Vítor Constâncio: The role of the banking union in achieving financial
stability
Speech by Mr Vítor Constâncio, Vice-President of the European Central Bank, at the FT
Banking Summit "Ensuring Future Growth", London, 26 November 2014.
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Summary
The banking union can be seen as the biggest European reform after the inception of the
euro, with vast implications that go well beyond the problem of the sovereign-bank loop. It is
a structural and institutional step with wide implications for the deepening of European
integration. Its two key elements - the Single Supervisory Mechanism and the Single
Resolution Mechanism - will help address the negative loop between banks and sovereigns,
notably by means of direct recapitalisation of European banks that would not overburden
already indebted sovereigns.
Another important objective of banking union is to overcome financial fragmentation and
promote financial integration. There are four ways by means of which I expect the SSM to
make a difference to banking in Europe: by improving the quality of supervision; by creating a
more homogenous application of rules and standards; by improving incentives for deeper
banking integration; and by strengthening the application of macro-prudential policies.
There is a need to broaden the scope of the existing macro-prudential policy toolkit in
general and also to broaden the toolkit available to the ECB in particular. One reason is that
macro-prudential policy should become a fully effective policy to smoothen the financial
cycle.
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Ladies and gentleman,
Thank you for inviting me to address you today on the suggested topic "Banking Union and
financial stability". Financial instability and materialisation of systemic risk imply a situation of
impairment of the financial sector's normal functioning to the point that it induces losses in
the real economy. The impairment may take the form of disturbances in financial institutions
or of boom/bust episodes in financial or other asset markets. The origins of instability may be
exogenous to the financial system such as large macro shocks, or endogenous to the
system. The latter comprise financial imbalances such as excessive leverage and risk or
widespread contagion in the system, including across borders. Both the origins and
amplification mechanisms of financial instability can relate to financial misconduct, wrongly
designed policies or financial institutions' fragility.
Following the financial crisis erupting in 2007/8, the euro area was once again on the verge
of a big crisis in the summer of 2012. Two initiatives proved to be essential to avoid disaster:
a substantive institutional reform and a policy announcement. The latter was the ECB's
decision to announce the Outright Monetary Transactions (OMT) programme at the
beginning of August 2012. It was immediately successful in reversing the increase in yields in
the bond market and in gradually reducing financial fragmentation in the euro area.
Overcoming the tail risk of a collapse was not only very positive to Europe but also to the
world economy.
But it is the other initiative that I want to concentrate on today: the decision by the European
Summit of June 2012 to create a Banking Union.
Banking Union is a structural and institutional step with wide implications for the deepening of
European integration. The political sign of Member States willingness to further increase their
interdependence by sharing sovereign power was in itself a game changer for the markets.
As you may recall, the whole idea of launching a single European supervisor was born as a
consequence of the decision to prepare direct European recapitalisation of weak banks. The
crisis had convinced Member States to frontally address the negative loop between banks
and sovereigns, notably by means of direct recapitalisation of European banks that would not
overburden already indebted sovereigns. This naturally required that supervision would have
also to be transferred to the European level. The embryo of Banking Union thus saw the light
of day.
In the meanwhile, it was clarified that European direct recapitalisation could only happen
after the Single Supervisory Mechanism (SSM) would become operative and following a
comprehensive assessment of the banks' balance sheets. In this way, it would be ensured
that direct recapitalisation would not be used to cover bad legacy assets stemming from the
crisis or pre-crisis fragilities. Many months later, agreement was reached among Member
States to accept the second element of the Banking Union - the Single Resolution
Mechanism (SRM). As the ECB often underlined, these two components were necessary for
the framework to work effectively. The Banking Union can thus be seen as the biggest reform
after the inception of the euro, with vast implications that go well beyond the problem of the
sovereign-bank loop.
In this way, the question of direct European recapitalisation ceased to be the main focus of
attention. In the view of many commentators, the SRM became the expected instrument to
achieve the separation of banks and sovereigns. This is a somewhat misleading view as only
in combination with the later approval of the Bank Recovery and Resolution Directive
(BRRD) could the SRM be effective in solving the bank-sovereign loop. The BRRD gave
powers to the SRM to resolve banks using wide bail-in of shareholders and main bank's
liabilities without having to utilise the resolution fund or public money.
The BRRD implements a true paradigm change, ending the culture of bail-out and ushering
in a culture of bail-in. As of 2016, in all resolution cases, the BRRD will impose to the
Resolution Authorities, a bail-in of shareholders and creditors equal to at least 8% of total
liabilities including own funds of a given bank. It should be noted that the amount of 8% is
very substantial when compared to the losses that banks faced in the recent crisis. To give
you an idea: between 2008 and 2010 only one bank had losses exceeding the 8% threshold,
and the average for all other banks was slightly less than 3%. If we look further back to the
Nordic financial crisis in the 90s, none of the banks affected faced losses close to 8% of its
total liabilities including own funds.
According to the new rules, only insured deposits are totally excluded from the bail-in tool.
Only after the 8% amount is bailed-in from shareholders and creditors can the resolution
fund, to which the banking sector contributes, take part in the process and for a maximum
amount of 5% of total liabilities (including own funds) of the bank under resolution.
Furthermore, only in case this is not enough (which, based on past crisis experience would
be exceptional) can public sources be used. Public money, either from national governments
or from direct European recapitalisation of banks, can only be used at the very end of the
process which will make it an extremely rare event.
It is important to highlight that by avoiding the commitment of public money and protecting
tax payers as much as possible - a goal widely shared -participant countries in the Banking
Union must shed considerable sovereign power. In fact, large countries with strong public
finances must renounce to provide domestic banks with the implicit subsidy of public support.
This will reduce their strength in competing in the European space with an advantage and
will be progressively reflected in banks' ratings and funding costs. On the other hand,
countries with vulnerable public finances and smaller banks will no longer be able to support,
and possibly keep, their national champions. Finally, in both cases, governments accept the
transfer of supervision and resolution of banks to the European level in what has to be
considered a remarkable sharing of sovereignty and a desire for "ever deeper union".
With these important steps, the first goal of Banking Union to separate banks from
sovereigns has, in practice, been achieved. This is a crucial foundation for an integrated
financial system that can support the real economy equally well across the whole of Europe.
Reducing fragmentation and eliminating macro-financial imbalances
Another important objective of Banking Union is to overcome financial fragmentation and
promote financial integration. In particular, this will constitute a key task of the SSM.
There are four ways which I expect the SSM to make a difference to banking in Europe: by
improving the quality of supervision; by creating a more homogeneous application of rules
and standards; by improving incentives for deeper banking integration; and by strengthening
the application of macro-prudential policies.
The prudential supervision of credit institutions will be implemented in a coherent and
effective manner. More specifically, the Single Rule Book and a single supervisory manual
will ensure that homogeneous supervisory standards are applied to credit institutions across
euro area countries. This implies that common principles and parameters will be applied to
banks' use of internal models, for example. This will improve the reliability and coherence in
banks' calculation of risk-weighted assets across the Banking Union. On another front, the
harmonisation in the treatment of non-performing exposures and provisioning rules will mean
that investors can directly compare balance sheets across jurisdictions. The recent
completion of a thorough Asset Quality Review (AQR) jointly conducted with demanding
stress tests induced the banks to frontload significant balance sheet enhancing measures,
build up confidence in the European banking sector and created a strong platform from which
the Banking Union can confidently build on.
The SSM should create the conditions and incentives for deeper integration of the European
banking market, which should, in turn make the euro area less vulnerable to fragmentation.
Barriers to deeper retail banking integration that existed in the past will no longer be relevant
with a single European supervisor. The substantial compliance costs that came from having
to observe different sets of rules and interact with several different authorities should also be
reduced.
At the same time, the benefits of cross-border integration should increase. Cross-border
banking groups will be able to optimise their internal management of capital and liquidity.
Additionally, more integrated banking markets contribute to intensify competition: banks, as
well as other financial market participants, will have to change their strategies. More
competition means that capital is allocated more efficiently. It should promote access to new
funding opportunities for companies, encourage investment and thus contribute to higher
economic growth. Small and medium-sized enterprises without direct access to capital
markets, in particular, may benefit the most from de-fragmentation.
In monetary unions in general, genuine financial market integration helps smoothing out the
effects of asymmetric shocks via a mechanism of risk sharing. This can operate through
income insurance, for example, when a country's residents hold claims to dividends, interest
or rental income from investments in other countries. In the U.S., this form of risk sharing has
shown to be more important than federal budget transfers. In the euro area, such risk sharing
will need to assume an increasingly important role, especially given the absence of a more
significant central budget.
However, it should be underlined that incomplete financial integration also carries significant
risks. As the crisis has demonstrated, financial integration increased the risk of contagion,
without in parallel generating adequate risk sharing arrangements to offset its adverse
effects. For example, increased cross-border interbank funding was not accompanied by a
sufficient diversification on the asset side. As a result, in some jurisdictions banks quickly
accumulated significant exposures to local assets (such as real estate), and when the crisis
hit, cross-border funding was quickly withdrawn and sizeable losses had to be absorbed
within national borders.
Supervision exclusively at the national level allowed excessive imbalances to build up within
the currency area. For example, net cross-border claims of banks in non-distressed EMU
countries vis-à-vis distressed countries almost tripled between 2003 and 2008 while
crossborder claims within the core countries increased by factor of about 1.7 over the same time
period. Lack of genuine financial integration and low financial sector resilience would
continue to expose us to systemic risks further down the road.
The new centralised bank supervision organised in the SSM can however help prevent such
developments. The prudential supervision of credit institutions will be implemented in a
coherent and effective manner. A fully integrated approach will be taken to the supervision of
cross-border banks. Joint Supervisory Teams will directly supervise significant banking
groups - comprising supervisors from the SSM within the ECB and National Competent
Authorities. This will enable the SSM to detect, early on, the build-up of imbalances and
excessive risk-taking related to exposures to single sectors and across borders, and
therefore to be proactive should local financial developments become threats to broader
financial stability.
Closer financial integration will also enhance the transmission of monetary policy decisions
throughout the euro area and thereby contribute to financial stability. In the medium to
longterm, the Banking Union will support the formation of a genuinely European financial system
that will foster competition and consolidation in the banking industry. Adequate regulation will
ensure that the associated efficiency gains can be reaped without the risk of creating
too-bigto fail institutions.
Enhancing the macro-prudential toolkit
Another important dimension that the Banking Union introduced relates to the new
macroprudential policy instruments that, for the first time, were given to the ECB/SSM. This is
particularly important at a moment when we expect monetary policy stance to remain very
accommodative for an extended period of time in order to attain our price stability objective.
Inflation became very distant from our official target since October 2013 and threatens to
continue on the low side for some time to come. The environment of low nominal growth now
prevailing creates serious risks to the social and economic fabric of the euro area.
The ECB is responsible for price stability which is always effectively controlled by monetary
policy on a medium-term basis. This is a basic tenet of monetary theory that justifies the
independence of central banks. Having reached the zero lower bound of our policy rates, we
decided on a package of measures that include medium-term provision of liquidity conditional
on banks' lending behaviour and two programmes of asset purchases. To explore new
channels of transmission of monetary policy that have worked in other countries like the U.K.
and the U.S., we are aiming to increase the size of the monetary base and our balance sheet
by directly injecting money also into non-bank economic agents.
We expect that within the time of the programme, the adopted measures will lead the
balance sheet to return to the size it had in early 2012. We have of course, to closely monitor
if the pace of its evolution is in line with that expectation. In particular, during the first quarter
of next year, we will be able to better gauge if that is the case. If not, we will have to consider
buying other assets, including sovereign bonds in the secondary market, the bulkier and
more liquid market of securities available. It would be a pure monetary policy decision,
buying according to our capital key, within our mandate and our legal competence.
The transmission channels involved include signalling and influencing inflation expectations,
exploring spill-overs resulting from investors using the cash received to buy other assets,
including foreign assets with influence on the exchange rate, and finally, the freeing up of
space in banks' balance sheets to increase credit to the real economy. Therefore the counter
argument that the policy would not be effective on account of already low sovereign yields is
not well founded. The transmission goes well beyond the direct effect on the yields of the
purchased securities. Even less valid is the argument that sovereign bond purchases, should
these be deemed necessary, would ease the pressure on governments to do structural
reforms. It is not the task of a central bank to exert more or less pressure on governments to
adopt policies for which they are responsible. Central banks deserve their independence on
account of their responsibility for price stability in a symmetric way, which means in both
directions.
With this huge challenge that monetary policy faces, a continuing accommodative stance is
warranted as we have indicated in our forward guidance. At the same time, we see a
worldwide trend for some froth in financial asset markets. Even in Europe, where the trend is
less marked, we have some asset segments of "localised buoyancy". However, monetary
policy cannot address the problems inherent to the financial cycle, especially in the present
situation. This is the role of macro-prudential policy with a different set of policy instruments.
Fortunately, the Banking Union attributed the ECB/SSM with a range of policy instruments of
this nature.
Importantly, the SSM introduces a co-ordination mechanism between national
macroprudential authorities and the ECB in preparing macro-prudential policy decisions. This
mechanism - by taking into account the wider geographical area on which many European
banks operate - allows macro-prudential policies in the SSM to be well co-ordinated, better
targeted to risks having cross-border implications and, hence, more effective than national
ones.
However, I see a need to broaden the scope of the existing macro-prudential policy toolkit in
general and also to broaden the toolkit available to the ECB in particular. One reason is that
macro-prudential policy should become a fully effective policy to smoothen the financial
cycle. This is not the case at present since macro-prudential tools to address the credit cycle
applicable to the non-banking sector are largely missing.
Recent regulatory and policy measures were targeted at the banking sector, for example -
and perhaps most crucially, within the Capital Requirements Regulation and Directive
(CRR/CRD IV). However, bank credit in the euro area is still declining and whatever froth can
be observed in some market segments these cannot be driven by bank credit. Instead,
entities in the non-bank sector - the so-called shadow-banking sector - are expanding
creditintermediation and maturity transformation activities.
Just to quote some figures, since the end of 2012, the total assets of banks under SSM
supervision have decreased by 11%, whereas investment funds of all types have increased
their asset holdings by some 30%, having doubled since 2009. The so-called
shadowbanking sector represents already more than 60% of total bank assets in Europe. Therefore,
I see a need to expand the scope of macro-prudential instruments to the non-bank sector.
Some of these measures are already available to policy makers in the U.S. and in the U.K.
Let me briefly list some of these extensions to the macro-prudential apparatus that I think are
necessary.
First, we need to improve the quality and range of data to cover the whole financial
system, in order to have credible notion of the overall development of leverage and maturity
transformation.
Second, exposures of banks to the shadow-banking sector should receive more specific
limitations. A specifically tailored treatment was missing in the Basel Committee's large
exposure rules that were agreed earlier this year. However, the EBA is currently developing
principles that will provide a basis for closer management of this activity in future.
Third, macro-prudential authorities should have the power to identify and require that
systemically important non-bank financial institutions should be subject to more
enhanced surveillance standards similar but not equal to the bank supervision regime, as
it is the case in the U.S.
Fourth, we would like to see counter-cyclical margin requirements for the extension of
credit for trading in securities markets. The Federal Reserve Board has this competence
through the so-called Regulation T.
Fifth, given the tight interaction between credit, housing and business cycles, all
macroprudential authorities should possess powers to directly regulate real estate and
housing credit. They are already available to U.K. or Irish authorities. Loan-to-value or
debtto-income limits are obvious measures that could be considered
Finally, over the-counter derivatives should be traded on exchanges or electronic
trading platforms when they are sufficiently standardised and cleared through central
counterparties - as was committed to in the Pittsburgh G20 Summit.
Conclusion
Let me conclude.
Today I have emphasised how Banking Union is an essential complement to the Monetary
Union and how it will enhance confidence and foster integration in the European financial
system.
We have made impressive progress in developing and establishing the new European
regulatory framework. The Comprehensive Assessment has made a big contribution to
increase transparency in the European bank sector and ensured a successful operational
start of the ECB's new regulatory and supervisory powers.
At this point, I believe that we will begin to see that banks are once again ready to play their
role in financing the real economy. As borrowers' demand resumes, I am convinced that
European banks will be in good shape to provide the funding that will support investment,
jobs and growth.
Nonetheless, new macro-prudential challenges seem to be building in the non-banking
sector, which have to be carefully monitored and authorities given the policy tools needed to
properly address them. The ECB would need to be entrusted with macro-prudential
instruments because only then can it be made fully accountable in ensuring financial stability
in the euro area.
Thank you for your attention.