05 October 2021

SUERF: The Path to Euro Area and Banking Union Membership: Assessing the Incentives for “Close Cooperation” and Adherence to the Exchange Ra

ECB announcement that both Bulgaria and Croatia were required entry to ‘close cooperation’ with their respective central banks ... after fulfilling the necessary supervisory and legislative steps prior to the inclusion of their respective currencies in the Exchange Rate Mechanism II (ERM II).

The move towards greater monetary integration requires appropriate banking supervision to ensure the stability of the ensuing cross-border credit flows between the respective groups of countries. Together, these two steps pave the way for Bulgaria’s and Croatia’s future participation in the euro area. It is evident from the research undertaken in this paper that there are clear benefits of close cooperation for these Member States whose domestic currencies were already linked to the euro, in view of the dominant position euro area banks have in their respective domestic markets. Those banks channel the likely strong expansion of credit that goes hand in hand with the participation in the ERM II as shown in the latest round of participation (Estonia, Lithuania, Slovenia, Latvia and Slovakia). It is more difficult for a national authority to exercise discretion in implementing ECB decisions once it is committed to the path leading to full European Monetary Union (EMU) membership. The uncertainty about the functioning and durability of the close-cooperation arrangement is largely removed.

The establishment of the Monetary Union and the Banking Union in Europe greatly advanced integration among Member States, but also raised questions about how to achieve effective coordination between euro area institutions and counterparts in non-member European countries, and how those non-members might transition towards inclusion in those unions if they chose to follow that path. This Policy Brief addresses certain aspects, focusing on the cases of Bulgaria and Croatia, countries which recently initiated close cooperation with the Banking Union and committed themselves to abide by the ERM II. More details can be found in our recent paper (Nieto and Singh, 2021).

It had always been envisaged that non-euro area countries could join the Monetary Union after a successful “probationary period” under the ERM II. However, the roadmap for Monetary Union did not shape the way non-euro area countries would join the Banking Union and enter in close cooperation in banking supervision and crisis management.

In the cases of Bulgaria and Croatia, the ECB Governing Council adopted a decision to establish close cooperation with the other relevant central banks following the fulfilment of the necessary supervisory and legislative prerequisites.2 In parallel, the inclusion of their respective currencies in the ERM II was announced.3 Participation in the ERM II is a precondition for as well as fulfilment of the nominal convergence criteria to join the euro, and as such it is binding and of a temporary nature. It should be noted that the currencies of Bulgaria and Croatia were already closely tied to the euro at the time of applying to the ERM II. Bulgaria had a currency board (first with the deutschmark, and subsequently with the euro after 1999) after a devastating debt and banking crisis in 1997. Croatia had a peg first with the deutschmark, and from 1999 to the euro, with a narrow band. All the countries that joined the ERM have become members of the EMU with the sole exception of Denmark, which opted out of the obligation to become a member for national political reasons.

Together, these two steps pave the way for Bulgaria’s and Croatia’s future participation in the euro area.

This is the first time a Member State’s national currency would join ERM II since the start of the EU banking union. Upon the introduction of the euro a Member State now also joins the banking union, which is irreversible and involves direct powers of the Single Supervisory Mechanism (SSM) and the Single Resolution Mechanism (SRM) over its banking system. Therefore, participating in ERM II with a view to later adopting the euro also involves – for Bulgaria’s [and Croatia’s] as well as for any other Member State’s national currency that will in the future join ERM II – preparing for joining the banking union.4

After the launch of the SSM, as an integral part of the institutional architecture of the euro, it was rational that EU policymakers would expect EU Member States when joining the ERM II to also require close cooperation with ECB. The requirement for close cooperation when applying to the ERM II deals with the ‘efficiency’ gaps in the pre-existing arrangements that neglect the possibility of negative bank sovereign ‘loops’ (Nieto and Schinasi (2007), Podstawski and Velinov (2018) and Dumitrescu-Pasecinic (2019)). Against this background, as is the case for the ERM II, the ‘participation’ mechanism should be understood as a binding requirement of a temporary nature until the applying country joins the EMU.

The SSM Framework (the SSM Regulation (2013), the SSM Cooperation Framework Regulation (2014) and the 2014 ECB Close Cooperation Decision) permits non-euro-area Member States to participate in the SSM through a close-cooperation arrangement.5

In the cases of Bulgaria and Croatia, the binding and temporary nature of the close-cooperation mechanism highlights a particular case of the bespoke general governance arrangements of the SSM Framework, in which the possibility of ‘opting out’ fades with the incentives for joining the euro. The Figure below presents the options open to non-euro EU countries in terms of participation in the ERM II and/or the close-cooperation arrangement. Only simultaneous participation with a view to joining the euro is incentive compatible, as explained in this Policy Brief.

Figure: Options open to non-euro EU countries in terms of participation in the ERM II and/or the close-cooperation arrangement


Source: Authors’ analysis.

The SSM framework explains how the Member States entering “close cooperation” within the SSM will have a relationship with the ECB in the SSM which is ‘comparable’ but not ‘equivalent’ to Member States of the euro area (Singh, 2020). The SSM framework confers on the ECB the right to instruct the national authorities rather than directly supervise their significant banks. Domestic legislation in the Member States, entering into “close cooperation”, is required to mandate the national authorities to abide by the ECB requests and guidelines. The right to suspend and terminate the “close cooperation” arrangement remains in the SSM framework. However, the commitment to join the Monetary Union minimises the ‘authority dilemma’ for the ECB since suspension and termination will become a non-issue. Hence, the incentive for simultaneous application to join the ERM II and to enter “close cooperation” is apparent, as the political commitment for joining the Monetary Union and Banking Union converge.

Close cooperation involves marked changes in the allocation of related powers. In the case of a subsidiary of Banking Union banks in a country outside “close cooperation,” the ECB as the apex of the SSM can effectively impose conditions on the subsidiary via the parent without formal involvement of the host supervisor. When a close cooperation arrangement is in place, ECB decisions addressed to supervised entities are replaced by instructions to the respective national supervisor (termed the National Competent Authority – NCA) and on occasion the macroprudential authority (termed the National Designated Authority – NDA). The higher the proportion of foreign euro area banks to domestic banks, the greater the need for cooperation and coordination in order to minimise information asymmetries and limit the risks of contagion from cross-border banking....

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