Vítor Constâncio: Towards the Banking Union
Speech by Mr Vítor Constâncio, Vice-President of the European Central Bank, at
2nd FIN-FSA Conference on EU Regulation and Supervision - "Banking and Supervision
under Transformation" organised by the Financial Supervisory Authority, Helsinki,
12 February 2013.
* * *
Ladies and gentlemen,
It is a great pleasure to be here today and I am grateful to the organizers for having invited
me. All of us have been reflecting on the lessons to be drawn from the crisis relevant for the
European project and in particular the ones related to the monetary union. The initial choice
for monetary union was to have a minimalist framework: the adoption of a single currency
plus a fiscal brake, the Stability and Growth Pact, to ensure stability, exclude free riders and
help the single monetary policy. All other policies, economic or concerning financial stability
like supervision, were left for the national level. It was assumed, in line with the economic
thinking of the time, that monetary integration would spontaneously foster the
synchronisation of the economic cycle and that national "shock-absorber" would be sufficient
to deal with country specific developments.
The crisis has made it clear that a highly interconnected and integrated area such as the
euro area, requires a stronger institutional framework. An important element to strengthen
the financial institutional framework is the creation of the Banking Union.
The Council proposal on the Single Supervisory Mechanism of last December is testimony to
the urgency in setting up a basic pillar of the Banking Union.
A strong and independent supranational supervisor will contribute in a significant manner to
the smooth functioning of the monetary union and to restore confidence in the banking
sector. The regaining of confidence in the banking sector is key to reverse recent
developments towards financial fragmentation and help restart a well-functioning interbank
market.
My intervention today is divided into two parts. In the first part I will touch upon the different
elements of the Banking Union and reflect upon the underlying rationale for its establishment.
In the second part of my speech I will focus on the SSM by reviewing its main features as
well as the immediate challenges for the ECB to prepare itself to assume its supervisory
task.
Part I - the Banking Union
The key building blocks of a Banking Union
The Banking Union aims at building an integrated financial framework to safeguard financial
stability and minimise the cost of bank failures. As we all know, it consists of five
complementary building blocks, of which the SSM forms an integral part.
The first block is the establishment of a single rulebook, which in a substantial way exists
already. The European Banking Authority (EBA) has the legal competence to monitor its
implementation. The addition of the CRD IV, the Resolution and Deposit Guarantee
harmonisation Directives will lead to the creation of a single rulebook that will significantly
contribute towards creating a level playing field. Likewise, the SSM will also contribute to
reinforce the single rulebook, as a European dimension will be provided to the way
supervision is conducted.
The establishment of a EU framework for single supervision forms the second element
of the Banking Union and will be at the centre of my talk today. The SSM will be a
mechanism, composed of national competent authorities and the ECB, with the possibility of
non-euro area Member States to participate. The process to establish the SSM is underway,
with the Council proposal forming the basis for the current discussion at the European
Parliament. We at the ECB are quite pleased with the Council's proposal which is being
assessed by the European Parliament. In all my comments I will refer it as it corresponds to
the current basis for the future SSM.
A third element of the Banking Union is the establishment of a Single Resolution
Mechanism. An important pre-condition is a swift adoption of the Bank Recovery and
Resolution Directive, as it lays out a harmonised toolbox of resolution powers. The Single
Resolution Mechanism would build on the measures and tools laid down in the Directive,
particularly by providing a robust framework that allows for prompt and coordinated
resolution action, specifically where cross-border banks are concerned. As we all know, the
swift and orderly resolution of cross-border banks is the Achilles heel that needs to be
addressed.
The framework for the Single Resolution Mechanism is still to be defined and I look forward
to the Commission's upcoming legislative proposal. Let me nevertheless highlight the main
features that in my view such a Mechanism should have. It would have the same institutional
and geographical scope as the SSM. The SRM would be an operationally decentralised
system, where the ultimate responsibility rests with a Single Resolution Authority. The Single
Resolution Authority would be at its centre, govern the resolution of banks and coordinate the
application of resolution tools. It should have a comprehensive set of enforceable tools,
powers and authority to resolve all banks in the SSM. In particular it would ensure that failing
banks are resolved swiftly, through impartial decision-making focused on the European
dimension. The timely resolution of banks should avoid the cascading of problems from one
bank to other banks, thereby affecting European financial stability.
In order for the Single Resolution Mechanism to be perceived as credible, it should have
sufficient funding. I am not talking about bailing-out banks with public money. Resolution is
about resolving the situation of banks that have attained the point of non-viability and about
doing it in a way that minimises the involvement of public money.
First, the writing-down of capital instruments and bailing-in of creditors should be fully
exploited. Second, funds accumulated in a European Resolution Fund should be used to
provide additional funding needed to realise a least-cost resolution strategy. These
contributions should be risk-based and collected ex-ante from all banks participating in the
SRM. Third, as a last resort, if the resources of the European Resolution Fund do not suffice,
funds could be drawn from a European-level fiscal backstop mechanism. However, any fiscal
support to the SRM should come in the form of credit to the European Resolution Fund. The
Fund would need to repay the loan through additional levies on the banks under the SRM
according to pre-specified rules. This should ensure that the mechanism is fiscally neutral
over the medium term. Resolution activity may require the temporary use of public money if
the Resolution Fund would not have enough resources, for instance, to capitalise a bridge
bank that is sold later on to the private sector thus recovering the capital involved. In the US
this is ensured by the existence of Treasury credit line, limited to 50bn dollars that can be
drawn upon by the FDIC and later repaid.
The existence of this financial backstop can be considered as the fourth element of a
complete banking union, especially because, as announced by the European Summit, there
will be the possibility of direct capitalisation of banks by European funds. This element,
whatever its terms, will be of great important for the achievement of one goal of the banking
union project, namely to mitigate the negative feedback loop between banks and sovereigns.
Finally,
the fifth element of the Banking Union will be the establishment of a common
system of deposit protection. A first step in this direction will be the adoption of the
legislative proposal on deposit guarantee schemes, providing a harmonised framework. This
framework should ensure depositor confidence and enable the national deposit guarantee
schemes, built on common EU standards, to interact with the SRM. A European deposit
guarantee scheme is therefore not essential in the short term. Nevertheless, a common
system, built on common EU standards, will be important in the future to ensure enhanced
depositor confidence in the robustness of all European banks. This element would also
contribute to reduce the risks of financial fragmentation that results from contagion fears and
is detrimental to the smoothing functioning of the single monetary policy.
Rationale for a Banking Union
I see the Banking Union as essential to sustain and strengthen the EMU framework. It is
worthwhile to dwell upon the reasons why I consider it so. After all, the nature and features of
banking union must be strictly connected with what justifies its existence.
First, a single supervisory mechanism is necessary because of the increasing
between financial institutions and markets across the euro area over
interconnectedness
the past decade, be it through internationally active banking groups, bilateral trading
exposures, or presence in the same market segments. The recent financial crisis
demonstrated how quickly and powerfully problems in the financial sector of one country can
spread to another. This is especially the case in a monetary union. As a result, problems in
the banking sector might originate at the national level, but are more and more likely to affect
other countries of the euro area as well, and may quickly threaten the stability of the entire
euro area banking system. Such developments and the underlying financial structures can
best be assessed by a central authority rather than through cooperation between national
ones.1
This has been captured by the so-called "financial trilemma". The concept of the trilemma is
adapted from the famous "monetary trilemma" on the impossibility of simultaneously
achieving three objectives: a fixed exchange rate, capital mobility, and national monetary
policy.2 In a very similar way, but applied to international finance, as put forward by Dirk
Schoenmaker (2011) following a model by Xavier Freixas (2003)3 the "financial trilemma"
illustrates the impossibility of achieving three objectives in an environment with globalized
financial markets: financial stability, financial integration and national financial policies,
especially supervision.
For instance, the financial stability objective could possibly be pursued with national financial
policies and supervision but only at the expense of further integration. The resulting
fragmentation of the single market is however clearly at odds with the EMU framework and
the requirements of the single monetary policy. Similarly, financial stability cannot be
safeguarded as financial integration progresses (with an ever greater degree of
interconnectedness between financial institutions and markets) and financial sector policies
remain a strict national competence. Pursuing financial stability and integration as joint
objectives requires true European level policies. This is particularly illustrated in a ECB
working paper by Holthausen and Ronde (2004)4 showing that with increasing financial
1
See, e.g. Gros, D (2012), "An incomplete step toward banking union", CEPS discussion paper.
2
First put forward in Padoa-Schioppa, T. (1982) "Capital mobility: why is the Treaty not implemented?" Address
to the Second Symposium of European Banks and reproduced in Padoa-Schioppa (2000) "The road to
monetary union in Europe" OUP. See also Paul Krugman (1987) "Economics integration in Europe: some
conceptual issues" in T. Padoa-Schioppa "Efficiency, stability and Equity" OUP and Obstfeld, M,
J. Shambaugh, and A. Taylor (2005), "The Trilemma in history: tradeoffs among Exchange rates, Monetary
Policies, and Capital Mobility", Review of Economics and Statistics 87, 423-438.
3
Schoenmaker, D. (2011): "The Financial Trilemma", in Economics Letters, 111 pages 57-59; Freixas, X.
(2003) Crisis management in Europe. In: Kremers, J., D. Schoenmaker, and P. Wiert (eds) 2009, "Financial
Supervision in Europe" Edward Elgar p. 141-165.
4
Holthausen, C. and T. Ronde (2004): "Cooperation in international banking supervision", ECB Working
Paper 245.
integration, pursuing national financial policies will generally not lead to financial stability,
because national policies seek to benefit national welfare, while not taking into account
externalities of their supervisory practices on other countries. This leads to an
underprovision of financial stability as a public good. From a different perspective, Goodhart and
Schoenmaker (2009)5 show, both in a model and using European data, that a coordination
failure emerges when ex-post coordination among different national supervisors leads to an
underprovision recapitalisation of cross-border banks after a banking problem.
A lesson of the trilemma is, therefore, that it is beneficial for the provision of financial stability
to replace national policies with policies at the supranational level, thus geographically
aligning supervisory incentives with the effect such supervision has on the financial sector as
a whole. Other welfare enhancing benefits will come from the reduction of reporting costs for
international banks, the easier centralised management of liquidity and the improving of the
overall management of risks.
The materialisation of all these benefits will depend, however, on a vital condition for the
functioning of the SSM, namely that it ensures a truly unified European perspective and does
not act as a sort of an inter-governmental body of national supervisors. The elimination of
any possible national bias implies that it has to function really as one system with a strong
center and this will be its greatest challenge.
A second reason that justifies the banking union project regards the requirements for a
smooth functioning of the single monetary policy. Its transmission mechanism across all
member countries of the euro area requires an appropriate level of financial integration that
ensures well performing cross border money markets. After a spectacular integration of
money and financial in the first 10 years of monetary union we have observed increasing
fragmentation that only recently, after the creation of our OMT programme, started to abate.
This fragmentation has impaired the transmission mechanism of monetary policy. It has, of
course, several different causes but could have been mitigated in the first place if some
elements of a banking union had been in place. This would have contributed to a stronger
separation between sovereign and banks by creating enhanced confidence in the national
banking sectors ́ solvency and liquidity situations. This would happen not only as a result of
an effective overall supervision but also would stem from the elimination of ring-fencing
practices condoned or even incentivised by some national regulators.
The elimination or mitigation of the banks and sovereigns negative feedback loops will then
be promoted by several elements of the banking union acting together: the Single
Supervisory Mechanism, the Single Resolution Mechanism and the European direct
recapitalisation of banks.
The third reason that justifies the banking union project has to do with the development of
large financial imbalances within the euro area in both public and private sectors. In
particular, the development of macro and external imbalances was significantly driven by
private sector indebtness, proving that the fiscal brake was not enough to guarantee macro
stability and excessive heterogeneity among member states. This provided the rationale for
the recent creation of a formal Macroeconomic Imbalances Procedure to monitor and
promote timely policy measures to avoid the building up of macroeconomic instability in
member states.
This was in part because fiscal rules were implemented weakly, not applied rigorously and
subsequently watered down. Some countries therefore ran persistent deficits in good times
private
or maintained high levels of debt. But the greater imbalances in fact emerged in the
sector.
Between 1999 and 2007, the ratio of public debt to GDP in EMU declined on average by
5.6 percentage points. But in the same period, the ratio of private sector debt to GDP
increased by 26.8 percentage points. For the same period, in the stressed countries, the
cumulative increase in the private debt ratio to GDP versus the public debt ratio, amounted
respectively, to 49 and 24 per cent for Portugal, 75 and minus 35 per cent for Spain, 101 and
minus 10 per cent for Ireland, 217 and 4 per cent for Greece. In 2007, just before the crisis
started, the level of public debt on average in the euro area was 73% but was 63% in
Portugal, 46% in Spain and 26% in Ireland.
Private debt levels were able to increase so significantly because the integration of national
markets allowed for higher borrowing from abroad and increased leverage. Banks were at
the centre of this process both in lending and borrowing countries. As we now know, these
flows were not perfectly optimised by rational private agents. The minimalist institutional
construction of the euro area lacked the tools to discourage these developments.
The official bodies that could - and perhaps should - have intervened more to prevent these
developments were national supervisors both in lending and borrowing countries. Yet they
lacked the perspective to do so and also the instruments to contain private capital flows that
were considered to result from optimizing self-equilibrating markets. Only macro-prudential
measures agreed through a consensus at the European level could have dealt with the
situation. In other words, there was a mismatch between the degree of integration and the
scope of governance. In retrospect, the euro area was not prepared to deal with the build-up
of systemic risks.
This was in a large part the result of two features of the dominant economic thinking at the
time:
- first that the private sector is essentially stable and self-correcting composed of fully
rational agents always optimizing inter-temporally with knowledge of the future probability
distributions to infinity of economic returns and variables. In such a world no defaults are
admitted or dangerous bubbles possible. Only the public sector can create instability. The
Stability Pact was then supposed to be enough to ensure stability.
- that finance does not matter for real economy fluctuations. After the Real
second,
Business Cycles school, the rational expectations hypothesis and the intertemporal
optimization paradigm, money and finance were considered not relevant anymore. Money
crept back in the new consensual macro model through the introduction of wage and price
rigidities, allowing for short-term real economy effects of monetary policy. On the contrary,
finance continued to be invisible with the Efficient Market Hypothesis ensuring a reliable
plumbing of the real economy. Banks and capital markets were not considered endogenous
sources of instabilities with real economy effects. They were absent from macroeconomic
models.
All these features are being corrected, both in economic theory and models and in
institutions. The important consequence for the monetary union framework is the launching
of the banking union project and within its supervision component the attribution to the SSM
of macroprudential policy instruments. Previously, the ESRB had been created only with the
competence to issue warnings and recommendations. Economic theory and the
overwhelming evidence of the importance of systemic risk in the crisis explain why the ECB
insisted from the beginning that concrete macroprudential instruments were given to the
SSM. The participant countries in the mechanism, which also can use those instruments, can
feel more reassured that systemic risk at the European level will be better addressed in the
future.
Part II - the Single Supervisory Mechanism
Main features of the SSM regulation
The Single Supervisory Mechanism is to become operational in 2014. Let me briefly highlight
its main features some of which are related with the previous analysis.
SSM as one system
The SSM will operate as a system, catering for all expertise of national supervisors and at
the same time possessing a strong decision-making centre. As I mentioned before, this is an
important feature necessary for the effectiveness of the new entity. Appropriate
decentralisation procedures will need to be defined while preserving the unity of the
supervisory system and avoiding duplication.
To ensure a strong centre, the ECB's final responsibility for supervision within the SSM is
matched by control powers over the system as a whole, as well as by very close cooperation
arrangements with national authorities. The first aspect in the draft Regulation approved by
the Council that ensures that the intention is indeed to create one system of European
supervision results from the legal competence given to the ECB over all the banks in the
participating countries. Naturally at the centre of the system, the ECB could not directly
supervise all the thousands of existing banks. Only the more significant banks will be subject
to that direct supervision. All the others will continue to be supervised by the competent
national authorities. The SSM is more than just the ECB and includes all the national
supervisors and central banks and so will have to function in a much decentralised way.
Decentralisation does not mean fragmentation. What makes the SSM work truly as one
system, besides the legal competence over all the banks, are some other main features:
First, all the components of the system will have to act in accordance with a system of
guidelines, ECB specific regulations and manuals of supervisory practices that will be
approved at the center by the Supervisory Board. The respect for these rules will be
monitored and subjected to peer reviews.
Second, the center at the ECB will receive all the supervisory data, regarding all the banks
Third, the bodies at the center of the system, at the ECB, have the power to transfer to direct
supervision any bank or group of banks that may be considered relevant and may be the
origin of systemic risk. As we know from the crisis not only big banks may the source of more
general financial instability. This legal competence is also an important persuasive tool to
ensure harmonised supervisory practices throughout the system.
Extensive powers of the SSM
A second important feature of the SSM regards its extensive powers in the conduct of its
supervisory function.
The SSM, with the ECB at its centre, is entrusted with an extensive
set of micro- and macro- prudential powers, covering all key tasks relating to the
prudential supervision of credit institutions. This broad array of tasks and powers is crucial,
as it is the foundation for the SSM to effectively supervise banks.
In concrete, the micro-prudential tasks range from the authorisation of credit institutions to
having the power to carry out early intervention when a bank is in financial distress. These
tasks are matched with a broad set of powers to carry them out. In this context, the ECB may
conduct all necessary investigations and on-site inspections and obtain all necessary
information to carry out its task effectively. In addition, in order to enforce its decisions and
rules, the ECB also avails of sanctioning powers.
Beyond all these aspects that are usual in respect to supervisory authorities, there are two
other points I would like to underline. The first refers to the so-called early intervention
powers as they are foreseen in the draft Directive about bank resolution that should be
approved in the near future and long before the SSM will start operating. These early
intervention are vast in what concerns the governance and scope of activity of institutions
that start to have problems that can lead them to a point of non-viability. As such, these
powers are related to what is usually called "prompt corrective action" regarding problematic
banks and can be applied before the bank is delivered to the Resolution Authority.
Another important competence conferred upon the ECB as the centre of the SSM concern
the macro-prudential instruments to be possibly applied both to the euro-area financial
system as a whole or to individual countries. These powers are shared with national
authorities that can also take measures in this field but it is nevertheless another essential
element of the proposal. The crisis has shown that supervising the micro-prudential risks at
individual banks separately is not sufficient and that macro- and micro- risks can actually be
mutually reinforcing.
Involvement of non-euro area Member States
A third important feature of the SSM relates to the preservation and deepening of the Single
Market, particularly the fact that national competent authorities of non-euro area Member
States have an option to participate in the SSM. They can participate through establishing
a close cooperation with the ECB. By giving non-euro area Member States full membership
and voting rights in the Supervisory Body, the body responsible for the preparation of
decisions on supervisory matters, they are placed on an equal footing with euro-area
Member States. However, as the ECB Governing Council is the ultimate the decision-making
body of the ECB, its role in the SSM is reduced to the possibility of accepting of accepting or
rejecting the decisions of the Supervisory Board. At the same time, a system integrating a
mediation panel is foreseen in the Regulation in case of divergences that may involve a
noneuro area Member State. All these mechanisms were accepted at the level of the Council by
all governments which seems to indicate that we might see an extension of the SSM well
beyond the euro area.
Separation of monetary and supervisory functions, while benefiting from synergies
A final feature of the SSM Regulation I would like to highlight relates to the principle of
separation of the monetary and supervisory function. The important role given to the
Supervisory Board vis-à-vis the Governing Council, already referred to, is one of the various
safeguards ensuring a clear separation between the monetary and supervisory function of
the ECB. Additionally, deliberations of the Governing Council on supervisory matters will be
strictly separated, including separated agendas and meetings.
The ECB fully subscribes to the need for a clear separation between its monetary and
supervisory function and the provisions to this end mentioned in the proposed legislation. But
let me stress that separation does not mean isolation. The conferral of supervisory tasks to a
central bank is in line with the responsibilities of many other central banks that combine
these two functions. In fact, the crisis has only strengthened the trend of central banks
acquiring supervisory responsibilities and there are many good reasons for conferring
supervisory powers to the central bank.
A first argument is that a stable financial system is a necessity for the smooth conduct of
monetary policy and as such a major concern of any central bank. Second, there are
information synergies between the oversight of payment systems and the supervision of
banks. The ECB is not only responsible for the oversight of all large-value payment systems
operating in the euro area, but also the owner of the TARGET2 system, the largest of such
systems. Third, central banks have a lot of expertise on the financial sector. The constant
monitoring of the different market segments in order to assess the transmission of monetary
policy contributes to their understanding of the financial sector and to act quickly in situations
of financial stress. Fourth, central banks will be able to achieve a better management of its
counterparties ́ creditworthiness in monetary policy operations. Fifth, central banks are
particularly prepared to manage macroprudential policies as they have a deep knowledge of
the macroeconomic and financial cycles and monetary policy shares the same concerns with
macroprudential policy, namely the stabilisation of the cycle to ensure price stability in the
medium and long term. This provides the justification for the fact that in Europe and around
the world Central Banks are given macroprudential authority even when they not have micro
supervisory powers. In fact, the usual arguments to separate monetary policy from
supervision do not apply to macroprudential policy. In particular, the potential conflicts, the
sensitivity and reputation risks resulting from decisions about individual institutions do not
arise in what regards macroprudential policies. It is then to be expected that the Governing
Council of the ECB will show more interest in those policies. On the other hand, there are
also advantages in not subsuming the macroprudential perspective in the micro supervisory
body as the systemic risk is not the natural standpoint of observation of such body.
Macroprudential concerns should be functionally separate in any organization that has both
functions as it happens currently with various central banks in Europe.
Thus, although the conduct of supervision will be a new task for the ECB, as the euro area's
central bank, we have built up extensive expertise in macroeconomic and financial stability
issues. While safeguarding any potential conflicts of interest between the monetary and
supervisory function, the benefits of combining these two tasks in one institution are evident
and should be reaped.
Of course the concentration of more powers at the ECB, implies a higher level of
accountability. The Council proposal also addresses the issue by creating a Review Panel
of the SSM decisions from a legal point of view and, in particular, by defining the
accountability of the SSM before the European Parliament.
Main immediate tasks of the SSM
One of the main priorities for the ECB during 2013 is ensuring the operationalization of the
SSM, so that it can assume its responsibilities effectively and efficiently.
Building a strong centre
Creating a strong centre in a decentralised system such as the SSM, will be crucial to ensure
the ECB's reputation is safeguarded. The monetary policy function of the central bank
requires that it maintains a high level of credibility. This is essential to keep anchored inflation
expectations. When the central bank is responsible for both price stability and banking
supervision, weaknesses in supervision could damage the reputation of the central bank as a
competent monetary authority. Furthermore, it could be argued that the central bank faces
higher reputational risks in conducting its supervisory function than its monetary policy
function. This is simply due to the very different nature of the tasks. News about a failing
bank can be automatically wrongly perceived as a result of deficient supervision cancelling
out reputation built over a stream of years with no news about problem banks.
In addition, the ECB will need to build up its reputation in its supervisory function. While the
full independence and legal means are at the core of the system in the SSM construction, the
close proximity with the supervised entities and expertise of national supervisory authorities
are essential to ensure that no aspect is overlooked. As I mentioned before the system will
be very much decentralised. Even in the case of banks directly supervised from the centre,
the experts from national authorities will be involved in on-site inspections and these and
other operations should be conducted in the context of joint supervisory teams headed by
ECB ́s experts.
The success of the SSM will hinge on the knowledge and skills of its human capital.
Therefore the recruitment of skilled and experienced staff, including banking supervisors, will
be a priority. This will be, to a large extent, built on the system resources, in line with the
experience in cooperation within the Eurosystem.
Review of banks' balance-sheets
An immediate task of the SSM will be a comprehensive review of the banks brought under its
responsibility, namely the banks that will come under the direct supervision of the ECB. This
is requested in the Council Regulation in view of possible legacy issues, which could put the
SSM reputation at stake further down the road. Ahead of assuming the responsibility for the
supervision of banks, the ECB in cooperation with national supervisory authorities will need
to carry out a comprehensive assessment of their balance-sheets. This exercise will include
elements of an asset quality review which is instrumental in identifying potential legacy
problems.
The treatment of legacy assets in the overall Banking Union project is an important
issue, notably in connection with the European direct recapitalisation of banks. It has
to be ensur