Benoît Coeuré: Why the euro needs a banking union
Speech by Mr Benoît Coeuré, Member of the Executive Board of the European Central Bank,
at the conference "Bank funding - markets, instruments and implications for corporate
lending and the real economy", Frankfurt am Main, 8 October 2012.
* * *
I would like to thank Carmelo Salleo for his contribution to the speech. I remain solely responsible for the opinions
expressed herein.
Introduction
Ladies and gentlemen,
It is a great pleasure to be here with you this evening as part of this conference. I firmly
believe that good research underpins policy choices and, as you know, the European Central
Bank (ECB) is very committed to carefully conducted, high-quality analysis as the bedrock of
its decision-making.
Bank funding has been the focus of policy-makers' concerns for the past few years, ever
since the collapse of Lehman Brothers, which brutally reminded us all of the systemic
dimension of liquidity and funding risk. Such a cataclysmic event elicited a host of responses,
ranging from central bank interventions to prevent a meltdown of the financial system to the
design of new regulations to limit risk-taking by financial institutions. The shock was global -
and the response has been global. However, much work still needs to be done, so I welcome
opportunities such as this conference to gain a better understanding of the dynamics and
determinants of bank funding and of their implications for the financial system and the real
economy.
Our interest in bank funding, as central bankers, stems also from the fact that it touches upon
the very essence of our respective mandates. Money, remember, is the liability of the
banking system. Central bank money represents but a fraction of broad money. To ensure
that money is sound, and, in the euro area, that it is "single", we need the banking system to
be equally sound, and importantly, single.
It is against this background that I will devote my remarks tonight to the latest development in
European policy, specifically the decision to proceed with a banking union to complement
monetary union in the euro area. I will discuss the desirable components of a banking union,
towards which a single supervisory mechanism represents the first step.
The establishment of a banking union is a key factor in the completion of monetary union,
and probably a turning point in the current crisis, with profound repercussions for the financial
sector and the real economy alike.
Over the past few years, the mounting pressures in funding markets have led to a growing
fragmentation of the banking system of the euro area along national lines. Links between
banks and sovereigns have grown tighter, and in some countries the credit supply has been
negatively affected. The conduct of a single monetary policy has become increasingly difficult
as the transmission channels have become heterogeneous. This fragmentation was affecting
the whole economy of the area, and a banking union has been proposed in order to
re-establish a smooth transmission of monetary policy and ensure that the credit supply
meets the real economy's needs.
Some evidence on the fragmentation of the banking system
First of all, let me give you some evidence on the fragmentation of the banking system.
The ECB has been continuously monitoring the degree of integration in the euro area
financial markets. The latest Financial Integration in Europe report, published in April 2012,
showed several indicators pointing to rising fragmentation in various market segments as the
sovereign debt crisis has escalated.
In addition to the price-based indicators highlighted in the report, quantity-based indicators
also continue to point to a further and significant renationalisation of euro area banks' funding
markets. Banks located in peripheral countries continued to lose market funding, while those
in some other countries retained it and managed to issue bank debt at attractive yield levels.
The market for secured bank funding has also been affected by the increased tensions in
some euro area government bond markets.
Differences between bank lending rates offered to non-financial corporations and households
in euro area countries reflect divergences in bank funding conditions that go beyond
country-specific economic conditions. Let me give you a few examples.
The coefficient of variation across euro area countries of the short-term cost of borrowing for
non-financial corporations has been increasing towards all-time highs. Also, in some
countries retail lending rates have increased markedly, while policy rates have decreased.
Since mid-2011, the rate charged by the ECB on its main refinancing operations has
decreased by 75 basis points but the composite cost of borrowing has decreased by a similar
or greater amount in only 20% of cases. In another 20% of cases, it has even increased by
more than 25 basis points.
The dispersion of lending rates has risen both across jurisdictions and across categories of
enterprises. For example, the cost of short-term borrowing for corporates in France is still
around the same level as that recorded at the beginning of 2011; by contrast, in Italy, over
the same period of time, the cost of borrowing for corporates has widened by almost
100 basis points. In addition, in countries facing economic and financial distress, bank
financing conditions are tightening further for small and medium-sized enterprises. This is
particularly problematic not least because of the limited access that small companies have to
alternative sources of financing. For example, the spread between rates on small and
large-sized loans has widened further in the case of Spain and Italy: in August 2012 it stood
at 286 bps in Spain and at 188 bps in Italy, the highest levels for both countries since 2003.
All in all, we can say that the renationalisation of the credit supply, coupled with funding
pressures on both banks and sovereigns in certain countries, has weakened the impact of
monetary policy, as partly unjustified domestic spreads keep rates applied to households and
non-financial corporations higher than what would be consistent with monetary policy rates.
Why does financial integration matter so much for monetary policy?
In order to clarify why financial integration is crucial for monetary policy, let me use a
metaphor drawn from agriculture: ever since ancient times farmers have watered their fields
through a complex network of canals fed by wells or rivers. Whenever a canal was blocked,
the farmer had to act quickly to unblock it in order to save his crop. The practice of irrigation
was in fact first described in the Epic of Gilgamesh in the second millennium BC.
Credit is the water of the economy, and for the economy to run smoothly it needs to reach all
its parts in the same way. Central bank money is the well, banks are the canals and we are
the farmers. Whenever a canal of this kind is obstructed, we must find a way of restoring a
smooth supply and we must act rapidly, as without adequate credit the dynamism of an
economy quickly fades. And I should add that the Epic of Gilgamesh also describes the
damage caused by a flood, a reminder that liquidity can become destructive if it gets out of
control.
Indeed, the ECB has taken a number of measures to provide liquidity to credit institutions in
the euro area, thereby alleviating their funding needs. Such measures include fixed-rate
tender procedures with full allotments, longer-term refinancing operations up to a maturity of
36 months, the expansion of eligible collateral accepted in the refinancing operations, and
FX tenders aimed at mitigating funding costs in foreign currency. And the ECB will stand
ready to withdraw liquidity when upward risks to medium-term price stability materialise.
Right now transmission channels are obstructed for two reasons, one conjunctural and one
essentially structural.
The conjunctural reason is that sovereign spreads in some peripheral countries, which are
today the basis for the pricing of bank funding, can rise above what fundamentals would
suggest, as they reflect various concerns felt by market participants, from over-pessimistic
views of macroeconomic trends to redenomination risk.
The correlations between the yield levels of euro area bank bonds and those of the
respective banks' sovereigns are elevated and have lately increased somewhat further,
particularly in the peripheral economies. This has also been the case for credit default
swaps. This reflects a spillover effect from the sovereign market to the banking sector's
funding costs and impairs the transmission of lower monetary policy interest rates to the real
economy.
In response, the ECB has announced the Outright Monetary Transactions (OMTs) -
interventions on sovereign bond markets to repair the transmission channel when the level of
spreads hampers monetary policy transmission and reflects market's perception that the
single currency might break up. OMTs would be implemented to the extent that they are
warranted from a monetary policy perspective for countries under an EFSF/ESM
macroeconomic adjustment or precautionary programme, as long as programme
conditionality is fully respected. IMF involvement will also be sought. OMTs would not be
carried out while a given programme is under review, but they would resume after the review
period once programme compliance has been assured. The announcement of the OMTs has
reduced concerns about the materialisation of destructive scenarios. But it is essential that
governments continue to implement the necessary steps to reduce both fiscal and structural
imbalances and proceed with financial sector restructuring measures.
The structural reason that the transmission channel is malfunctioning is the tight link between
sovereign and bank funding conditions. The risk that banks' balance sheets would be
contaminated by sovereign risk was highlighted at an early stage by Barry Eichengreen and
Charles Wyplosz (1998).1 If banks are to transmit monetary policy impulses evenly, they
need broadly similar funding conditions. However, if the ultimate responsibility for the stability
of the banking system falls within the domains of individual sovereigns, clearly the two are
linked and when one of the two becomes riskier, this risk is transmitted to the other. Hence
the need to sever this link by transferring responsibility for the stability of the banking system
to the European level.
How to re-integrate the banking system: the rationale for a banking union
To have one banking system again, several measures need to be jointly implemented.
First of all, each government must deliver fiscal consolidation - this is the objective of the
Fiscal Compact that was agreed on last December. Once all sovereigns have fiscal balances
that are sustainable in the long run, sovereign spreads should narrow again - but this will
take time. In the meantime, we are facing a long transition.
Second, we need to strengthen the banking system to the point where its creditworthiness is
less dependent on that of sovereigns. Euro area banks have to improve their resilience, both
in terms of capital and of liquidity. This objective has been fostered by the European Banking
Agency (EBA), notably in its final report on the recapitalisation of European banks which was
published last week. It has revealed a significant reduction in banks' capital gap. In this
respect I would like to stress the importance of the EBA's recommendation that banks keep
high absolute levels of core Tier 1 capital, corresponding to the current 9% ratio, in the
transition to the Basel III standards.
Finally, in order to cut the ties between individual sovereigns and banks and achieve a fully
integrated banking system that mirrors and supports a fully-fledged Economic and Monetary
Union, we need to construct a banking union.
Let me first define what I mean by a banking union. It is an institutional framework which
ultimately should have three legs: a single supervisory mechanism (SSM), a common
resolution structure and a shared deposit insurance. The SSM would bring all supervisory
decisions about euro area banks under one roof, at the ECB, allowing supervisors to take
into account externalities and general exposures to systemic risk. The common resolution
structure, with a unified resolution regime and single resolution fund, would manage
efficiently the wind-down even of large cross-border banks. Shared deposit insurance would
reassure depositors that their money is safe in any euro area bank, regardless of its country
of operations or legal domicile.
These three elements, when operational, would effectively sever the link between banks and
sovereigns, and support the functioning of the EMU. Euro area institutions would be
responsible for the euro area banking system, and the euro area sovereigns as a whole
would back it. What I would like to stress here is that the banking union, agreed upon by the
Heads of State or Government at the end of June, is both a game changer for the crisis and
a leap forward for Europe. It will change the dynamics of investors' decisions. Moreover,
within the euro area there would no longer be a host or a home supervisor, and this
arrangement should ensure that cross-border allocation of capital and liquidity would be
primarily driven by business considerations. Banks' funding costs should start to indicate
again their individual creditworthiness, without the premia that reflect their sovereign's fiscal
position or redenomination risk. A common resolution fund would decrease the too-big-to-fail
problem and thus reduce moral hazard; furthermore, it would spread the burden of resolution
rather than saddling any single sovereign with it. Finally, depositors would not need to
consider shifting their funds across the continent in search of a safe haven, as all banks
would offer the same insurance coverage.
Of course, as with all structural changes and new institutional constructions, setting up a
fully-fledged banking union will take some time. The most urgent component of the banking
union is in my view the SSM, which should enter into force as early as possible in 2013 to
allow the ECB to prepare for its new tasks, with full accountability and a governance
structure that strictly separates monetary policy from supervisory decisions. I won't go into
the details of the current proposal put forward by the European Commission. For this, since
we are at a research-oriented conference, I would refer you to the report2 on the European
Commission's banking union proposals which has just been published by the Advisory
Scientific Committee of the European Systemic Risk Board.
The implementation of the SSM and the resolution structure should be closely coordinated,
which means that proposals on the latter will be needed in 2013. Yet the exact structure of
the deposit insurance scheme will depend also on what reforms are enacted after the
recommendations of the Liikanen Report,3 published last week, that aim to protect retail
depositors from excessive risk-taking by banks with structural measures that would reshape
the industry.
Common challenges to both the resolution structure and deposit insurance scheme will be to
agree on adequate ex ante burden-sharing rules between governments that provide market
participants with the right incentives while preserving financial stability, and adequately deal
with legacy issues. The final form of the banking union will appropriately reflect these
considerations, and we are confident that implementation will start as planned with the
establishment of the SSM in early 2013.
Conclusions
Let me conclude by stating once more that for monetary policy to work we need an
integrated banking system, and to have an integrated banking system we need it to be
supervised across the euro area as a whole, which will make it possible to be backstopped
by the euro area as a whole.
This is the vision put forth in the Four Presidents' Report, this is the commitment made by the
euro area governments, and the ECB supports it wholeheartedly. The monetary and the
banking union are symbiotic, and they are the logical extension of the Maastricht Treaty, both
in historical and political terms.
I look forward to a stimulating discussion and wish you a very successful conference.