Carlos da Silva Costa: From Banking Union to Financial Union -
overcoming current challenges
Address by Mr Carlos da Silva Costa, Governor of the Bank of Portugal, at the seminar
"Banking Union: The new frontier of financial regulation in the European Union", Lisbon,
25 January 2016.
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Accompanying slides can be found on the Bank of Portugal's website: Slides (PDF).
Banking Union - Where do we stand?
Where we came from: from the Single Market to the Banking Union
Underlying the Banking Union are two steps that are almost causally linked.
The Economic and Monetary Union (EMU) was established in 1999 in response to the need
for exchange rate stability, to protect the orderly functioning and integrity of the single
market. The establishment of a single currency and the adoption of a single monetary policy,
managed by a European Central Bank, resulted from the practical impossibility of reconciling
the free movement of capital with national monetary policies and exchange rate stability
under the European Monetary System. The European Monetary System was incompatible
with both the openness of economies within a single market and the existence of national
monetary policies. Indeed, even when monetary policies were aligned, the lack of confidence
over this trilemma could give rise to exchange rate fluctuations. This inconsistency led to the
1992-93 exchange rate crisis, when the magnitude of fluctuations made it necessary to
widen the fluctuation bands, which had a direct impact on intra-EU trade flows.
Following the onset of the international financial crisis in 2007-08, the limitations to the EMU
institutional framework became clear. The mechanisms in place - particularly, the Stability
and Growth Pact and the single monetary policy - were unable to prevent the build-up of
major imbalances across the euro area countries. Such imbalances resulted from excessive
indebtedness of various institutional sectors in several countries and divergent developments
in their competitive positions, amid particularly favourable market conditions, which did not
properly reflect the sovereignty of national economic policies.
The divergence in competitive positions was exacerbated most notably by: (i) the lack of both
cooperation mechanisms to monitor wage developments under the EMU and price-setting
mechanisms against a background of low inflation rates, and (ii) some disregard for the
buildup of external deficits in several countries, which could have been due to the lower severity
of external account imbalances in economic unions at a later stage of integration.
When these imbalances became apparent, the change in the markets' risk perception led to
financial fragmentation in the euro area, which affected not only the most vulnerable
economies via an inability to access external financing, but also the monetary policy
transmission mechanism itself, and, consequently, the EMU.
The fragilities brought to light by the EMU framework made its deepening inevitable, which
over the past few years has resulted in:
• The strengthening of fiscal discipline mechanisms, with the adoption of the Fiscal
Compact, the Six-Pack and the Two-Pack, and the establishment of the European
Semester as an annual cycle for policy coordination in the EU;
• The establishment of mechanisms to prevent the build-up of imbalances impacting
on the competitive position of euro area countries (the so-called Macroeconomic
Imbalances Procedure);
• The creation of a Banking Union, with the purpose of breaking the bank-sovereign
nexus, which was behind the severity of the euro area crisis;
• The establishment of a common mechanism for last-resort lending subject to
conditionality (European Stability Mechanism).
Where we stand: a Banking Union under construction
Today, we stand on undeniably stronger ground than we did before the onset of the
international financial crisis, but which is still insufficient to break the bank-sovereign nexus
and safeguard the existence of a genuine European financial market.
The remaining shortcomings result mostly from three factors:
First, the Banking Union, which is composed of three pillars, is still institutionally incomplete.
We have:
• A Single Supervisory Mechanism, which has been the single supervisory authority
since November 2014;
• A Single Resolution Mechanism, invested with resolution authority powers since
1 January 2016, but still subject to the limited funding capacity of the European
Resolution Fund;
The intention, agreed but yet to be implemented, to establish a common deposit
•
guarantee scheme.
Second, Europe lacks as yet a network of large banks established across all territories, as
country-based banking systems are still predominant. Institutions tend to have a limited
presence at EU level, while having systemic importance in the territory where their business
is concentrated. This stands in contrast to what is seen, for instance, in the United States,
where large banks with reach across the country coexist with small local banks, which are
not systemic in nature.
In the current framework of a banking union still under construction, national authorities
continue to be responsible for national financial stability, i.e. they continue to be responsible
- and therefore accountable - for the safeguarding of depositors' confidence and the
financing of the economy in their own countries. Nonetheless, they have neither the powers
nor the instruments to deal with the impact of decisions in terms of supervision, resolution
and implementation of competition rules, which are taken at European level and significantly
restrict the options available to national authorities. This limitation of powers and instruments,
however, is not perceived by the common citizen, given that national authorities - with
responsibility for national financial stability - continue to be the most visible decision maker
and communicator. The depositors' incomplete reading of the decision-making process
inevitably weakens confidence in the conduct of financial policy and in the system itself.
Therefore, European restrictions on national authorities' action, in a context where
risksharing at European level is not complete, not only hinder the safeguarding of financial
stability, but also heighten the underlying risks, affecting agents' confidence in the financial
system.
Third, in Europe, multiple entities define and implement sectoral policies with material impact
on financial system developments, especially the Single Supervisory Mechanism (and the
Governing Council), the Single Resolution Mechanism and, with regard to the
implementation of regulations and competition rules, the European Commission. These
entities are focused on their respective mandates and, in spite of the evident spillovers, their
action is not appropriately coordinated or framed within an overall view of sectoral policy for
the financial system.
In effect, both regulation and its discretionary component, i.e. the practice of supervision,
resolution and the enforcement of competition rules, have sectoral and national
consequences. These tend to be more relevant the lower the coordination is among the
different authorities and the further away the decision centre is from the territory affected by
the decisions. Such difficulties are further hindered by the absence of decision-making
mechanisms at European level which may ensure the agility, swiftness and confidentiality
indispensable for an effective banking resolution function.
The current situation poses significant challenges that require urgent reflection and action at
European level; otherwise, the growing negative perception regarding the European project
may deteriorate further.
The asymmetry between powers and accountability and the limited vision arising from the
fragmentation of responsibilities and the absence of a consistent sectoral policy at European
level give rise to perverse incentives. If these are not adjusted in due time, they may
jeopardise the sustainability of the Banking Union itself and the objectives underlying its
creation.
Where we are going: from the Banking Union to the Capital Markets Union
The Banking Union is a necessary but insufficient condition to ensure the existence of a
single European financial system, efficiently channelling savings to investment opportunities
within the European Union territory.
Given that financing in Europe is dominated by the banking system, it must be ensured that
banks are granted the possibility of securitising their credits and placing those securities with
institutional investors. On the one hand, this would allow European banks torelease funds to
finance new investment and to have alternative sources of funding in the capital market; on
the other hand, insurers and pension funds, which currently invest in long-term securities
issued outside Europe, would have the opportunity to invest in European securities.
The development of a European securitization market is hindered by the fragmentation of the
fiscal and regulatory frameworks (capital markets, insolvency, etc.) prevailing in Europe.
Although the harmonisation of national frameworks within a reasonable time frame is not
realistic, it would be advantageous, in particular for smaller countries, to develop an opt-in
European scheme that would make it possible to overcome the identified barriers.