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Banks are first to witness the challenges of European integration

Anna Sienkiewicz, Economic Research Department, Crédit Agricole S.A.

In this fifth and final article on Europe, we examine how banks have been at the centre of changes in institutional governance since the crisis, especially with the launch of the Banking Union in 2012. Largely unknown to the general public, this project is actually the first example of a supranational approach since the creation of the European Central Bank and the single currency. And for good reason, because economic and monetary integration is impossible without financial integration.


The 2008 crisis exposed shortcomings in financial system regulation at global level. But it also showed how some supervisory authorities had been lenient on so-called national champions. In consequence, Europe’s political leaders focused on two priorities:

- tightening regulatory requirements for banks; as a result, the European Union adopted the Capital Requirements Regulation and the fourth Capital Requirements Directive, linked to the successive versions of the Basel accords at international level;

- making prudential supervision more trustworthy by establishing a supranational supervisor. This led to the formation in 2011 of the European Banking Authority (EBA), tasked with setting technical standards and drawing up a single rulebook. The EBA’s remit also extends to coordinating supervisory practices, though these are still a national prerogative.

This first raft of measures failed to give the banking industry a clean bill of health, since the EBA lacked credibility at the outset. Supervisory sovereignty was not transferred to it; nor did it have the power to impose penalties. In addition, when Allied Irish Bank and Bankia collapsed in 2010-2011 – despite having passed the European stress tests – investors and depositors finally lost faith.

More basically, the deepening crisis in the eurozone showed that micro-prudential regulation was powerless to tackle the zone’s true weakness: the fact that banks and sovereign states were interdependent at a time when monetary union was incomplete. This resulted in an endless vicious circle between, on the one hand, public finances weakened by systemic banking crises, and, on the other hand, banks that were hurt by their sovereign exposures, both directly due to their government bond holdings and indirectly as a result of refinancing conditions. The consequences for market integration were dire: capital flows between northern and southern Europe contracted, and investors and depositors shunned banks on the eurozone periphery. National supervisors also contributed to this fragmentation by ring-fencing capital and liquidity at national level, including for members of a same banking group that were based in different countries.

This fragmented financial market morphed into a fragmented banking market. As a result, financing conditions for the real economy began to move in different directions. They worsened sharply for countries in the south, where small and medium-sized businesses had to cope with credit rationing, and hindered proper transmission of monetary policy. The European Central Bank intervened to mitigate the risk of a eurozone breakup. One of its measures, three-year long-term refinancing operations (LTRO), launched in December 2011, gave banks a huge liquidity injection but failed to harmonise lending rate levels for non-financial agents.

In consequence, micro-prudential supervision and monetary policy alone proved incapable of restoring financial integration, on which the eurozone’s monetary and economic integration hinges. In fact, the link between banks and sovereigns actually tightened, a paradoxical outcome. Thus LTROs enabled southern banks to boost government bond holdings, not only because of their high yields but also due to a regulatory bias that encouraged the holding of domestic sovereign bonds.


The turning point came in summer 2012 with the announcement of unlimited sovereign bond purchases (the Outright Monetary Transactions programme, hitherto dormant) and the promise that banks could be recapitalised directly through the European Stability Mechanism (ESM). Both these developments were conditional on the launch of the Banking Union.

The Banking Union is an unprecedented project that radically overhauls the governance of the institutions in charge of banking supervision. It stems from the awareness that the eurozone needs special tools to ensure its financial stability, namely a single system of supervision that is impervious to national interests, and crisis management tools (bank resolution and deposit guarantees) that are powerful and effective at European level, appropriate to the existence of major cross-border banks.

The launch of Banking Union was marked by a determined mindset and a significant transfer of powers to supranational level. But, as the eurozone crisis ebbed, national interests regained the upper hand in negotiations, resulting in uneven progress on the system’s three pillars:

1. The Single Supervisory Mechanism (SSM), introduced successfully and in record time in November 2014. The SSM operates under the auspices of the ECB, which directly oversees some 130 banks of significant size and delegates supervision of the rest of the sector to national authorities.

2. The Single Resolution Mechanism (SRM), organised around a Single Resolution Board formed in 2015 and responsible for preparing a resolution plan before a troubled bank fails and choosing the resolution strategy to apply once it does. The Board is not the sole decision-maker on this issue but collaborates closely with national authorities. The SRM has a Single Resolution Fund (SRF), set up in 2016 and funded by banks; the full endowment of €55 billion is due to be reached in 2024. The SRF will initially be segregated in national compartments, which will eventually be merged after a transitional period.

3. A single European Deposit Guarantee Scheme, which is a more politically sensitive issue. The ECOFIN Council published a roadmap in June 2016 stating that progress on this third pillar would depend on mitigating the risks in peripheral countries, in other words reducing the stock of impaired loans on banks’ balance sheets and curbing their exposure to the national sovereign.

The fact that Banking Union has not been finalised limits its scope, because each of the three pillars strengthens the others. As the banking supervisor, the ECB could decide that its regulatory requirements will apply to cross-border groups either entity by entity or at consolidated level. The latter case would mean that an entity’s excess capital and liquidity could circulate within the group, thus helping to create a true single banking market and fostering the emergence of pan-European banking groups. But that cannot happen until deposits are effectively fungible within the eurozone and so long as national guarantee schemes continue to ring-fence capital.


Banking Union alone, whether complete or incomplete, will not be enough to sever the link between banks and sovereigns. That would require budgetary union, which could act as a safety net for the SRF and deposit guarantee schemes, as in the US.

Measures have been taken at the EU level, alongside Banking Union, to limit recourse to the public purse in the event of a crisis. For instance, barring exceptions, the Bank Recovery and Resolution regulation provides for a bail-in, whereby a bank’s private creditors bear losses equivalent to 8% of its liabilities. Once satisfied, that condition grants access to the resolution financing arrangement, capped at 5% of liabilities, and then to public aid. However, this framework is credible only if a supranational safety net is available in cases where:

- a bail-in is likely to undermine financial stability;

- the resolution fund and deposit guarantee schemes have not been funded sufficiently and/or if they do not have sufficient access to the markets;

- governments are unable to intervene without jeopardising the public finances.

The ESM has a part to play in terms of risk-sharing. At present, its direct recapitalisation tool exists, but it is subject to three restrictions: (i) bail-in and use of the SRF; (ii) co-financing by the State that requested an intervention; (iii) a €60 billion cap on the funds available. Easing these constraints will help to loosen the link between banks and sovereigns. Moreover, the ESM could intervene indirectly by guaranteeing the funding of the SRF and the deposit guarantee schemes.

Banking Union is a huge step forward because it was one of the missing links in Economic and Monetary Union. Together with a package of emergency measures and an ultra-accommodative monetary policy, it stopped contagion and lowered risk premia. But its success is only partial and potentially tenuous. Whether we have all the tools needed to cope with another crisis is far from certain.

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