The Banking Union put to the test (Note)

DISCLAIMER: The author expresses his personal views and does not represent the institution that employs him.

Summary:

· The transfer of supervision to the European level appears to enable more effective supervision due to a lower risk of regulatory capture.

· Stress tests are gradually gaining momentum and credibility;

· Resolution at the European level is being implemented with a fund that is being gradually provisioned;

· Regulatory convergence remains to be achieved on many points.

The banking union projectwas launched five years ago at the same time as the OMT[1] in order to break the link between bank debt and public debt by bringing supervision, resolution, and deposit protection to the European level . Banks that hold large amounts of public debt can find themselves in difficulty in the event of sovereign default risk, and governments themselves can find themselves in a difficult situation if they have to borrow to bail out a bank on the brink of bankruptcy. It is this interconnection that was the main driver of the sovereign debt crisis in the eurozone.

The banking union project is based on three pillars: supervision, resolution and deposit protection. While the first two have given rise to two new European agencies, the third is still not in place. Sovereign spreads have undeniably fallen within the zone, partly thanks to the actions of the banking union: stress tests (in 2014 and 2016), supervision of the 130 largest banks by the European Central Bank (ECB), a framework for bank resolution, resolution funds, etc. However, much work remains to be done to consolidate the progress made: regulatory convergence, treatment of NPLs[2], and provisioning of resolution and deposit guarantee funds.

1. The Single Supervisory Mechanism

The first pillar of the Banking Union, the Single Supervisory Mechanism (SSM), was established in November 2014 following a review of the quality of assets on banks’ balance sheets, which revealed an underestimation of NPLs, and stress tests that particularly highlighted the fragility of the Italian banking sector (see: Banking Union, a fundamental but unfinished project formore details on the structure of the SSM).

· Organization of the Single Supervisory Mechanism

The SSM recruited more than 1,000 supervisors (three-quarters of whom come from national supervisory authorities) in less than a year and is structured into four sections (DGMS[3]):

1. DGMS I is responsible for the 30 largest European banking groups supervised directly by the ECB;

2. DGMS II is responsible for the next 100, which are also supervised directly by the ECB;

3. DGMS III monitors the 3,000 other banks in the euro area that remain under the responsibility of local supervisors but on which the ECB can intervene if it deems it necessary.

4. Finally, DGM IV has a cross-functional support role, for example in relation to risk models and assessment methodologies.

However, given the scale of the task, the European Court of Auditors highlighted the MSU’s lack of staff in a 2016 report. The MSU is funded directly by the banks through a fee system weighted by size and risk profile. Of the €404 million in fees for 2016, an increase of 24% compared to 2015, the 130 largest banks paid nearly 90% of the total.

As highlighted in the Bruegel report on the Banking Union (Bruegel, 2016), the supervision carried out by the SSM appears to be rather uncompromising and more intrusive than that of national regulators. Agarwal et al (2014) have shown that in the United States, local regulators are more conciliatory than federal regulators, who have more resources and are less sensitive to the local context. In order to limit the risk of regulatory capture due to excessive local proximity, the team responsible for supervising a bank within the SSM is always led by a supervisor of a different nationality from that of the bank. This intransigence on the part of the MSU is reflected in an average CET1[4] requirement of 10% in total under the second pillar of Basel III[5], which is higher than the minimum required under the first pillar, and also in a higher liquidity ratio requirement (ECB, 2016).

· Stress test results

The stress tests conducted at European level before the establishment of the Banking Union suffered from a lack of credibility. For example, in 2010, Allied Irish Banks passed the stress tests in July but required intervention by the Irish government later in the year. Similarly, in 2011, Bankia in Spain and Dexia in France and Belgium passed the stress tests but found themselves on the brink of bankruptcy a few months later.

The 2014 and 2016 stress tests conducted jointly by the European Banking Authority (EBA), the SSM, and the ECB made it possible to better identify banks in difficulty and require recapitalization plans (ECB, 2014 and EBA, 2016a). The asset quality review conducted in 2014 also revealed an underestimation of NPLs of €136 billion due to differences in standards for defining NPLs, raising the issue of regulatory convergence.

The methodology used for stress tests is known as « bottom-up, «  because it is the banks themselves that estimate the losses they will incur as a result of the economic scenario presented to them. This approach therefore gives banks considerable leeway in estimating their risks (see Arnould and Dehmej, 2016, for a detailed critique of the 2014 stress tests). However, the ECB also has an internal « top-down » model (where banks report their balance sheets and the supervisor applies a model to estimate the losses resulting from a given scenario), which allows it to check the losses reported by banks in the « bottom-up » stress test. This methodology is gradually gaining momentum, as it requires significant technological and human resources, which take time to put in place (the 2014 stress test was carried out with substantial assistance from consulting firms). However, it remains difficult to take into account the operational risk that regularly manifests itself in the form of fines, such as the Deutsche Bank, which was threatened with a fine of more than $14 billion in 2016. Similarly, by focusing on the largest banks, European stress tests do not yet take full account of the risk of contagion that could occur within a highly interconnected sector (Arnould and Dehmej, 2016).

· Regulatory convergence

To build effective supervision at the European level, the same rules must apply everywhere. Due to a certain degree of discretion left to Member States when transposing banking regulations within the euro area and different speeds of convergence from Basel II to Basel III, there are many regulatory differences between countries. In 2015, these regulatory differences were estimated at 150 (Nouy, 2015). For example, deferred tax credits[6], which were previously recognized as CET1 capital, must be gradually withdrawn. However, not all countries are doing so at the same pace, and some have even found a way to extend them.

There is also a challenge of convergence in supervisory practices, as highlighted by the EBA (EBA, 2016b), particularly with regard to Pillar 2 requirements and the methodology used (SREP[7]). In addition, certain regulatory instruments are still in the hands of governments, such as systemic buffers, which are additional capital requirements for banks deemed to be systemic, or the countercyclical buffer, which is a capital requirement that is supposed to increase during periods of growth and decrease during periods of recession in order to smooth the economic cycle. However, not all eurozone countries apply the same requirements. For example, Italy and Latvia have set the requirements for systemic banks at the domestic level at 0%, while most northern European countries have set these buffers at 2-3%.

2. The Single Resolution Mechanism

The second pillar of the Banking Union, the Single Resolution Mechanism (SRM), was established in January 2015. Unlike the SSM, the SRM is an independent agency, separate from the ECB, responsible for implementing bank resolution plans in the event of failure, as well as managing a resolution fund, which can be mobilized once 8% of the bank’s liabilities have been used in the resolution (see: Banking Union, a fundamental but unfinished project formore details on the structure of the SRM).

· Organization of the Single Resolution Mechanism

More than 200 employees were recruited to launch the SRM in 2015, which is responsible for the resolution of nearly 4,000 financial institutions. The resolution fund, which is to reach 1% of deposits covered by deposit insurance( approximately €55 billion), is being gradually built up over eight years between 2016 and 2023. As of June 30, 2017, the SRM had collected €17.4 billion from 3,500 institutions. Banks’ contributions are estimated using a methodology based on the level of risk on their balance sheets. However, the entire fund is not automatically pooled at the European level, and as the fund grows, the pooled portion increases. For example, in 2017, only 60% of the fund was pooled.

· Resolution balance sheet

In recent years, the « bail-in, «  where losses are absorbed by shareholders and junior or even senior creditors[10], as opposed to the « bail-out, » where in most cases the state absorbs the losses, has been gaining momentum. The implementation of the MRU and the European BRRD directive[11] requires banks to prepare a resolution plan and provides a legal framework for bail-ins.

Due to its recent implementation and gradual rise in prominence, there have been few opportunities to apply this new paradigm. The case of Banco Popular in June 2017 is a recent example of resolution. The ECB triggered the SRM resolution procedure after identifying an imminent risk of bankruptcy. Shareholders and junior bondholders saw their positions liquidated to cover part of the losses. The bank was then sold to Santander for a symbolic €1. However, this test remains limited as there was no need to call on senior bonds during the resolution or on the resolution fund. Shortly afterwards, also in June 2017, two Italian banks (BP Vicenza and Veneto Banca) were liquidated by the Italian government, without going through the MRU, after the recapitalization plans were deemed unviable by the MSU. Here too, shareholders and junior bondholders were called upon to contribute, but in this case senior creditors were reimbursed by the Italian government. While the Italian government’s involvement may suggest that the vicious circle between bank and public debt is still at work, the fact remains that a large part of the losses were absorbed through the bail-in and that no zombie banks, surviving solely on public infusions, were created.

• Regulatory convergence

Although the BRRD directive is supposed to provide a framework for resolution in the eurozone, liquidation laws remain national. However, resolution can only take place if the bank cannot undergo liquidation without risking contagion or, more generally, harming the public interest. If the liquidation framework differs, the use of resolution may vary between eurozone countries.

Furthermore, unlike the SSM, the SRM is not limited to the 130 largest banks. However , not all European countries are required to use accounting standards. The largest banks use IFRS[13], while those that are not listed on the markets are not required to do so (Pacter, 2015). Such a difference may also complicate the task of resolution or even lead to differences in treatment.

Conclusion

The Banking Union appears to be a success, as evidenced by the convergence of sovereign spreads and the gradual consolidation of the eurozone banking sector. However, the risk of a vicious circle between sovereign debt and banks has still not been resolved.

The absence of the third and final pillar, which should be a second fund dedicated to deposit insurance, the presence of national discretions that undermine equal treatment, and significant geographical concentration raise the question of the need for a complement to the Banking Union, such as the Capital Markets Union[14] or even a more advanced fiscal union.

References

Agarwal S., Lucca D., Seru A., and Trebbi F., (2014), « Inconsistent Regulators: Evidence from Banking, » The Quarterly Journal of Economics, Volume 129, Issue 2, May 1, 2014, Pages 889–938

Arnould G. and Dehmej S., 2016, “Is the European banking system robust? An evaluation through the lens of the ECB’s Comprehensive Assessment”, International Economics 147 (2016) 126–144

Bruegel, 2016, “European Banking Supervision: The First Eighteen Months”, Blueprint series 25

European Court of Auditors, 2016, “Single Supervisory Mechanism: a successful start, but improvements are needed”, Special Report No 29/2016

EBA, 2016a, “2016 EU‐Wide Stress Test: Results”

EBA, 2016b, “Report on the Convergence of Supervisory Practices”

ECB, 2014, “Aggregate Report on the Comprehensive Assessment”

ECB, 2016, “ECB Banking Supervision publishes outcome of SREP 2016 and recommendations on dividends and variable remuneration for 2017”, Press release 15 December 2016

Nouy D., 2015, The Single Supervisory Mechanism after one year: the state of play and the challenges ahead, Speech at Banca d’Italia conference “Micro and macroprudential banking supervision in the euro area”, Milan, November 24, 2015.

Pacter P., 2015, “IFRS as global standards: a pocket guide”, IFRS Foundation, London

Véron N., 2017, “Precautionary recapitalization: time for a review?”, Bruegel, Policy Contribution Issue No. 21 | July 2017

Véron N., 2015, “Europe’s Radical Banking Union”, Bruegel Essay and Lecture Series