12 March 2013

ECB/Cœuré: The way back to financial integration

Cœuré said that the banking union, together with the new regulatory standards, would help to mitigate the financial stability risks which arise when markets become more integrated, and which the previous regulatory and supervisory framework had failed to avert in the period leading up to the crisis.

Cœuré considered developments in the degree of financial integration in the euro area. He also  discussed how progress in financial regulation and supervision can also benefit financial integration in Europe, in addition to making the financial system more resilient..

Surely, most economists would agree that international financial integration is by and large beneficial. This is for several reasons. First, stable, integrated and adequately supervised markets facilitate an efficient allocation of resources, both over time and across national borders, enabling investors to fund profitable investment opportunities whenever and wherever they arise. Second, financial integration allows the inter-temporal smoothing of consumption in response to occasional income shocks, and the diversification of households’ financial assets, protecting their revenue against shocks to their labour income. This second reason is of special importance in a monetary union, where the stability of the single currency requires adequate risk-sharing mechanisms through goods, labour and capital markets. Third, a higher degree of financial integration enhances competition among financial institutions as well as among financial market infrastructures and reduces the costs of financial intermediation.

It is clear to us that a strong and independent supranational supervisor will contribute significantly to the smooth functioning of the monetary union and to restoring confidence in the banking sector. Regaining such confidence, in turn, is also key to reversing financial fragmentation and restarting fully functioning cross-border markets.

The main objective of the banking union is to build an integrated framework that safeguards financial stability and minimises the cost of bank failures. Indeed, the banking union, together with the new regulatory standards, will help to mitigate the financial stability risks which arise when markets become more integrated and which the previous regulatory and supervisory framework failed to avert in the period leading to the crisis.

A complete banking union requires four building blocks.

The first building block is the establishment of a single rulebook. Such a single rulebook now exists with the agreement reached on the Capital Requirements Directive IV. The single rulebook sets guidelines for capital, liquidity and compensation policies, and contributes significantly to creating a level playing field for financial institutions across borders.

Second, the Single Supervisory Mechanism (SSM) will enforce supervision consistently across the participating Member States. The SSM will be a mechanism composed of national competent authorities and the ECB, with the possibility of non-euro area Member States also taking part. The process of establishing the SSM is under way, with the Council’s proposal forming the basis for the current discussion at the European Parliament.

A third element of the banking union will be the establishment of a Single Resolution Mechanism (SRM) and a Single Resolution Authority (SRA). The Single Resolution Mechanism would build on the harmonised resolution framework, as provided for in the draft Bank Resolution and Recovery Directive, and on the existence of a single resolution fund financed by the industry. It would enable prompt and coordinated resolution action, specifically where cross-border banks are concerned. For there to be a complete banking union there has to be a credible fiscal backstop. Any call on this backstop should be compensated ex post by levies on the financial industry. Indeed, the SRM is not about bailing out banks with public money. Instead, it is about minimising the use of public money. A credible backstop will be very important in respect of one goal of the banking union project in particular: mitigating the negative feedback loop between banks and sovereigns.

Looking further ahead, the fourth element of the banking union should be the establishment of a common system of deposit protection. This framework should enable the national deposit guarantee schemes, built on common EU standards, to interact with the SRM. A European deposit guarantee will undoubtedly be important in the future to ensure depositor confidence in the robustness of all European banks.

I see at least four main ways in which the European banking union, when fully implemented, can support broad and stable financial integration in Europe.

First, achieving both financial stability and financial market integration may not be possible under national financial policies, or at least much more difficult. This is the so-called “financial trilemma” of Schoenmaker, which states that policy-makers can only choose two out of the following three objectives: financial stability, financial integration and national financial policies, such as bank supervision and resolution. One of these has to give way. National financial policies fail to recognise the externality generated by cross-border banks in difficulty. As a result, they generate under-provision of supervision, then of capital for troubled banks with a cross-border and/or systemic component. In addition, national supervisors may more easily be subject to regulatory capture. Both facts undermine financial stability. By setting the incentives correctly, a fully-fledged banking union permits an internalisation of this externality, making sure that banks strengthen their capital and liquidity on sunny days and can continue to lend on rainy days.

Second, the Single Supervisory Mechanism can address cross-border externalities typically neglected by national supervisors and thus contribute to reversing the retrenchment and market fragmentation. Since the start of the sovereign crisis, countries with sound fundamentals have been accumulating savings rather than channelling funds to countries under stress through inter-bank or intra-bank capital markets. During crises, supervisors acting within their national mandates may encourage domestic banks with subsidiaries abroad to repatriate capital and liquidity, if a subsidiary is located in a country under stress. Conversely, they may encourage the domestic subsidiaries of foreign banks not to send funds to their parent banks located in countries with high-risk premia. In the context of a strictly national supervisory system, this is rational behaviour, given that the objective of the national supervisory authorities is the stability of the domestic financial system. That does not mean it is an optimal behaviour, as it is not conducive to the stability of the euro area system as a whole and ignores the possibility of adverse feedback from instability elsewhere. An authority acting within a European mandate, however, would not penalise cross-border lending in that way, leading to less financial retrenchment and renationalisation of funding.

Third, the financial crisis has shown that sovereign credit risk and the health of the financial system are closely related. In some countries, weak sovereign finances have fed into the domestic financial system, while in others the reverse has been the case. The introduction of a Single Supervisory Mechanism and a Single Resolution Mechanism will help to break this deadly embrace. Severing the risk link between the sovereign and its banking system is key to maintaining financial integration in times of crisis, to limiting pro-cyclicality and to counteracting the re-nationalisation of bond holdings.

Fourth, large banks that grow bigger and expand across borders could also be inclined to take on more risk, due to the moral hazard ensuing from the “too-big-to-fail” issue. The possibility of being resolved – which may not be perceived as credible at national level, but which may be possible at supranational level within the SRM – would contribute to containing such moral hazard, and hence in addition decrease the risk of an adverse loop between sovereign debt and the banking system. Together with the special treatment of systemically important financial institutions in the new regulatory framework, the Single Resolution Authority and the Single Resolution Mechanism are therefore important when it comes to containing the contagion risk and systemic risk that naturally increases within a more integrated banking system.

Finally, further development of cross-border retail lending prompted by the banking union would reduce vulnerability to sudden stops in wholesale funding markets. The creation of truly pan-European banks should be driven by business decisions, but it will be encouraged by the establishment of the single rulebook and of the Single Supervisory Mechanism, and later on, of a common system of deposit protection. It should then be accepted that the location of banking activities within the euro area will be determined only on the basis of efficiency arguments, not of industrial policy. Then, and only then, will the link between banks and sovereigns be irreversibly severed.

Full speech

© ECB - European Central Bank