at national as well as
crossborder level on a case-by-case basis. While the creation of a truly European banking system is
certainly in the ECB's interest, its supervisory mandate calls, above all, for the safety and
soundness of the institutions under its supervision. Waiving liquidity requirements and large
exposure limits could increase the interconnectedness within the banking group and lead to
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possible contagion effects in a banking union which has no common deposit insurance scheme
and where the Single Resolution Fund (SRF) still lacks a fiscal backstop.
The current incomplete banking union is asymmetric: while decisions on liquidity waivers are
taken at European level, the relevant risk-sharing mechanisms are still national. In each country,
bank depositors are protected by the national guarantee scheme. If a bank fails and the Single
Resolution Fund does not have sufficient resources available to finance its resolution, which may
well be the case for some time, until the common element of the SRF is sufficiently advanced, it
is a national credit line that backs the SRF. In this context, the ECB's Supervisory Board decided
this spring that there should always be a floor on the liquidity coverage ratio for those subsidiaries
that are significant on a stand-alone basis. This is to ensure that they hold a sufficient level of
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high-quality liquid assets to respond to liquidity needs at national level. Liquidity ring-fencing
reflects the absence of a common fiscal backstop in the banking union.
Completing the banking union
It would be unfair not to acknowledge the progress that we have made towards the banking
union. My main point is that we have to be more ambitious. Completing the union is not a
longterm project. If the aim is to foster cross-border integration of banks, finalising the union has to be
done within a timeframe that banks can work with when they make their strategic decisions on
how to adjust their business models.
In the political debate, completing the banking union is sometimes framed in terms of a trade-off
between risk sharing and risk reduction. In the banking sector, however, risk sharing and risk
reduction are often closely linked. A lack of risk sharing can trigger panic and contagion, which
has in the past led to the establishment of fiscal backstops and deposit insurance arrangements.
Well- functioning risk-sharing arrangements are based on controlling the degree of risk in the
banking system. I believe both routes need to be followed and to move forward in parallel - and
they need to be pursued ambitiously. I am convinced that leaving the banking union unfinished
would be the opposite of risk reduction.
A European Deposit Insurance Scheme would enhance overall depositor confidence by
protecting deposits in a uniform manner wherever they are in the EU. It would thus reduce the
probability of depositor payouts or the probability of resorting to other risk-sharing mechanisms,
such as the European Stability Mechanism. This is the very foundation of insurance: by pooling
resources and risks across a larger and more diverse group, the overall shock-absorbing
capacity of the system increases. In this sense, risk sharing turns into risk reduction. Take
another example: tackling legacy issues by cleaning up banks' balance sheets will increase trust
between banks and facilitate cross-border lending, possibly even cross-border mergers, thereby
fostering private risk sharing, independently of the discussion on how to progress with public risk
sharing.
On the risk-reduction side, we still have important elements of the international regulatory agenda
to implement in the EU, including the binding leverage ratio requirement, the net stable funding
ratio or the Financial Stability Board's total loss-absorbing capacity. With this in mind, I am
looking forward to the discussions on the risk-reduction package that the Commission adopted
very recently.
Completing the banking union requires a comprehensive approach: a symmetric institutional
architecture, where liability and control are aligned, harmonisation of the rules, strengthening of
the regulatory framework where needed to control the escalation of risks, and also a certain level
of public risk sharing to underpin confidence in the area-wide financial system. The Single
Resolution Fund was created in 2016, with national compartments and a mutualised
compartment available to fund capital and liquidity needs. Currently, the backstop for national
compartments consists of national credit lines. Looking ahead, it will be essential to establish a
common fiscal backstop in the Single Resolution Mechanism to ensure that the SRF has
sufficient resources to support any necessary resolution measures.
Conclusion
15 years ago the topic of this conference was the Single Financial Market - and by the way, the
keynote speaker back then was Wim Duisenberg. As he noted, "The gradual dismantling of
regulatory obstacles to remaining market integration in Europe will contribute to enhancing its
depth and efficiency, in turn contributing to an improved allocation of funds to the most profitable
investment opportunities, and thus supporting economic growth." This vision is still relevant
today. But to take it forward, it is crucial to be more ambitious and thus to ensure a better
balance between risk reduction through implementation of the regulatory agenda and supervisory
priorities, and risk sharing through the establishment of a common fiscal backstop in the banking
union.
1
I would like to thank Malte Jahning and Fédéric Holm-Hadulla for their contributions to this speech.
2
ECB (2008), Financial Integration in Europe, April 2008.
3
See Special Feature A entitled "Financial integration and risk sharing in a monetary union" in Financial
integration in Europe report, April 2016.
4
See Special Feature B entitled "National options and discretions in the prudential regulatory framework for
banks" in Financial integration in Europe report, April 2016.
5
See pages 10-14 of the ECB Guide on options and discretions available in Union law.