Erkki Liikanen, Governor of the Bank of Finland: The Future of EMU, Brussels Economic Forum, 19 June 2013
The experience since 2008 has demonstrated how vulnerable the banking system in the EU is to shocks. A problem at one bank can quickly spread to other banks both at home and over the borders.
The history shows that a banking crisis can have devastating effects on the real economy. Collateral damage to households and firms may become huge, and with it a major bill to taxpayers.
To avoid this in the future, a number of parallel and complementary reforms are currently at the table. These include first the well-known reform of the regulatory framework based on the Basel III recommendations. The second is the blueprint for the banking union, and the third is the reform of the banking structures in Europe.
In 2010 it became desperately evident that the bank and sovereign risks are tightly interconnected. The causality is two-way.
On the one hand, a bank is, through various channels (asset quality, ratings, deposit insurance), crucially dependent on the credibility of its home country. On the other hand, the home country is responsible for cleaning up the mess caused by a bank failure. This may endanger the solvency of the sovereign.
This issue of interconnectedness is particularly important for countries belonging to a monetary union, where the institutional design sets tighter constraints on the capacity of the central bank to act as a lender of last resort.
Since 2008 authorities have often been forced to intervene. Interventions have ranged from state guarantees and recapitalization to winding down institutions and setting up asset management companies.
The size of interventions is huge. Between 2008 and 2011 the EU member states provided more than €1,600 billion in various forms of support to the banking sector. This amounts to 13 per cent of GDP.
Research suggests that it is very difficult, if not impossible, to combine the three objectives: the desire to promote financial integration, the desire to maintain financial stability, and the desire to maintain financial supervision (and resolution) in the hands of national authorities. One of these must be given up. This difficulty is sometimes referred to as financial trilemma.
The integration of financial markets and promoting cross-border banking were cornerstones of the single market programme. Free flow of money and capital were expected to equalize prices of financial services and the risk-adjusted returns on investments. This was seen to promote the free flow of goods and services and to facilitate free movement of people. It was also considered to be a prerequisite for the smooth transmission of single monetary policy.
That financial stability is a desirable objective should be self-evident. We bitterly know how damaging financial instability may be to the real economy. Because of financial integration and the interconnectedness of banking, the consequences of financial instability are unlikely to be limited to a single country.
Because a properly functioning single market is a commonly accepted objective and financial stability is a common concern, the solution to the financial trilemma must be a single supervisory mechanism. The recent history has shown that home country supervision and the single passport principle do not suffice to secure financial stability.
To be a stable and coherent system, single supervision needs to be accompanied by an authority which has powers to restructure and wind down failing banks while minimizing the cost to taxpayers. This is more or less what the banking union is all about.
The idea of the EU-wide banking union started to fly in the euro-area summit of 29 June 2012, that is, almost exactly one year ago. The first sentence in the statement of the summit was: “We affirm that it is imperative to break the vicious circle between banks and sovereigns”.
The banking union consists of three pillars:
- Single Supervisory Mechanism (SSM)
- Single Resolution Mechanism (SRM)
- Harmonized deposit guarantee schemes (DGS) in way which is compatible with the banking union.
Of these the setting-up of the Single Supervisory Mechanism is progressing according to the blueprint drawn in June 2012. Two months ago the informal Ecofin Council in Dublin reached a political agreement over the single supervisory mechanism for banks.
The logistical preparations proceed in the ECB for the mechanism to be fully operational by July/August next year. There remain important open issues that deal with the technical implementation of the SSM. The forthcoming Balance Sheet Assessment and the regular stress tests should be of great help to the workings of the SSM.
The key question is that not only the same rules but also the same practices are strictly applied in the supervision of the whole euro area banking sector. This is crucial and must not be compromised. The technical details will determine whether or not it will succeed.
Once the Single Supervisory Mechanism is in place, the next step is to agree on the Single Resolution Mechanism. It is expected that the European Commission would present a proposal in the near future. The foundations of the SRM will rest on the forthcoming Bank Recovery and Resolution Directive, which is being finalized in the coming days. This regime should become operational in 2015.
Today there is much less disagreement than twelve months ago on the need to have the Single Resolution Mechanism and the bail-in rules. It is important to make progress on this front in order to have the resolution mechanism in place soon after the Single Supervisory Mechanism is set up. But again, it is also important to get the details right. Like monetary policy, successful bank resolution mechanism relies on credibility. To achieve credibility and to prevent moral hazard, the central resolution authority must be protected from political pressures by a clear and relatively narrow mandate.
The design of the third pilar of the banking union, the deposit guarantee system, is still in a earlier phase. Of the three elements, this is clearly the most difficult one to bring to the European level. Still as long as deposit insurance systems are predominantly national, a strong channel of contagion remains between the banking sector and the sovereign.
The time is not yet ripe for a European deposit insurance system. Once the SSM and SRM have established an effective control of the European banking sector, and certain legacy issues have been solved, progress there may start to look more natural.
Let me add a final thought on the banking union. Protecting the sovereign against contagion from a weak financial sector is not the only goal of the banking union.
The banking union should also protect banks against contagion from a weak sovereign. It should allow the private sector to maintain access to credit even if the solvency of the sovereign is in doubt. This should reduce the economic and social costs of sovereign insolvency. Indirectly, it would help to restore the credibility of the no-bailout rule, support market discipline and reduce moral hazard.
This, hopefully combined with separation of risky trading from deposit banking institutions, would reduce the expected liabilities of deposit insurance systems, hence easing the political difficulties of unifying the structure of deposit guarantee in Europe.
What else is taking place?
The new regulatory framework based on Basel III is in the process of being phased in. It will strengthen the resilience of the banking system. Banking sector representatives have raised critical voices against many of these reforms. To some extent this is understandable, just given theextent of the new regulations.
It is, however, important to constantly keep in mind that the cost of a banking crisis is so large that a small cost increase, incurred in good times, due to new regulation is warranted. The issue with regulation, however, is that they may create incentives to be circumvented in which case the transparency will once again be impaired and the complexity will increase.
Setting-up of a banking union and reforming the structure of the European banking system are complementary. Separation of investment from retail banking makes the structure easier to be supervised and easier to be managed. The dimension of the “too-big-to-fail” problem would be reduced. At the same time the dimension of the “too-complex-to-be-supervised” would be reduced.
To conclude, let me repeat that we should continue to work to create a financial landscape in Europe which will contribute to the completion of the single market and to financial stability.
We also need a financial system which will transmit monetary policy more evely across the euro area than is the case today, when renationalization of finance hampers European economic recovery.
Some of the required steps are politically difficult and require significant structural and financial adjustments in the banking sector. However, these obstacles are worth overcoming.
More European supervision and more resilient banking structure would only benefit Europe.