Vítor Constâncio: Towards a European Banking Union
Lecture by Mr Vítor Constâncio, Vice-President of the European Central Bank, at the start of
the academic year of the Duisenberg School of Finance, Amsterdam, 7 September 2012.
* * *
1. Introduction
Ladies and gentlemen,
I feel honoured to have been invited to the opening ceremony of the Duisenberg School of
Finance, a prestigious name that evokes the first President of the European Central Bank
with whom I had the privilege to work in the initial stages of the launch of the euro as a
member of the Governing Council. My presence here today is also a simple gesture to
render my homage to his memory as a great contributor to the European ideal.
I would like to focus my remarks on the underlying reasons for the decision to set-up a Single
Supervisory Mechanism as a major step towards a European Banking Union that was taken
at the European Summit in June 2012.
What is the meaning of a Banking Union? In my view it involves a transfer to the European
level of the regulatory and institutional framework responsible for safeguarding the
robustness and stability of the banking sector.
The first pillar is regulation. It is already largely at the European Union level, particularly with
the concept introduced by Tommaso Padoa-Schioppa of the "single rulebook" for the
27 Member States, which is based on the principle of maximum harmonization coupled with
a wider use of directly applicable regulations.
Accordingly, what is now at stake in forming a Banking Union goes much further. It implies
also achieving a European dimension for the main components of the institutional framework
for implementing, monitoring and enforcing regulation, both in normal times and in situations
of stress. According to theory and historical experience, this includes: Bank Supervision,
Bank Resolution and Bank Deposit Insurance. These are precisely the components of the
Integrated Financial Framework that has been presented to the June European Council by
President Van Rompuy in his Report "Towards a genuine Economic and Monetary Union".
I would like to be clear that I refer to providing a European dimension to the institutional
framework and not to a centralization of the competences pertaining to a Banking Union.
Even a fully federal system implies, by nature, decentralization of tasks between the federal
and the lower levels. In Europe, subsidiarity and proportionality are key constitutional
principles in the exercise of European competences, which are particularly crucial for a
well-functioning Banking Union.
The June Euro Area Summit initiated the construction of a Banking Union with the agreement
on the establishment of a Single Supervisory Mechanism, with the involvement of the ECB.
The reference to the ECB and the statement that the Commission will "bring forward
proposals under Article 127 (6) of the Treaty" mean that there is a direct link to EMU. As it is
well known, Article 127(6) provides that the Council by unanimous vote may "confer specific
tasks upon the European Central Bank concerning policies relating to the prudential
supervision of credit institutions." Accordingly, the single supervision will refer mainly to the
euro area as the ECB can only have binding powers in relation to the 17 members that have
adopted the euro. The focus on EMU is appropriate for several reasons, which I will
elaborate in my remarks. However, this does not exclude possible mechanisms for other
EU countries to be involved in the single supervisory mechanism, if so foreseen in the
Council Regulation activating Article 127.6 of the Treaty. This could facilitate further financial
integration in the single market as a whole.
The Statement of the June Euro Area Summit also makes clear that the single supervisory
mechanism is directly related to the decision to grant the possibility of direct recapitalization
of banks by the European Stability Mechanism. This new and important step in the effort to
de-link the vulnerabilities of sovereigns from euro area banks implies an allocation of
supervisory functions to the European level. Therefore, European recapitalization creates an
immediate need for European banking supervision. Later in this talk, I will argue why I think
that there are very good reasons for the involvement of central banks in the supervision of
banks. It is essential that both of these elements - recapitalization and supervision on the
European level - are implemented as expediently as possible.
2. Why the single monetary policy needs a Banking Union
The decisions taken at the June Euro Area Summit are part of the long term reflections on
the future of the Monetary Union, which are addressed by President Van Rompuy Report.
They are also clearly motivated by the challenges that we face in addressing the ongoing
crisis. The recognition of the negative effects of the feedback loop between banks and
sovereigns led to the decision to admit direct European bank recapitalization by the ESM.
This, in turn, motivated the decision to create a single supervisory mechanism.
The deeper rationale is however the need to construct a Banking Union for ensuring a
successful and well-functioning Monetary Union. Let me highlight the following arguments
supporting this concept.
First, a single supervisory mechanism is necessary because of the increasing
interconnectedness between financial institutions and markets across the euro area over
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
Seen from another perspective, the high degree of interconnectedness affects the impact of
supervision and other national policies not only on the domestic banking sector, but also, as
an externality, on other countries. 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 a "financial trilemma" has been defined, which illustrates the impossibility of
achieving three objectives in an environment with globalized financial markets. These
objectives are: first, financial stability; second, financial integration; and third, maintaining
national financial policies.
[Slide 1: The financial trilemma]
According to the financial trilemma, it is not possible to achieve all three objectives at the
same time. The reasoning behind is that with increasing financial 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.4 This leads to an under-provision of financial
stability as a public good.5 A lesson of the trilemma is 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.
Second, the events of the past few years have demonstrated that Monetary Union in Europe
requires a high degree of financial integration, in which financial institutions diversify their
assets and liabilities across euro area countries. This is essential for an effective
transmission of monetary policy. Until the start of the financial crisis and in particular until the
beginning of the sovereign debt crisis, there was good progress in all aspects of financial
integration. Unfortunately since then we have been facing a continuous development in the
opposite direction with fragmentation of markets along national borders. Even more than
that, we observe a reversal of flows with capital going to core countries and away from the
periphery.
One example of very quick initial integration was the euro area money market which
nevertheless has shown recently a much higher dispersion of rates, reduced cross border
volumes with a virtual stop to peripheral countries. Chart 2 illustrates how quickly and
profoundly interest rates in the short-term money market converged after 1999 and how the
dispersion exploded following the crisis.
[Slide 2: Convergence and fragmentation of money market rates]
Money markets trade an extremely homogeneous good - central bank money -, and the
changes made to the infrastructure (payment systems) were sufficient to establish a unified
market with a single price. In other market segments, prices somewhat converged, but not
fully. We are all aware how an exaggerated initial convergence of sovereign bonds yields
changed into an abnormal dispersion.
[Slide 3: Evolution of sovereign bond yields]
Also, remuneration of bank deposits or interest rates paid on corporate loans for instance,
started to diverge markedly across countries. At the same time, banks have started to
reverse the diversification of their portfolio across borders in recent years, especially in
detriment of stressed countries.
[Slide 4: Cross border credit exposures and cross-border share of assets]
In general, the crisis led to more disintegration. This can be seen for instance in the right
hand chart, which illustrates the importance of foreign bank subsidiaries and branches in the
total assets of the banking sector: there was a steep increase in integration in the first years
of the euro, but after the Lehmann failure, integration declined consistently.
Imperfect financial integration in a currency union of course complicates the task of the
central bank in a very direct way: it becomes more difficult to achieve similar impact in the
transmission of monetary policy and to ensure uniform levels of interest rates across
countries. Thus, the tendency towards less financial integration has unwanted effects also for
the conduct of our monetary policy. It is essential to reverse this fragmentation and restore
the proper transmission mechanism of monetary policy. This does not imply that we should
eliminate or artificially reduce the spreads of debt instruments across countries that are
justified by pure credit risk. However it is certainly within the remit of monetary policy to
intervene to mitigate risk premia that are related with fears of a break-up of the euro area and
have been identified in several analysis.6 This provides the rationale for the new programme
of Outright Monetary Transactions (OMT) that we announced yesterday. A necessary
condition for OMT is strict and effective conditionality attached to an appropriate European
Financial Stability Facility/European Stability Mechanism (EFSF/ESM) programme. The joint
work of conditionality and bond market interventions can achieve, we hope, the elimination of
the tail risk linked with a break-up fear that has been pervasive in the aggravation of the
sovereign debt crisis.
Besides supporting an effective monetary policy, a Banking Union - comprising single
banking supervision, common resolution schemes, and a unified deposit insurance - would
further foster further the integration of the single financial market. It is my conviction that
these elements would not only support the conduct of the single monetary policy, but also
significantly contribute to breaking the home-bias in banking activity and to allowing banks to
further diversify their portfolios across the euro area. Last but not least, a Banking Union will
also contribute to the vital delinking of sovereigns and banks that has been so detrimental
during the crisis.
third
The reason why a Banking Union is beneficial to a Monetary Union is that the natural
bias of national supervision, both in lender and borrowing countries, allowed the creation of
large macro imbalances in several segments of the euro area. Indeed, a major lesson of the
crisis is that financial supervision lagged behind financial integration and this contributed to
the build-up of macroeconomics imbalances. Let me illustrate this with a few numbers.
[Slide 5: Evolution of public debt levels]
This chart shows the evolution of public debt levels since the inception of the euro in 1999 of
a few selected euro area countries. As it can be seen, and perhaps contrary to public
perception, overall government debt levels went down in the first years of Monetary Union,
that is, in the period 1999 until 2007, by around 5.6%. Notably, we can see significant
reductions in Italy (-14.8%), Spain (-35.3%), and Ireland (-10%). The resulting debt levels of
several countries were still high in 2007, and in two cases far above 60%. Still, it cannot have
been the overall increase of public debt alone that led to the eruption macroeconomic
imbalances. It was the crisis, as can be seen from the chart that led to sharp increases of
public debt across all countries only after 2008. The dangerous feedback effects between the
state of sovereigns and their local banking systems emerged only after the start of the
financial crisis. It operated in both directions: either the support of banks overburdened the
sovereign or the sovereign weakness led the domestic banks to take on more recently a
higher share of national public debt.
This is seen in the following chart that shows the pattern of domestic banks ́ holdings of
national debt going down until 2009 and then increasing afterwards.
[Slide 6: Public debt held by domestic banks]
An aside aspect shown by the chart is that public debt was not taken predominantly by the
domestic banking sectors until 2009 as the domestic share declined until then, indicating the
progress of financial integration across member States during many years. To understand
what happened in the run up to the crisis it should be highlighted that until 2007 the evolution
of public debt in the countries now under stress was financed mostly by external investors
and not by resident financial institutions.
Another aspect that is sometimes also ignored refers to the fact that the banks' portfolio of
domestic public debt is not very high in percentage of total bank assets and even now is
generally below the historical average.
[Slide 7: Public debt held by domestic banks in % of Total Assets]
The points I just made seem to run counter to the idea that the macro imbalances in
peripheral countries was mostly driven by the public sector. As seen in the charts, with the
possible exception of Greece, that seems not to have been the case. I will show in a moment
that the imbalances came mostly from the private sector expenditure behaviour laxly
financed by the financial sector. This fact is in turn connected with another major lesson of
the crisis that reveals also a shortcoming in the initial design of the monetary union: the
notion that it was enough to discipline public finance, through the Stability and Growth Pact,
to avoid major imbalances in the euro area.
This mistake is surely related to two features of the dominant economic thinking at the time:
• that the private sector is essentially stable and self-correcting composed of fully
first
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.
• 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.
Later, in the new Keynesian consensual macro model money crept back in through
the introduction of wage and price rigidities, allowing for short-term real economy
effects of monetary policy. On the contrary, finance became invisible with the
Efficient Market Hypothesis ensuring a reliable plumbing as servant of the real
economy. Banks and their credit activity and capital markets and their financing
were not considered significant sources of instabilities with real economy effects.
They were absent from macroeconomic models.
This vision about the way the economic was supposed to work was discredited with the crisis
but surely influenced the initial concept that it was enough to discipline the public sector. We
know that in the end the SGP did not ensure that discipline and some countries deviated
from prudent fiscal policy. Nevertheless, what was more relevant to explain the macro
imbalances relates to the explosion of private debt in the peripheral countries financed by
domestic banks which were themselves mostly funded by other European financial
institutions and markets.
[Slide 8: Public and Private debt]
Contrary to public debt levels, the overall level of private debt increased in the first seven
years of Monetary Union by 14 percentage points or 27%. The increase was much more
pronounced in Greece (+217%), Ireland (+101%), Spain (+ 75.2%), and Portugal (+49%), all
of which are countries that have been severely under pressure during the recent crisis.
Another illustration of the role played by private indebtedness is provided by an analysis of
the evolution of the financial balances (savings-investment) of the different economic sectors
including the external one.
[Slide 9: Financial balances by sector]
The Chart shows how in Spain, Ireland and Portugal it was the increase in the deficit of
non-financial firms until the onset of the crisis that contributed, in turn, to the increase of the
external deficit, whereas in Greece the public deficit had a bigger influence.
The willingness of banks, domestic and foreign, to fund private agents was essential for the
creation of the large macroeconomic imbalances and the housing price bubbles that we have
witnessed. These were fuelled by excessive credit growth. This also implies that supervisors,
at least in some areas, appeared to have been overly lenient with the banking sector. To
some extent, this is due to the promotion of national champions and the objective of
supporting the local banking system. Some empirical support for this line of argumentation
comes from the US. A recent study shows, for the US, that local supervisors tend to be more
lenient with banks than federal supervisors are: they downgrade less frequently.7 The
authors justify this behaviour, among other factors, by regulatory capture. And indeed, there
is no reason to believe that these findings would be any different for other industrialized
countries, including the euro area. Therefore, following this argumentation, placing
supervision at the European level would help to alleviate national bias and possible
regulatory capture.
3. The ECB's involvement in a Banking Union
There are good reasons developed in the academic literature for allocating the task of
banking supervision either to the central bank or to a separate supervisory authority. Some of
these arguments have already been put forward in a 2001 paper of the ECB, which
concluded that national central banks should have a fundamental role in prudential
supervision in the euro area.8
Let me turn first to the benefits of allocating supervisory powers to the central bank.
•
A first argument why the combination of both supervision and monetary policy under
one roof is beneficial results from the fact that being responsible for monetary policy
creates for the central bank an intrinsic and deep interest in a stable financial
system. Such stability can be jeopardized through the failure or break-up of an
individual financial institution. If a banking failure occurs, the financial system might
be destabilized through contagion which could arise through several possible
channels: one such channel could be through bilateral exposures to the failing
institutions. Other channels could be related to informational contagion such as
uncertainty about such bilateral exposures, or uncertainty about the nature of the
shock that hit the institution. Moreover, those direct channels might be amplified if
resolution mechanisms are complex, lengthy or surrounded by too much
uncertainty. A central bank has an interest in avoiding the risk of such a destabilizing
situation because of its mandate for price stability: since the transmission of its
monetary policy relies in the first instance on the smooth functioning of the money
markets. Money markets are, however, one of the first markets to be affected if
there are doubts about the solvency of an institution. This was clearly witnessed in
August 2007, when the emergence of first doubts about the exposure of individual
European banks to the US sub-prime mortgage market led to a temporary standstill
of that market.9
•
Second, there is a close relationship between micro-prudential control of individual
financial institutions and the assessment of risks to the overall financial system,
which constitutes the central bank's macro-prudential responsibility. Even in those
countries where the central bank is not involved in individual bank supervision, the
central bank's responsibility for systemic stability is unchallenged. This is one
reason why the European Systemic Risk Board (ESRB) that was established in
2010 with a mandate for macro-prudential oversight, is chaired by a central banker
(the President of the ECB). The assessment of systemic risk would quite naturally
be facilitated if supervisory information about individual institutions was used.
•
Further information-related synergies exist between the supervision of banks and
the oversight of payment systems, which is a task usually allocated to the central
bank. The ECB, for instance, is responsible for the oversight of all large-value
payment systems operating in the euro area. Moreover, it is the owner of the largest
of those systems, the TARGET2 system.
•
Fourth, central banks have a lot of expertise on the financial sector, because of
their role in monetary policy and oversight as well as their general interest in
financial stability. These roles imply a constant monitoring of different segments of
the financial market in order to assess the transmission of monetary policy impulses,
regular interactions with counterparts to their monetary operations, and operational
and oversight activities in large-value payment systems. Such knowledge is likely to
be crucial in situations of financial stress, and enables central banks to be able to
assess such situations more quickly and profoundly than other institutions with
different mandates and functions. Thus, if a central bank were entrusted with
supervisory powers, it would be able to react relatively quickly in case of an
imminent banking failure.10 This ability would be particularly relevant in financial
crisis times, in which a number of institutions would be on the brink at the same
time, but in which there is great uncertainty about the depth and impact of the crisis
in general, and about individual banks' solvency in particular. Such a situation would
require particularly careful monitoring and expertise, which the central bank is in a
relatively good position to deliver. I would like to stress that also in the case that the
organizational structure of the central bank was such that the tasks of monetary
policy and supervision were operationally strictly separated, the transfer of such
knowledge about the state of different financial market segments could be
institutionalized quite easily.
•
A fifth argument is that the operational independence of the supervisory agency is
important for effective supervision. Here, I refer to independence from political
interference, and I have in mind situations in which local politics may have an
interest in the avoiding bank resolutions for political reasons. This independence
would be emphasized by allocating the supervisory responsibility to the central
bank.
Let me now turn to arguments about potential downsides of having central bank
involvement in banking supervision? The following arguments have been made in the
literature:
1. First, there is the issue of reputation risk of the central bank (an argument brought
forward by Charles Goodhart):11 the monetary policy function of the central bank
requires that it maintains a high level of credibility and reputation, since it is essential
to keep expectations of rising inflation at bay. According to this argument, if the
central bank is in charge not only of price stability but also of banking supervision,
poor supervisory performance (in particular, the occurrence of banking failures with
notable economic consequences) would damage the reputation of the supervisor,
and this may damage also the central bank's reputation as a competent monetary
authority. This could endanger price stability, the central bank's main concern. In my
view, this risk is overemphasized. The tasks of maintaining price stability and of
supervising banks are very different in nature, and their results are easily
measurable and distinguishable. If a central bank has a record of having achieved
price stability over a longer period of time, then instability in the banking sector might
complicate its price stability mandate, but it would not create doubts about its
commitment to further pursue this task. I am fully convinced that the public will be
able to distinguish between the two functions, and that repercussions from the
reputation gained in one or the other function would be minimal.
2. A second argument against allocating supervisory powers at the central bank
concerns possible conflicts of interest between the different central bank
functions. At the heart of this argumentation is the question whether the central
banks' concern for the health of banks would jeopardize its price stability objective. It
could do so for instance by creating an environment of low interest rates with the
aim of supporting the banking sector's health, or by using its capabilities for money
creation to support individual banks. However, is it really conceivable that a central
bank that is in charge of banking supervision takes these routes? To me, the
solution to these concerns lies in the organizational structure of the central bank. A
situation, in which the central bank puts at risk price stability in favour of financial
stability, is not conceivable if the central bank is given a clear hierarchical mandate
that places price stability before other concerns. Internal procedures can be, and
should be, designed in a way that this is efficiently implemented. Of course, central
banks may in crisis times be involved in lender-of-last-resort functions. But they
might take on this role regardless of whether they have a supervisory mandate or
not. And I should emphasize that such forms of liquidity support would in any case
be very limited both in its frequency - central banks should take on this role only in
case of a severe financial crisis - as well in duration. These limitations, connected
with a recessionary situation, ensure that extended liquidity support would have no
inflationary impact.
In practice, the allocation of supervisory responsibilities is handled very differently across
countries, even within the euro area. At present, a majority of euro area central banks, that
is, 12 out of 17 National Central Banks have full supervisory powers while 2 others are also
involved in supervisory tasks.
Around a decade ago, the situation was quite different, and there was a tendency towards
separation of the two functions. The recent trend, however, points towards combining both
functions under one roof. This trend reversal can be observed also outside the euro area. For
instance, in the UK, the FSA was founded in the late 1990s, but recent proposals aim at
re-allocating it under the umbrella of the Bank of England. In the US, the FED was also given
an extension of its mandate regarding supervision.
Indeed, the experience during the financial and sovereign debt crises has demonstrated the
benefits of including banking supervision under the central bank's purview.
4. Elements of a Banking Union
All the arguments I summed up above support the notion of having a supra-national, euro
area wide supervisory authority.12 As I have argued, this would be beneficial in order to
foster further financial integration, to deal with the high degree of connectivity between
financial sectors across borders, and would break the close link between banks and their
sovereigns.
The precise set-up of the future supervisory arrangements is still to be decided. Let me
express my personal views on the main principles that should guide such arrangements in
order to achieve the objectives that I have outlined.
First, it is crucial to ensure that there are no loopholes of supervisory responsibilities. The
euro area supervision should be conferred with a complete set of tasks and responsibilities,
in a clear and unambiguous manner.
Second, as I mentioned at the beginning of this talk, supervision should be conducted in line
with the principles of subsidiarity and proportionality. This implies that the operational
conduct of supervisory tasks should be decentralized to the largest extent with national
supervisors. Ideally, the single supervisory mechanism will consist of a network comprising
the ECB and national supervisors.
Third, supervision should encompass all euro area banks in a way that the home/host
distinction will cease to exist in the euro area, where all banks will become "domestic",
equally subject to euro area supervision. This is essential from a supervisory and financial
stability perspective, as well as to preserve the level-playing field among banks. The fact that
the ECB would have ultimate legal responsibility does not imply that all banks will be
supervised from Frankfurt and that the ECB will have to hire an army of supervisors. The
degree of intensity of supervision at the centre will be closely related to the systemic
relevance of banks. In this framework, the ECB would be closely supervising only the
significant cross-border banking groups. Local supervisors, operating under the umbrella,
guidance and monitoring of the ECB, would conduct the supervision of the overwhelming
majority of credit institutions. Crucially though, the ECB would maintain, the ultimate legal
responsibility, which would include the right to exercise at any moment a closer supervision
of any institution or group of institutions if it finds it appropriate. This approach would ensure
the harmonization and the level playing field in the implementation of the single supervisory
mechanism and will be enough to overcome any inefficient national bias in conducting bank
supervision.
Fourth, as I also argued already, there should a clear organizational separation between
monetary policy and supervision. This can be realized at all organizational layers, from the
analytical and informational level to the decision-making level. In a recent interview
Commissioner Barnier referred that the Commission ́s proposal includes the creation of
Supervisory Board in the ECB which goes in the right direction.
Fifth, euro area supervision should be conducted in independence, in line with the
Basel Core Principles, and also be subject to high standards of democratic accountability to
ensure confidence in the conduct of this public function in the euro area.
Sixth, the single supervisory mechanism should contribute to the deepening and
reinforcement of the single financial market. This implies that the role of the EBA should be
fully safeguarded as regulator and as the entity responsible for monitoring the
implementation of the "single rulebook" by all supervisors.
The euro area supervisory jurisdiction will need to be matched by two further institutional
evolutions.
The first of these is the move towards a Quite naturally,
unified bank resolution scheme.
this is an integral element of the Banking Union, which must have a resolution authority to
close or restructure banks whenever appropriate. Again,