Vítor Constâncio: Banking Union - meaning and implications for the
future of banking
Speech by Mr Vítor Constâncio, Vice-President of the European Central Bank, at Banking
Union Conference, organised by the Master in Banking and Financial Regulation, Navarra
University, Madrid, 24 April 2014.
* * *
Ladies and gentlemen,
Thank you for inviting me to speak here today.
I was asked to share with you my views on the latest developments regarding the European
Banking Union: what is the meaning of what has been achieved and what are the
implications for the future of banking and the financial system in the Eurozone?
There are many good arguments to explain the rationale of building a European Banking
Union to complement the Monetary Union. I have addressed them in several recent
speeches.1 Today, I will skip the arguments related to correcting the flaws in the initial design
of the monetary union that, by keeping supervision at the national level in both creditor and
debtor countries, contributed to the large imbalances before the crisis, generated by the vast
private capital flows intermediated by banks.2 Contrary to the "it was mostly fiscal" view of the
crisis, private financial sector developments largely explain the build-up of unsustainable
current account and competitiveness positions in peripheral countries before the crisis.
The current account deficits in most peripheral countries were in fact led by very large capital
inflows coming from core countries with capital account surpluses. The exposures of banks
from core to peripheral countries more than quintupled between 1999 and 2008.
Competitiveness losses in the periphery were simply the mechanism that connected the
capital account surplus and the current account deficit - that is, an appreciation of the real
exchange rate caused by economic over-heating. As John Williamson explained long ago, it
is impossible to have "an immaculate transfer" from capital inflows to current account
deficits.3 National supervisors found it impossible to contain these developments because
they had to respect the single market rules and lacked the macro-prudential tools to offset
the effects of large capital inflows. But by introducing supervision at the European level, the
Banking Union offers a possibility to better pre-empt such developments in the future - and
therefore to better protect the real economy and financial stability in the whole area.
Today, I will concentrate my remarks on two more practical and immediate goals of the
Banking Union: (i) to eliminate the sovereign-bank loop and thereby reduce financial
fragmentation and (ii) to repair bank ́s balance-sheets, recover the impaired credit channel
and consolidate the on-going mild economic recovery. In my remaining remarks, I will
discuss some implications for the financial system's future and for the role of macro-
1
Banking union and the future of banking, speech by Vítor Constâncio, Vice-President of the ECB, at the
IIEA Conference on "The Future of Banking in Europe", Dublin, 2 December 2013; Towards the Banking
Union, speech by Vítor Constâncio, Vice-President of the ECB, at the 2nd FIN-FSA Conference on EU
Regulation and Supervision "Banking and Supervision under Transformation" organised by the Financial
Supervisory Authority, Helsinki, 12 February 2013; Towards a European Banking Union, speech by Vítor
Constâncio, Vice-President of the ECB, Lecture held at the start of the academic year of the Duisenberg
School of Finance, Amsterdam, 7 September 2012 (ECB website).
2
See "The European Crisis and the role of the financial system", speech by Vítor Constâncio,
VicePresident of the ECB, at the Bank of Greece conference on "The crisis in the euro area" Athens, 23 May 2013
(ECB website).
3
See Williamson, J., "Comment", in Bergsten, F. (ed), International Adjustment and Financing: The Lessons of
1985-1991, Institute for International Economics, 1991, p. 243.
prudential policies. I will conclude with a few words about what else is needed to complete
the repairing of our monetary union.
1. The sovereign-banks' feed-back loop
As you may remember, the whole idea of launching a single European supervisor was born
in the June 2012 Summit as a consequence of the decision to prepare direct European
recapitalisation of weak banks. The acute situation of liquidity shortage in late 2011 that led
us at the ECB to conduct two long-term refinancing operations (LTROs) with a maturity of
three years, and the continuing sovereign debt crisis convinced Member States to frontally
address the bank-sovereign link, notably by promising the possibility of European capital
injections that would not overburden the already indebted sovereigns. This naturally required
that supervision would have also to be transferred to the European level and the embryo of
Banking Union saw the light of day. Later, the Van Rompuy Report elaborated the concept
by adding a Single Resolution Mechanism and a future possible Deposit Guarantee Scheme.
In the meanwhile it was clarified that European direct recapitalisation could only happen after
the Single Supervision Mechanism would become operating and after a comprehensive
assessment of the banks' balance sheets would be conducted. This is because direct
recapitalisation would not be used to cover bad legacy assets stemming from the crisis.
Many months later, agreement was reached among Member States on the second element
of the Banking Union - the Single Resolution Mechanism (SRM) - to add to the Single
Supervision Mechanism (SSM). As the ECB underlined many times, those 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-banks' loop.
In this way, the question of direct European recapitalisation - for which a framework has not
yet been decided - ceased to be the main focus of attention. In the view of many
commentators, the Single Resolution Mechanism became the expected instrument to
achieve the separation between banks and sovereigns. This is a somewhat misleading view,
as I will explain later.
What makes the question of the link between sovereigns and banks important relates to the
fact that weak banks weakened the sovereign and the reverse was also true in the financial
crisis. Some governments had to support their national banks with significant consequences
to their own debt. In other cases, weakened sovereign with low ratings and difficulty in
accessing the financial markets, enfeebled the banks who saw their ratings tumble and their
funding become more difficult. At the same time, as the sovereign debt crisis in 2010 became
explicit and triggered contagion effects across countries, banks' holdings of domestic debt
rose, thereby increasing their dependence of the sovereign's fortunes.
These different forms of dependence created a negative feed-back loop that induced
financial fragmentation among member of the monetary union and contributed to impair the
credit channel and the transmission of monetary policy. Monetary policy interest rates were
not properly transmitted and deposit and credit rates became much too different among
countries as if we were not related to the same currency and to banks operating in a
monetary union.
The ECB did the utmost to repair the transmission of monetary policy and restore the credit
channel. The OMT initiative coupled with the development of the Banking Union project,
proved finally effective reducing fragmentation. The recent world market developments and
the perception that the tail risk of euro redenomination was overcome, contributed to an
inflow of capital looking to the European periphery, further mitigating fragmentation of
financial markets in the Eurozone.
Both components of the Banking Union, the SSM and the SRM help reduce the negative
feed-back loop between banks and sovereigns but do not completely eliminate it.
Let me start with the first building block: the SSM. One important objective of the SSM
regulation is to improve the quality of supervision and to ensure homogenous supervisory
standards across the euro area. The SSM, upon its operational start in November, will root
its supervisory work on the best supervisory practices. The general principles, processes,
and methodology for supervision will be described in the SSM Supervisory Manual of which a
comprehensive public version is being prepared.
The SSM will lead to a convergence of rules and standards and a harmonised supervisory
culture. For example, by imposing common principles about methods and models'
parameters that improve the reliability of banks' internal models it will address the problems
created by differences in the way that banks calculate risk-weighted assets. Importantly, the
SSM will ensure that the same risks are given similar weights, knowing of course that the
same types of risk can have different manifestations in different markets, in accordance with
the local economic situation. There will also be a harmonised treatment of non-performing
exposures and provisioning rules, which at present varies between jurisdictions and is not
directly comparable for investors. More generally, the substantial compliance costs, from
having to observe different sets of rules and different sets of reporting requirements, as well
as having to interact with several different authorities, will be reduced.
Direct supervision of significant banking groups will be undertaken by joint supervisory teams
that will comprise supervisors from both the ECB/SSM and National Competent Authorities,
thus enabling a fully integrated approach to the supervision of cross-border banks.
Compared with supervision at national level, this integrated approach will enable the SSM to
detect excessive risk-taking and the cross-border externalities associated with it, and to be
therefore proactive if local financial developments develop into threats to broader financial
stability.
I expect all these changes in the supervisory framework to contribute to reducing
fragmentation by creating a level playing field for financial institutions and spreading best
practices across borders, thus removing the barriers that existed in the past. Essential for
de-linking banks from sovereigns is the trust that the financial system at large will develop in
relation to the banks both directly and indirectly supervised by the SSM. This can help
normalise interbank markets and overcome financial fragmentation.
That said, high standard banking supervision is not centred on preventing bank failures at
any cost. In fact, to effectively perform its tasks, a supervisor must also be able to let failing
banks exit the market. This is the reason why the SSM has also been given the
competencies to withdraw from credit institutions, the authorisation to operate. However,
given the role of banks in the financial system and in order to safeguard financial stability, the
supervisor has to feel confident that the resolution of banks is conducted in an orderly
fashion. This brings me to the second pillar of the Banking Union.
The establishment of the SRM is the second crucial step towards addressing financial
fragmentation and breaking the sovereign-bank nexus. The main point here is that the
orderly resolution of banks, even big ones, may contribute to avoid costly rescues by
sovereigns that may endanger their own finances.
The SRM puts in place a single authority responsible for the resolution of banks in the euro
area and participating Member States. This will enable swift and unbiased resolution
decisions, which will address notably cross-border resolution cases in an effective manner. In
this respect, the SRM should be viewed as a necessary - and logical - complement to the
SSM. It would indeed be ill-advised to elevate the responsibility for supervision to the
European level, while keeping resolution at the national level. This would create a mismatch
of responsibilities, undermine the credibility of the SSM as supervisor, and delay the
resolution of banks, a task that has to be done swiftly.
An important element of the SRM is the Single Resolution Fund, which will be financed via
levies on the banking sector and gradually mutualised. Starting with national compartments,
it will become one truly single European Fund in the course of eight years. By mutualising the
cost of bank resolution, this approach will loosen the link between domestic banks and their
sovereigns and further level the playing field. A shortcoming of the SRM is the absence of a
clear common financing arrangement that would provide additional temporary resources
when needed.
However, the SSM and SRM are not enough to completely sever the ties between
sovereigns and their domestic banks. The SSM and harmonised supervision may not be
enough to build sufficient trust among banks and, on the other hand, the SRM may face legal
limitations to autonomously manage orderly resolutions of significant banks, using its own
funds. These limitations come from the Bank Recovery and Resolution Directive (BRRD)
which, in my view, is the most crucial regulatory change in Europe of late, applicable to all
28 EU member countries, and will significantly contribute to breaking the bank-sovereign
nexus. Let me explain.
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. This amount of 8% is very substantial if we
compare it to the losses which 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 by this crisis faced losses of more than 8% of its
total liabilities including own funds.
Let me first briefly describe what happens once a bank enters into resolution and how the
socalled "bail-in tool" works under the new framework. The bail-in tool follows a sequential
approach. Before any resolution fund can be tapped, shareholders and creditors have to first
absorb losses amounting to at least 8% of total liabilities including own funds. Although
uninsured deposits from individuals and small firms come last among liabilities possibly
subject to bail-in, they would be included if needed to attain the 8% total. 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 money from the resolution fund be
used and for a maximum amount of 5% of total liabilities (including own funds) of the bank
under resolution. Public resources can then be used only in case this is not enough (which,
based on past crisis experience would be exceptional).
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, in practice, should happen
exceedingly rarely. Bail-in of shareholders and creditors plus the use of the Resolution Fund
should in most conceivable cases, be enough to ultimately cover for the losses incurred by
the bank. The "Government financial stabilisation tools" that the Directive introduces are an
instrument of last resort after having assessed and exploited the other resolution tools to the
maximum extent possible. We are still far from the initial plan regarding this important
question but the goal of avoiding to burden the sovereign with banks' rescues has in practice
been achieved.
While we all agree with the objective of protecting taxpayers' money, it is important to
examine what are the implications of the new rules for the banking market and for the
sovereignty of member states. As a natural result of the backlash against banks in our
democratic polities following the huge crisis rooted in the financial system, the new
framework imposes that banks' bailout with public money is the ultimate resource after
extensive bail-in tools have been activated. I agree that bailouts, especially when
shareholders and bank management are not penalised, create moral hazard that may feed
subsequent reckless management behaviour down the road. The difficult judgment is of
course to navigate in a general financial crisis between the Scylla of moral hazard and the
Charybdis of financial collapse.
The second aspect I wish to highlight is 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, showing a remarkable
willingness to continue to deepen European integration, thus reinforcing monetary union. 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.
Another aspect of the BRRD reflecting the reluctance in the use of public money is the
disposition that foresees that a criterion to put a bank formally into resolution is that it
"requires extraordinary public support". This disposition will apply as of January next year
and will very likely be in force when the corrective supervisory action stemming from the
SSM Comprehensive Assessment will be in course of implementation. I rush to indicate that
there is a possible exemption to this rule. But according to certain interpretations, the rule is
applicable, for instance, to a listed bank that fails the baseline scenario of a stress test,
cannot raise private capital and has to request public assistance. Very likely, if such bank is
formally put into resolution it may suffer irreparable damage in the market place, further
complicating its situation and generating spillover effects on other banks.
This could mean, according to those interpretations that under the BRRD, a bank may be put
into resolution before actually attaining the point of non-viability if it just fails a baseline
scenario of a stress test. We should be mindful that resolution does not lead to resurrection
of the institution and, as seen by the market, implies deep restructuring, downsizing or even
the winding down of an institution.
The interpretations already mentioned would also imply that the public backstops for the
purposes of the SSM Comprehensive Assessment announced last November, if used, would
trigger putting the bank into formal resolution if the exemption I mentioned before would not
apply. The terms of the exemption, surrounded by several conditions, are basically
dependent on the need to avoid a serious disturbance in the economy of a Member State
and preserve financial stability. We certainly hope that in the context of such a wide-ranging
undertaking to assess the robustness and resilience of European banks, there will be
reasonable financial stability aspects to justify, in several cases, such exemption. Also, in
2015 such an exemption should have no operational implication for the bail-in rules of the
Directive as, contrary to the rest of the BRRD articles, bail-in rules will be applicable only
after January 2016. Also, the granting of such exemption would not preclude the application
of the only bail-in rule in place in 2015 which exists in the context of State Aid principles.
Therefore, it is an exemption without substantive consequences in terms of bail-in rules.
The rules now in place stem from the European Commission's communication on "State Aid
rules to support measures in favour of banks in the context of the financial crisis" of July
20144, which establishes that any public support to banks considered as State Aid should be
preceded by bail-in of bank shares, capital hybrids and subordinated debt, as mentioned.
Again, in this case, the text contemplates that exceptions "can be made where implementing
such measures would endanger financial stability or lead to disproportionate results". For
concrete cases, at the end of the SSM Comprehensive Assessment, it may be adequate to
invoke such principles.
In 2015, another potential complication may come from problems of a legal nature that can
create difficulties to the maintenance of a level playing field in the context of our exercise.
Some countries may have no national law or legal ability to implement burden sharing rules
ahead of the entry into force of the BRRD bail-in rules in 2016.
Amid these concerns, it is hoped that all the relevant legislation and related exemptions are
applied in the wake of our Comprehensive Assessment with the adequate balance between
the different values of avoiding moral hazard, assuring market discipline and level playing
field, and safeguarding financial stability.
The present situation of apparent easy access to capital markets driven by investors'
appetite to invest in banks is however reassuring. Hopefully, this situation will remain
unchanged until November so that banks that need to reinforce their capital buffers will be
able to raise money in the private market and the whole question of public backstops can
move to the background. Nevertheless, I advise all banks, besides raising adequate levels of
capital, to carefully study the new legislation on resolution and bail-in because the bank
market and even competition for capital control will be significantly affected as it enters into
force. On the other hand, investors should be incentivised to learn and interiorize the new
bail-in rules that will dominate the market for banks' securities from now on.
I want to finish this section with some general considerations concerning the delicate
judgment calls that dealing with financial crises necessarily entail. We should be reminded
that not only direct public support for banks has a cost to taxpayers but that financial
instability may imply significant costs for taxpayers. We just have to compare the worldwide
costs for taxpayers stemming from no public intervention in the case of Lehman Brothers,
with zero cost for taxpayers following the USD 700 billion injection in US banks to rescue
them in 2008, which have by now been totally repaid by the banks. Financial instability can
have a meaningful cost to taxpayers even if that it is not visible in the very short term, a
notion that all policy makers should keep in mind. Obviously, to avoid moral hazard, any
intervention should penalise shareholders and managers appropriately as it was done in the
exemplar case of the Nordic banking crisis, where financial and economic collapse was
avoided with, in the end, virtually no costs for taxpayers when the restored banks were sold.
After the financial crisis and the misbehaviour of several institutions, which by the way, is still
being uncovered, the change of culture from easy public bailouts to a new culture of private
bailing-in is justifiable and I support that trend. The burden of proof should be put on those
who want to invoke exemptions to the new approach. However, for those of us able to
understand the externalities to the whole economy and society that a financial crisis can
generate, balanced and complex judgements have always to be applied. A distinction has to
be made between how to deal with a few individual cases and the way to address the risks of
generalised financial crises. The new European legislation contemplates the necessary
exceptions that, as a last resort, foresee interventions that can safeguard financial stability in
a Member State or in the area as a whole. I trust that the new legislation will be applied by
the competent authorities with rigour, wisdom and a sense of proportion in the aftermath of
our Comprehensive Assessment.
2. Banks' balance-sheet repair and the economic recovery
I turn now to the implications of Banking Union for other economic aspects. Some
economists are of the view that negative developments in bank credit in the Eurozone are
predominantly due to credit supply restrictions linked with insufficient capital to absorb losses
supposedly still unrecognised.5 This view is not entirely correct. We have observed a marked
increase in banks' capital ratios since the beginning of 2009. Since the onset of the global
financial crisis, the top 20 European banks have increased capital in dollar amounts, net of
share buy-backs, by much higher numbers than the corresponding top 20 American banks:
USD 289 billion by EU banks against USD 179 billion by US banks. And according to the
FDIC, the leverage ratios of the biggest European banks, calculated according to the same
accounting standards, are very close to their American peers.6 Since mid last year in
particular, European banks have implemented write-offs and increased provisions and
capital, partly anticipating the Comprehensive balance-sheet Assessment that the ECB is
conducting this year. As a result, confidence in the euro area banking sector is now starting
to rise. This development has been recognised by the stock market where banks' share
prices increased by 41% in 2013, above market average growth of 20%.7
Nevertheless, the task of bringing back confidence in the EU banking sector is still underway.
This is why the Banking Union, and in particular the Comprehensive Assessment of banks'
balance-sheets, is so important. It will trigger corrective supervisory action where it is needed
and dispel any remaining doubts about asset valuations and the corresponding level of
provisions. This in turn, will help bring the deleveraging process in the banking sector to a
swifter conclusion.
In the short-term, this may have a pro-cyclical effect. However, a fast and targeted rebooting
of the banking system could have two positive effects going forward.
The first effect is cyclical. A well-functioning banking sector will support the transmission of
our monetary policy in all parts of the euro area, thus helping observed growth to rise
towards potential growth and the output gap to close. This is because, on the asset side,
banks that are restructured and recapitalised will no longer have incentives to ration lending
towards smaller firms with higher capital charges. And on the liability side, as they gradually
reach their target loan-to-deposit ratios through raising deposits, the funding costs between
banks in the core and periphery of the euro area will further converge.
The second effect is structural. To the extent that the Comprehensive Assessment helps
fixing the bank lending channel and ends the so-called "ever-greening" of loans8, it will
support an efficient credit allocation process. This could in turn support the overall process of
reallocation within the euro area economy, thus boosting productivity and possibly reversing
the slowdown in potential growth.
Nevertheless, a word of caution is warranted in the sense that a sudden jump start of credit
growth may not result immediately. Recent behaviour of credit is not explainable only by
credit supply restrictions, but it is largely linked to lack of demand. Completing banks'
balance-sheet repair is thus a necessary but not sufficient condition to consolidate the
ongoing recovery.9 The weak domestic demand outlook prevailing in the Eurozone combined
with slack industrial capacity is the most important explanation for the drop in private
investment during the crisis, and the most important limiting factor for higher growth.
6
"Basel III Capital: A Well-Intended Illusion", remarks by FDIC Vice-Chairman Thomas M. Hoenig to the
International Association of Deposit Insurers, 2013 Research Conference in Basel, Switzerland.
7
Changes in banks' share prices and overall stock market in the euro area (from early April to end 2013).
8
Although the identification of "evergreening" practices is challenging, a large number of analyses have been
conducted on this issue, looking at Japan's "lost decade". See, among others, Caballero, R., T. Hoshi and
A. K. Kashyap (2008), "Zombie Lending and Depressed Restructuring in Japan", American Economic Review,
Vol. 98, No. 5. One more recent study looks at the global financial crisis and identifies lending patterns
consistent with evergreening practices, although limited to smaller banks; see Albertazzi, U. and D. Marchetti
(2010) Credit supply, flight to quality and evergreening: an analysis of bank-firm relationships after Lehman,
Bank of Italy Working Paper No. 756.
9
See "Growing out of the crisis: Is fixing finance enough?" ,speech by Vítor Constâncio, Vice-President of
the ECB, at the Annual Hyman P. Minsky Conference on the State of the US and World Economies,
Washington D.C., 10 April 2014 (ECB site).
3. Other important effects of the Banking Union
I believe the on-going overhaul of bank supervision and resolution frameworks will have
implications that go well beyond the primary objectives of financial stability and completion of
the monetary union. I will focus on three aspects.
Further integration of the European banking market
The first effect is the probable consolidation of the European banking sector. Some
restructuring in the euro area banking sector has already been on-going since 2008. For
example, in net terms the number of credit institutions has fallen by 9% since 2008, or
around 600 institutions, while total assets of the euro area banking sector have declined by
almost 12%. However, this consolidation was more due to retrenchment than to active M&A
deals in the industry, which have instead been rather weak. From 2008 to 2012, the overall
value of deals decreased fourfold to just EUR10 billion, with cross-border deals being the
most affected. Yet, the Herfindahl-Hirschman concentration indicator for the euro area banks
remains, at the 690 level, well below the 1600 level above which concentration becomes
detrimental, which means that there is margin for further efficiency-driven consolidation. The
weak profitability and excess capacity of the European banking sector also suggests that
efficiency gains could be reaped from more consolidation. This, together with the on-going
repair of bank balance-sheets, should set the stage some time down the road for a new
phase of M&As geared towards improving efficiency.
It seems likely that the Banking Union will create the conditions for further integration of the
European banking market. Unified supervision should create greater trust among banks and
cross-border banking groups will be able to optimise their internal management of capital and
liquidity and reduce compliance costs. On liquidity and capital, we expect hidden barriers to
disappear and allow their management at the level of the whole SSM space. A movement to
subsidiarisation that we observe in other parts of the world has no justification inside the
SSM perimeter. In this context, it is only natural that the establishment of the SSM and the
Comprehensive Assessment of banks' balance-sheets could open to a period of general
restructuring in the European banking sector spontaneously driven by market forces.
Enhancement of the capital markets role
In the euro area, banks have historically played an important role in financing the real
economy. Bank loans account for most of household borrowing and around 50% of
nonfinancial firms' external financing, which is very different from the US where around 75% of
firms' financing comes from capital markets (equity and debt securities). However, recent
evidence from the euro area and the US suggests that corporate bond financing was an
important alternative to bank financing during the financial crisis, when banks were unwilling
or unable to lend, mostly reflecting pressure to de-lever.10 Although these pressures have
eased and the economic recovery is beginning in Europe, I expect the move towards more
capital market-based intermediation to persist going forward. One reason is that the new
regulatory environment gives banks incentives to hold marketable, liquid securities, such as
corporate bonds or asset backed securities, as opposed to corporate loans. This will, in my
view, increase the complementarities betwe