12 November 2012

From the internal market to a banking union: A proposal by the German Council of Economic Experts

Authors: Peter Bofinger, Claudia M Buch, Lars P Feld, Wolfgang Franz, Christoph M Schmidt

Currently, two main obstacles prevent the introduction of a banking union. The first are bad assets on banks’ balance sheets. During the crisis, the share of non-performing assets on banks’ balance sheets, in particular in the crisis countries, has increased quite significantly. Dealing with these legacies from the past should remain the task of national governments. The second obstacle is the lack of an appropriate legal and institutional framework for a functioning banking union. For these reasons, the German Council of Economic Experts has developed a three-stage plan for the transition to a banking union. In each phase, liability and control are at the same level. Also, the costs of dealing with legacies from the past should not be shifted to the European level.

Phase 1: Legal and institutional preconditions

In a first step, binding deadlines for the banking union and for the transitory arrangements will be specified. This would be followed by the creation of the legal prerequisites in each individual Member State and the establishment of the European institutions. Changes in the relevant European treaties would be required in order to implement the banking union as described above. Ideally, this phase should be finished within one year’s time.

Already in this phase, financial institutions should consent to the sharing of information between the relevant authorities at the national and European level. In parallel, elements of mutualisation of risk should be reduced gradually. The ECB should, if financial market conditions allow, tighten conditions for refinancing credit gradually by conditioning access to refinancing facilities on the soundness of the financial institution in question. It needs to be ensured that such tightening of conditions for ECB refinancing is coordinated with access to ELA (Emergency Liquidity Assistance).

Phase 2: Qualification phase

In the second phase, banks qualify for entry into the banking union and for a European banking licence. Both banks and national supervisors, can apply for admittance of a bank into the banking union. In order to prevent delayed applications, a fixed deadline after which only banks with a European banking licence remain on the market will be specified. Qualification for a European banking licence involves a complete re-assessment of the value of banks’ assets – including claims vis-à-vis the government – through external experts. Also, banks obtaining a European banking licence must meet the full regulatory requirements of Basel III as well as a Leverage Ratio of at least 5 per cent of total on- and off-balance sheet activities.

European authorities can admit a bank into the banking union after the qualification phase has successfully been completed. Hence, banks would enter the banking union successively. Until banks have obtained a European banking licence, liability and control would remain at the national level. In order to prevent European authorities to be swamped by applications of possibly thousands of banks, banks would be classified into different groups according to, for example, their size. In a first phase, only the largest banks such as those currently monitored by the European Banking Authority would have to qualify for entry into the banking union. They would be followed by the mid-sized and, finally, the smallest banks. For each of these banks, group-specific deadlines for application for a European banking licence would be specified. The criterion according to which banks are classified should refer to a point in time in the past in order to prevent manipulation.

Given the continuing instabilities on financial markets, restructuring and, in particular, the winding down of large financial institutions is unlikely to occur. Authorities might fear that such an event could trigger contagion effects. This implies though that larger and potentially systemically important financial institutions in distress have incentives to gamble for resurrection. In order to minimise the risk emanating from such behaviour, European authorities established in the first phase should, in parallel to national authorities, supervise even those financial institutions for which the group-specific deadlines have not yet been reached. In particular large, global banks should be supervised by the European authorities as quickly as possible. Stress-tests can be used to determine possible capital shortfalls, and capitalisation plans to restore a sufficient volume of capital shall be developed. Care needs to be taken that such capitalisation plans do not involve the shedding of assets in order to restore a sufficient level of capital adequacy.

One objection against gradual entry into banking union could be that it might lead to a segmentation of financial markets and to a potentially destabilising shifting of deposits among banks. Yet, this concern would be mitigated by the fact that deposit insurance would remain at the national level. Hence, the explicit guarantees for bank deposits would not change if banks eventually obtain a European banking licence. Also, the general regulatory framework under which banks operate would be the same for all banks. There would be differences across banks with regard to the solvency of the fiscal authorities behind each bank and thus with respect to the implicit guarantees of banks’ deposits. This is a substantial element of uncertainty for depositors, in particular for the banks from the crisis countries. With a structured transition to a banking union, however, uncertainty should decrease rather than increase.

During the transition, it is likely to be necessary for some banks to be restructured and possibly even resolved. In particular, banks which have not applied for a European banking licence until the end of the group-specific transition phase as well as banks that have been denied a European banking licence should enter a mandatory restructuring process. If fiscal resources beyond the fiscal capacities of the government in question are necessary, the government could apply for funds for bank recapitalisation from the European Stability Mechanism. The conditions under which such funding should be granted could be related to the Memorandum of Understanding recently been specified for the case of Spain (Council of the European Union 2012), and it should particularly be ensured that existing shareholders bear losses. During this phase, the government would assume the liabilities for funds provided by the European Stability Mechanism, and the European Restructuring Authority established in Phase 1 should accompany the process. Hence, “recapitalisation” of banks does not imply the unconditional rescue of distressed banks with taxpayer’s money. Rather, recapitalisation is part of a process in which only viable banks with a sound business model remain in the market.

Phase 3: Full banking union

After completion of the second phase, supervision of all banks will rest with the European authorities. The European Restructuring Authorities will be in charge of the restructuring and resolution of banks. It can resort to funds from a European bank restructuring fund, the European Stability Mechanism and pre-specified rules for fiscal burden sharing. All banks remaining in the market would have a European banking licence; both control and liability would be at the European level. Given that Phase 1 would be completed within a year’s time, Phase 3 could potentially resume in the year 2019, i.e. in the year in which banks have to meet the new Basel III regulatory requirements.

Authors' note: This contribution summarises a proposal of the German Council of Economic Experts (GCEE) developed in its recent annual report (GCEE, 2012b). It complements previous contributions of crisis management in the banking sector (Buch and Weigert 2012, GCEE 2012a) and on the Debt Redemption Pact (Doluca et al 2012, GCEE 2011).

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