And the Unique Supervision Mechanism has arrived…

The creation of this type of mechanism represents a necessary extension of the measures taken by Basel III, in terms of strengthening the capital base of banking institutions. It should also harmonize banking regulation across the zone, to avoid disparities. In the past, the stress test methods used by some supervisors have proved inadequate for measuring banks’ actual capital requirements.

and the fragility of their banking system. This was the case in Ireland and Spain, where banks successfully passed their stress tests, only to find themselves rapidly facing serious difficulties and undercapitalization.

Overall, the agreement on the ESM sends a strong message to the markets, demonstrating that European solidarity is no longer a myth (or much less so). The Eurozone is capable of meeting the deadlines it had set itself, given that EU finance ministers had expected an agreement by the end of 2012 and that, given the latest developments, it was more likely to appear in 2013. This type of mechanism is yet another building block in the drive to bring the Eurozone out of the crisis, but also to ensure and guarantee its stability in the future. The ESM follows in the footsteps of the Outright Monetary Transactions (OMT), the European Financial Stability Facility (EFSF) and the European Stability Mechanism (ESM). The establishment of a single supervisor should also be complementary to the ESM, given that the ESM’s banking component to recapitalize banks could not be operational without the December 13, 2012 agreement. Despite the fact that the single supervisor will be in place from March¹, 2014, the direct recapitalization of a bank that requests it should not pose any problems, according to Mr. Moscovici, the French Finance Minister, who has specified that such an operation will be carried out as soon as it is deemed necessary, well before 2014.

For the press, this agreement represents the first stage of the banking union: what do we mean by the first stage? First of all, it’s a first step, in the sense that an agreement has finally been reached, but now it’s a question of setting the next stages in motion by making this resolution official: by enabling the ECB to rapidly adapt its structure to become the new prudential supervisor; by harmonizing regulations between the various national supervisors; and finally by being able to apply the appropriate measures(stress tests or sanctions, for example). As we shall see later, this is only the first step, as there is still room for improvement. Whether in terms of the prudential nature of this supervision, or its reinforcement via other additional measures (banking competition, conditions for bank mergers, deposit guarantees, the role of central clearing houses, to name but a few), everything suggests that to establish strong, lasting stability, current provisions will need to be constantly supplemented, while possibly incorporating proposals made in other regions or zones[1].

Difficult negotiations…for a « snatch-and-grab deal

As we have seen, until recently[2], there was little reason to believe that an agreement could be reached before the end of 2012. Exchanges of views between the various countries have effectively slowed down the timetable, and there was nothing to suggest that compromises (or rather concessions) would be reached so quickly. Initially, the problem of maintaining the ECB’s independence in its decisions and missions emerged. After negotiations and observation of the experiences of certain countries, such as France’s Autorité de Contrôle Prudentiel (ACP), it was decided that the ECB would be responsible for making decisions concerning: the granting or withdrawal of banking licenses, the monitoring of compliance with capital requirements and the organization of stress tests. The ECB will promote the harmonization and homogeneity of regulatory and supervisory systems, while national supervisors, in constant coordination with the ECB, will implement the tasks within their territories. The ECB’s independent status is more than necessary and justified. This is why it will retain this status for all monetary policy matters, but the internal mechanism of the ESM will be accountable to the European Parliament for its supervision, which should not pose any problems in itself.

Regarding the relationship between the MSU and the European Banking Authority[3], a number of questions have been raised about the articulation between these two institutions. The European Banking Authority was created in November 2010, following the recommendations of the de Larosière report on the overhaul of the European supervisory system. It covers the 27 EU member states, and is tasked with ensuring the standardization of banking regulations for these countries. Unlike the MSU, it plays no supervisory role, so there is no risk of them working at cross-purposes in the same segment. In the final analysis, the two regulators should operate in harmony at European level, despite a few marginal legal issues to be resolved. Beyond this articulation, another problem has arisen concerning voting rights between different members, whether within or outside the Eurozone. More than other European countries outside the monetary union, the British were particularly worried about finding themselves isolated within the EBA. As voting is by qualified majority, the Eurozone will doubtless always have a greater say in decisions, since all 17 member countries are expected to adopt similar provisions in terms of financial market regulation. The UK, for example, feared that it would not be able to take part in debates on financial services, or that it would not be able to defend its own financial sector, which is vital to the smooth running of its economy.

To make the MUS more credible, there was also talk ofextending itto other European Union countries whose currency is not the euro. Given the prominence of financial institutions from Eurozone countries in these other countries, the use of MSU standards is a form of guarantee for establishing a degree of banking stability through financial integration. However, their participation faces legal barriers and would require a revision of the Treaty, further slowing down the implementation of the ESM. What’s more, the ECB Governing Council cannot incorporate non-Eurozone member states into its decisions, and the latter will not always have an interest in following ECB directives, having their own Central Bank and monetary policy. Indeed, the UK, Sweden and the Czech Republic recently declared that, under these conditions, they had no interest in joining and would not take part. On the question of voting rights for the EBA, mentioned above, it was envisaged that a qualified majority vote would only be validated if a majority was obtained both between countries in the zone on the one hand, and between non-member countries on the other, so as not to exclude certain countries, such as the UK, from the decision-making process. The latest information available does not allow us to know whether this will be the case or not, but it is already foreseen that the United Kingdom’s vote will count as two. This type of consideration should not be attributed to any other country, whether or not it is a member of the Eurozone…

Failure to align the other European countries could contribute to a two-speed Europe in terms of banking and financial regulation. Beyond this disadvantage, another major problem emerges: faced with an increase in regulation via the introduction of the MSU, some financial operators could then redirect themselves to more attractive markets (the City, Wall Street) where regulatory adjustments would be of lesser importance. This type of arbitrage would be to the detriment of the Eurozone, even though it is more stable and healthier, and its institutions could suffer as a result. It is for these two reasons, mentioned above, that maintaining the European Banking Authority mission is a priority to ensure a certain degree of uniformity of rules for the 27 EU states. It is to be hoped that, at the same time, other countries, such as the USA, will also make the necessary efforts and take the necessary steps to adopt similar rules, in order to promote the international integration of banking and financial standards (highly utopian in view of the lack of enthusiasm shown by the Americans, already in the past, in meeting the Basel Committee’s conditions).

In terms of the scope of supervision, the European Commission (EC) advocated that all credit institutions in the Eurozone (some 6,000 banks) should come under the ECB’s umbrella; Germany, however, was opposed to this and opted for limited supervision, aimed primarily at systemically important financial institutions (SIFIs). Unlike France, where four banks are of systemic importance[4], the vast majority of German banks are essentially regional banks or local savings banks, which maintain close relations with the companies of Mittlestand, the success story of the German model. Direct supervision of these banks by the ECB could therefore hinder the financing of the economy, even though they present little risk, given their size. This type of argument is far from proven, as demonstrated by the examples of Northern Rock (UK) and Bankia (Spain), two modestly sized institutions that failed during the crisis, dragging other financial institutions down with them and generating systemic risk. The current level of banking interconnection, both between the largest institutions (SIFIs) and between the smaller ones, is sufficiently high for an idiosyncratic risk to rapidly turn into a systemic risk. Stricter and more appropriate supervision of SIFIs is undeniable, but it would be a damaging mistake to underestimate other types of institution. The example of Herstatt bank, a mid-sized bank in Germany, whose bankruptcy in 1974 caused unprecedented financial turmoil at the time, causing the New York banking payment system to malfunction and shut down for several days, is the best example[5]. What’s more, these smaller institutions have the advantage of having far less complex structures than larger ones, which can only facilitate their supervision. To ensure effective and lasting financial stability in the Eurozone, we need comprehensive and general supervision, while at the same time adopting specific provisions for certain, riskier agents.

On December 10, 2012, the Cypriot government issued a solution, in order to calm debates and reassure German concerns, by proposing that the ECB assume intense supervision of Eurozone banks, only for those whose assets exceed 30 billion euros. However, the ECB could have a right of oversight over banking institutions that fall below this threshold but are in delicate situations and experiencing major difficulties. In the end, it was the Germans who won the day, as this solution, proposed by the Cypriots, was chosen on the night of December 12-13. This was more of a concession than a compromise. Only 200 banks (out of 6,000) will therefore be subject to closer supervision by the ECB. Of course, the level of interconnection between these 200 institutions and the other 1,800 must be quite high. Supervising this small number of large institutions would also enable us to keep an eye on the rest of the banks. But this type of argument can be reversed, as these connections between banking institutions intrinsically contain systemic risk. The failure of a small bank should not be considered solely as an idiosyncratic shock, as the contagion effects would then be considerably neglected, which is unfortunately the case with the reduction in the ECB’s field of supervision. What’s more, the prudential aspect is of lesser importance, since by not supervising all institutions ex ante, the risk of allowing systemic risk to build up and increasing the likelihood of contagion could increase, making it more difficult to resolve these problems ex post. The advantage of supervising all banks on an ongoing basis is that we can better monitor risks (and systemic risk in particular), while leaving ourselves room for manoeuvre to foresee certain malfunctions and implement measures to regulate them. Such room for manoeuvre no longer exists with restricted supervision of large banks alone.

The urgent need to recapitalize banks

Finding common arrangements as quickly as possible was all the more necessary given that the introduction of the ESM should make it possible to launch the banking component of the European Stability Mechanism (ESM). In order to support the Eurozone and its members in the face of the difficulties encountered with the sovereign debt crisis, the European Council decided that the ESM should be able to recapitalize banking institutions. Despite the late inauguration of the ESM on March¹, 2014, an aid plan for Spanish banks had been validated by the Eurogroup at the beginning of December, and this despite the fact that its introduction was the sine qua non condition before allowing the ESM to recapitalize banks. The announcement had already gone some way towards reassuring and calming the markets, but given the urgency of the Spanish situation, it was imperative to speed up negotiations and convince the still reluctant members of the need for an agreement (short of complete harmonization and global supervision). The plan to recapitalize Spanish banks amounts to 39.5 billion euros, which is certainly not enough, but already provides significant support for a banking system that is on the verge of collapse[6]. In particular, this aid should enable four nationalized banks[7] to be provided with equity capital, enabling them to transfer some of their toxic assets to Sareb, the bad bank set up to recover all the « rotten products » of other banks.

It is important to understand here that it is essentially European banks that buy up, on the primary and secondary markets, debt securities issued by Eurozone governments. As a result, they have a large number of such securities in their equity portfolios. Sovereign risk and banking risk are therefore intimately linked at present. Usually, these securities are considered « risk-free » assets, but since the crisis, they no longer are (or no longer are so much), given that the possibility of a government defaulting, in part, cannot necessarily be ruled out. So when these debt securities deteriorate, as is currently the case, this is automatically reflected in the banks’ portfolios, which in turn deteriorate. What’s more, banks generally use government securities as collateral in their financial operations, i.e. they can act as collateral in a transaction with another operator. As a result, banks’ collateral is currently of poorer quality, which places constraints on their financial operations. They no longer necessarily have sufficient margins, still hold a large number of outstanding loans and, in a context of great uncertainty, prefer to place their reserves with the ECB[8] rather than grant credit. These two phenomena contribute to making banks more fragile, while at the same time failing to provide the economy with the liquidity it so urgently needs. The introduction of the ESM, and all that it generates, would therefore help to break this negative spiral between sovereign and banking risk.

The banking union needed to be strengthened and harmonized to ensure greater European integration and solidarity on financial issues. In terms of aid and support for banks in troubled countries, the ESM and OMT must now take up the baton. It is difficult to draw conclusions today about the real future contribution of the single supervisory mechanism. For even if it is urgently needed to trigger a massive aid plan for the banking system, we must hope that last-minute compromises on supervision and prevention will not compromise the guarantee of banking and financial stability, which Europe sorely needs.