12 February 2014

ECB/Draghi: Banking Union will create more sustainable financial integration

Summary

Draghi explained that financial integration is necessary for an effective monetary union. But “the euro area did not succeed in achieving sustainable financial integration”, the ECB’s President said. “And we can see the importance of financial integration all the more in its absence.”

According to Draghi, financial integration before the crisis was incomplete. While the interbank market was fully integrated, retail banking remained fragmented. That led to a situation where banks used short-term and debt-based funding to increase lending towards favoured domestic sectors such as real estate. “As banks’ assets were not well allocated, nor well diversified geographically, they were more vulnerable to domestic shocks. And as their foreign liabilities were mainly interbank, they could not share the subsequent losses with other jurisdictions.” So when the crisis hit, the cost of repairing balance sheets fell largely on their domestic fiscal authorities. “The result was the infamous bank sovereign nexus”, Draghi said.

Banking Union will generate a higher quality of financial integration. The SSM will enable supervisors to mitigate the possible destabilising effects of financial integration. It will also help to maximise the benefits of integration by creating a policy framework more conducive to cross-border banking. If problems still occur, the planned European resolution framework will help by improving private risk-sharing while insulating sovereigns. To reach that aim, Draghi made a case to improve the design of the SRM and SRF. The proposed 10-year period to mutualise national compartments into a single fund “creates uncertainty”, the president said. “We would see merits in doubling the pace of mutualisation to have a genuine European fund within five years.”

SRM

"There are some elements in the Council agreement on the SRM that I believe could be improved. The main problem is uncertainty about resolution financing arrangements. This is important, because if markets cannot ascertain ex ante how resolution will be financed, and in what quantities, they may find themselves having to price-in a residual risk of national government involvement, thus perpetuating the bank-sovereign nexus.

One issue that creates uncertainty is the protracted time period – currently 10 years – over which national compartments are to be mutualised into a single resolution fund. As legacy risks will be addressed by the ECB’s comprehensive assessment, this seems an unduly long period. We would see merits in doubling the pace of mutualisation to have a genuine European fund within five years. To be clear, this would not imply that banks have to pay higher fees. The fund would still only reach its target level after 10 years, yet it would be a truly single fund after five years.

Another issue that needs clarifying is what backstop arrangements will be in place in this transition period, and also in the steady state. What makes resolution authorities credible is the knowledge that, when private sector solutions do not suffice, they can draw on temporary public bridge financing. This steadies expectations and supports financial stability.

Indeed, the job of a resolution authority could become more complicated if there are doubts about the adequacy of its resources in times of systemic stress. Even in the US, where such a public backstop is in place, the FDIC felt that its job was complicated during the financial crisis by media scepticism about its finances.

For this reason, we believe that a single resolution fund needs a solid public backstop – be it an ability to temporarily borrow from the market backed by guarantees from participating Member States, or access to a credit line, potentially from the European Stability Mechanism. This would not be a transfer system between taxpayers: as in the US, such borrowing would be recovered by additional levies on the banking sector in the future. Therefore, the only transfer would be an intertemporal one among banks."

Conclusion

"Financial integration is essential for a well-functioning single currency, but it is not something we can take for granted. We have learned a painful lesson here. Incomplete financial integration is an Achilles heel: it creates vulnerabilities and is liable to fragment. With the banking union, I am confident we are laying the foundations for more complete financial integration in the future.

There are two final points I would like to make.

First, while I have spoken mainly about banking sector integration, a single financial market must also ultimately extend to capital market integration... There are still several barriers to such integration, and these call for the attention of policy-makers. One example is barriers to high-quality securitisation of bank loans, whose removal may help to promote lending to households and SMEs, and reduce fragmentation... We need to begin addressing these issues in a pragmatic manner, while never losing sight of our goal.

Second, we should not forget that fragmentation also comes from the demand side. If less competitive countries undertake structural reforms that promote higher economic growth, their economies will converge towards more competitive ones, and finance will tend to follow. This is why, in addition to the Banking Union, the re-establishment of country competitiveness is essential to reintegrate financial markets. In other words, all participants have to help achieve and sustain financial integration.

Full speech

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