02 November 2012

Bundesbank/Dombret: Europe cannot afford 'bumpy start' with banking union

Breaking the link between banks and sovereigns is vital to make the euro area more stable. A banking union can be a big step in that direction – but only if we harness the disciplinary forces of the market, not if we do away with them. Core elements of a banking union therefore have to be, first, a comprehensive bail-in of bank creditors, and second, an adequate risk-weighting of sovereign bonds in banks’ balance sheets.

In order to minimise the risk that bank rescues pose to government finances, creditors have to be the first in line when it comes to bearing banks losses. Implicit guarantees have to be removed as taxpayers’ money can only be the last resort. By the same token, sovereign bonds need to be adequately risk-weighted when it comes to the adequacy of capital buffers. Riskier bonds have to become more expensive in terms of the amount of equity that they tie down, as is already the case with non-sovereign bonds. This serves two purposes: Firstly, such surcharges should translate into lower demand and hence, larger spreads, which gives a disciplining signal to the respective sovereign. And, secondly, banks would become more resilient in cases of market turmoil. In addition, there should be caps on banks’ maximum exposure to individual sovereign creditors, as is already the case with private creditors.

Such enhancements of the regulatory framework need to complement the envisaged European supervisory mechanism. In principle, this single European supervisor could help to prevent future crises by enforcing the same high standards irrespective of the banks’ country of origin and by taking transnational interdependencies into account.

At the moment, it looks as though the ECB should carry out this task. This is, first of all, an expression of confidence in the competence of central banks. But conducting monetary policy and financial supervision does not come without risks. If the institution tasked with ensuring banks’ financial soundness simultaneously influences their financing conditions through its monetary policy, conflicts of interest might arise. Besides restructuring, let alone closing down banks is an intervention into property rights which requires democratic accountability. If the ECB were really to be tasked with supervising European banks, there would have to be a strict separation of monetary policy and supervision. But such a separation is difficult, from both a legal and an organisational point of view. Here, many questions still need to be resolved.

A banking union will only contribute to financial stability if its design preserves sound incentives for all the actors involved. This holds true not only for future risks, but also for risks that have already materialised. After all, a banking union is also an insurance mechanism. And as with any insurance, only future loss or damage that is unknown ex ante should be covered. Therefore, the legacy assets, these are those risks which evolved under the responsibility of national supervisors have to be dealt with by the respective Member States. Anything else would amount to a fiscal transfer. It may be that such fiscal transfers are desirable or even deemed to be necessary. But then, they should be conducted through national budgets and be subject to the approval of national parliaments, rather than under the guise of a banking union, which would then have to start under a heavy burden. And, in the event of such transfers being made, the proper sequencing of events is the key. We should not end up in a world where risks from bank balance sheets are rapidly mutualised, while an effective single supervisory mechanism would be slow in coming.

Getting the single supervisory mechanism and a common resolution and restructuring regime operational is a daunting task. Several conceptual issues have not yet been resolved. How do we deal with the 10 EU members that do not belong to the euro area? What are the specific roles of the single supervisor and of the national supervisors who do the daily work in checking about 6,000 banks in the euro area? And even when these questions have been resolved, the legal preparations both at the European level and in the Member States would be hugely demanding – as it is often the case with such large projects, the devil is in the detail.

I do not want to appear as an inveterate objectionist, even though the institution of which I am a representative is sometimes accused of that role. Rather, I am deeply convinced that Europe has to get this banking union project right and cannot afford a bumpy start. For this reason, too, a banking union will not be a quick fix for the current crisis. But it can be a major milestone towards a more stable and prosper monetary union and hence instrumental in re-establishing confidence in the euro area.

© Deutsche Bundesbank