A fresh approach to complete the banking union in the eurozone

A fresh approach to complete the banking union in the eurozone

A fresh method of complete the banking union in the Eurozone

Negotiations on the banking union in the Eurozone have already been stuck since the Italian government assembled a blocking minority opposing further discussions on proposals to lessen legacy risks in banks’ balance sheets. This column argues that completing the banking union should once more get priority, and that the European deposit insurance scheme could progress immediately by giving in its early phase that the ESM would provide a liquidity line to national deposit guaranty schemes that had exhausted their funds, without sharing of losses.

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The banking union negotiations in the Eurozone have already been stuck since, in the Ecofin Council of June 2016, the Italian government were able to assemble a blocking minority opposing any more discussions on proposals to lessen legacy risks in banks’ balance sheets. Completing the banking union should now again get priority, as the current half-baked banking union – lacking a common system of (cross-border) deposit insurance (European Commission 2015) – leaves the Eurozone subjected to idiosyncratic financial shocks with the capacity of endangering its survival.

Tackling legacy risks

The request that banks’ balance sheets be cleared of legacy risks, before moving fully mutualisation of losses with the European deposit insurance scheme (EDIS), is legitimate and really should be heeded. Legacy risks mainly arise from the large stocks of non-performing loans (NPLs) and banks’ exposures with their national sovereigns.

The stock of NPLs in the Eurozone still hovers around €800 billion, or around 5.5% of loans, and is targeted in a few countries – notably Italy, Cyprus, Portugal, Ireland, and, to a smaller extent, Spain. Although it holds true that the stock has been diminishing too slowly, the robust economic recovery is currently adding momentum with their reduction. In Italy, the precautionary recapitalisation of Monte dei Paschi di Siena and the liquidation of two medium-sized Veneto banks plus some other small banks can lead to the reduced amount of NPL stock by about one-fourth in today’s year.

Furthermore, new policies to handle the issue have already been adopted by the Supervisory Board of the Single Supervisory Mechanism (SSM) and the Ecofin Council. Last March, the SSM issued its comprehensive Guidance to banks on non-performing loans (ECB 2017a); banks’ performance in managing NPLs will be the main SSM Pillar Two supervisory evaluations which, if considered unsatisfactory, can lead to additional bank-specific prudential requirements, possibly like the request to improve capital. 1 These measures already are resulting in an acceleration in the disposal of NPLs.

Moreover, at its meeting on 11 July, the Ecofin Council needed a comprehensive method of NPL disposal combining policy action at the national and European levels to boost the efficiency of judicial processes and debt recovery frameworks, develop secondary markets for distressed loans, and foster restructuring of banking systems to adjust to the brand new business environment (Ecofin 2017).

A far more important legacy risk is banks’ heavy contact with their sovereign. The EBA 2016 transparency exercise shows that some three-quarters of total sovereign exposure is vis-à-vis the house sovereign; and bank holdings of their national sovereign typically are typically around 140% of Tier1 capital, with some countries hovering around 200% (e.g. Belgium, Germany, and Italy). This example raises the chance of a re-emergence of the doom loop between sovereign distress and banking crisis, in the case investors lose confidence in the sustainability of the sovereign debt of 1 Eurozone member state.

ESRB (2015) identified two main options to handle the problem: i) introducing risk-weighting for sovereign holdings by banks (mainly predicated on market ratings), thus raising capital requirements; or ii) deciding on those holdings some variant of the prudential rules on large exposures. 2

Risk-weighting national sovereigns would inevitably affect sovereign markets of highly indebted countries, in the expectation of large sales by banks. Another notable drawback of risk-weighting is its pronounced procyclicality, as risk assessment varies with economic and financial conditions. And, finally, unless risk-weighting were also adopted by non-Eurozone regulators, it could place Eurozone banks at a severe competitive disadvantage. The point is, no agreement upon this seems around the corner within the Committee on Banking Supervision meeting in Basel, as a result of opposition of non-EU countries such as for example Japan.

A rigid application of the large exposure threshold of 25% of eligible capital currently in effect could also prove disruptive both to banks’ balance sheets and (some) sovereign markets, since it would force banks to attempt massive liquidations of sovereigns. However, a gradual entry into force and careful calibration of the brand new prudential limits could reduce such undesireable effects yet provide sufficiently strong incentives for bank portfolio diversification. Useful proposals for designing the brand new rule have been produced by Enria et al. (2016) and Véron (2017). Such curbs to exposure would eschew the drawbacks of sovereign risk-weighting given that they will be set independently of any credit risk-assessment and for that reason would also avoid procyclical effects. They might not distort the particular level playing field in accordance with other jurisdictions.

Sovereign portfolio diversification will be favoured by, and even require, the establishment of a European ‘safe asset’ that investors – including banks – could turn to within their search for sovereign risk diversification (Enria et al. 2016). Several proposals have already been tabled to handle the problem, but up to now these have not been favoured by either member states or investors. 3 An alternative solution which has not yet been considered is always to allow ESM offer to switch banks’ excess sovereign holdings to be removed beneath the new prudential rules with newly issued ESM bonds. The credit risk on sovereigns thus acquired by the ESM should remain with the selling banks and, in the event of need, would fall back onto the national deposit insurance funds.

Getting EDIS off the bottom

Integrated credit and asset markets within EMU would be able to hedge against country-specific resources of risk through capital markets. Moreover, EMU ought to be resilient – i.e. it will not unravel and be per se a way to obtain instability – when confronted with large financial and economic shocks (ECB 2017b).

However, without EDIS, market fragmentation will probably persist. This appears to reflect to a significant extent the uncertainty generated by political events calling into question the continuing future of the monetary union. As has been established by solid academic research, following seminal paper by De Grauwe (2011), this is really because of a particular externality created by the mix of a common currency managed by an unbiased central bank, and fiscal and economic policies managed at the national level. When the latter diverge, doubts will probably arise on the sustainability of the sovereign debts of some countries, because the liquidity because of their orderly roll-over depends upon the willingness of the ECB to intervene as lender of final resort for distressed sovereigns – an intervention that persistent divergence in economic fundamentals makes highly controversial within the ECB Governing Council and official policy circles.

There can be an evident paradox here. We are able to effectively reduce market fragmentation and acquire more private risk-sharing from credit and capital markets and then the extent that investors in financial markets think that the likelihood of a brand new financial meltdown in highly indebted countries is quite low – but this involves that the institutional arrangements of EMU provide strong insurance against liquidity shocks hitting either sovereign markets or the banks. This will be recognised as a solid argument towards completing the banking union with EDIS – while, of course, continuing work at risk reduction – since it would eliminate or reduce to the very least the possibility that a big liquidity shock in a single national bank operating system will again set in place the doom loop between banking and sovereign crises.

The European Commission (2017) has aired the theory that within an initial phase of EDIS, the machine would only give a liquidity line to cover any liquidity shortfall of national deposit guaranty schemes (DGSs). The others would be included in national DGSs, if needed by charging additional ex post contributions on the banks for the reason that country. Furthermore, the transition to subsequent phases where national banking losses will be progressively mutualised, will be at the mercy of a targeted asset quality review (AQR) to verify progress in the reduced amount of NPLs and sovereign exposures.

Conclusions

EDIS could progress immediately by giving in its early phase that the ESM would provide a liquidity line to national DGSs that had exhausted their funds, without sharing of losses. Meanwhile, risk reduction would accelerate through the stronger policies already established by the SSM for the reduced amount of NPLs and a brand new approach to the reduced amount of banks’ sovereign exposures, predicated on a modified version of the large exposure prudential policy.

Author’s note: This column summarises the analysis within Micossi (2017).

References

Brunnermeier, M K, L Garicano, P Lane, M Pagano, R Reis, T Santos, S Van Nieuwerburgh and D Vayanos (2011), “ESBies: AN AUTHENTIC Reform of Europe’s Financial Architecture”, VoxEU.org, 25 October.

Brunnermeier, M K, S Langfield, M Pagano, R Reis and S Van Nieuwerburg (2016), “ESBies: Safety in the tranches“, ESRB Working Paper Series No 21 / September.

De Grauwe, P (2011), “The Governance of a Fragile eurozone“, CEPS Working Document No. 346.

Delpla, J and J von Weizsäcker (2010), “The Blue Bond proposal“, Bruegel Policy Brief 2010/03.

ECOFIN (2017), Council conclusions on Action intend to tackle non-performing loans in Europe’, 11 July.

Enria, A, A Farkas, and L L J Overby (2016), “Sovereign Risk: Black Swans and White Elephants“, European Economy, 8 July.

ESRB (2015), ESRB report on the regulatory treatment of sovereign exposures’, European Systemic Risk Board, Frankfurt /Main.

German Council of Economic Experts (GCEE) (2011), Euro Area in crisis, Annual Report 2011/12, Third Chapter, GCEE, Wiesbaden, 18 November.

Lenarcic, A, D Mevis and D Siklos (2016), “Tackling sovereign risk in European banks“, ESM Discussion Paper 1, Luxembourg: European Stability Mechanism.

Micossi, S (2017), A Blueprint for Completing the Banking Union, CEPS Policy Insights No. 2017-42/November.

Véron, N. (2017), “Sovereign Concentration Charges: A FRESH Regime for Banks’ Sovereign Exposures”, prepared in the context of the Economic Dialogues between your European Parliament Economic and Monetary Affairs Committee with the President of the Eurogroup, November.

Endnotes

[1] Art. 97 of CRD IV offers the supervisory review and evaluation process (SREP) which is section of the Pillar 2 of Basel Accords. The main element reason for SREP is to make sure that institutions have adequate arrangements, strategies, processes and mechanisms and also capital and liquidity to make sure a sound management and coverage of their risks, to that they are or may be exposed, including those revealed by stress testing along with other risks that institution may pose to the economic climate.

[2] For a complete description of the regulatory treatment of sovereign exposures in banking regulations, see Enria et al. (2016) and Lenarcic et al. (2016).

[3]Various proposals to determine such a ‘Eurobond’ were discussed earlier this decade, like the red-and-blue bond proposal by Delpla and von Weiszächer (2010) and the Redemption Fund advocated by the GCEE (2011). These proposals proved controversial for they entailed some backup by the European institutions or the member states, that was regarded as a fresh way to obtain moral hazard for highly indebted member states. Recently, Brunnermeier et al. (2011 and 2016) have proposed the usage of securitisation structures to produce a liquid multi-country sovereign exposure – so-called European Safe Bonds, or ESBies – by pooling member states’ sovereigns according to pre-defined rules. ESBies wouldn’t normally entail any public backup nor sharing of losses that may arise from single sovereigns, but would nonetheless create highly regarded ‘tranches’ least subjected to sovereign credit risks, because of structured finance technology.

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