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A refresher of European banking union and AQR

Nicolas Veron explains European banking union and its acronyms. The two main pillars are the SSM (Single Supervisory Mechanism), run by the ECB, and the SRM (Single Resolution Mechanism), run by the SRB (Single Resolution Board). Before taking up its new role next month, the ECB will publish a stress test and an AQR (Asset Quality Review). The new framework is expected to ease the home bias of banking regulation and the sovereign-bank “doom loops”. Deficiencies include a lack of area-wide deposit insurance and insufficient resolution funds.

Nicolas Veron (2014), “Banking Union in Nine Questions”, Testimony for the Interparliamentary Conference under Article 13 of the Fiscal Compact, September 30, 2014

On the euro area’s bank-sovereign nexus view post here.
On new euro area bank recapitalisation and resolution rules view post here.

For an earlier more critical assessment of the European banking union also view post here.

The below are excerpts from the testimony. Emphasis and cursive text have been added.

The basics

“Banking union generally refers…either to the process of transfer of authority over banking policy from the national towards the European level, or to the European banking policy framework resulting from that transfer process…The starting point of the process was the [euro area] summit…on June 28–29, 2012, at the end of which leaders memorably declared “we affirm that it is imperative to break the vicious circle between banks and sovereigns” and announced the creation of the Single Supervisory Mechanism (SSM).”

“As of now, the foundation of banking union is composed of two key pieces of EU legislation. The Single Supervisory Mechanism Regulation of October 15, 2013, designates the European Central Bank (ECB) as the licensing authority for all euro area banks from November 4, 2014. The Single Resolution Mechanism(SRM) Regulation of July 15, 2014, creates a Single Resolution Board (SRB) in Brussels from January 1, 2015, and gives it a central role in the future management of crises involving banks directly supervised by the SSM. The SRM Regulation also entrusts the SRB with a Single Resolution Fund (SRF).”

The motivation

“Banking union was started because the earlier framework, which combined national banking policy with European integration through the Internal Market and EMU, had failed to deliver financial stability and was increasingly likely to precipitate the breakup of the euro area.”

“For each national banking supervisory authority, the prudential mandate to ensure financial stability collided with the concern to protect and foster domestically-headquartered banks against their European competitors. The domestic banks’ interests were widely viewed as aligned with the national interest, under a pervasive mindset of “banking nationalism” that typically considers banks as instruments or even agents of government for the purpose of industrial policy (directed lending) and/or government financing (“financial repression”)… High level of public support of domestic banks, combined with the simultaneous refusal to extend similar support to fellow member states as sovereign issuers was a core driver of the bank-sovereign vicious circle of market contagion,”

There were two and only two options to break the bank-sovereign vicious circle: either on the sovereign side, or on the banking side. The sovereign-side option would have required “fiscal union” in the form of a potentially unlimited joint debt issuance capability…Though widely discussed in 2011, no basis for agreement was found beyond the imposition of an EU straightjacket on national fiscal decisions…As the bank-sovereign vicious circle intensified in the spring and early summer of 2012, this left banking union as the only remaining option to avoid the breakup of the euro area.”

The implementation

“The Single Supervisory Mechanism …will assume direct supervisory authority over the euro area’s 120 largest banking groups on November 4, 2014. The Single Resolution Board will start operations in Brussels on January 1, 2015. The Comprehensive Assessment, a crucial element of the transition, is addressed separately under the next question.”

“The SSM’s key decision-making body, the Supervisory Board, has been appointed, as has been the Administrative Board of Review. Senior staff positions were appointed months ago, and in total more than 550 recruitments had been made for the SSM by early July…The ECB also appears to have been remarkably successful in enlisting the cooperation of national bank supervisors.”

The “Comprehensive Assessment”

The Comprehensive Assessment is the transitional process…by which the ECB checks the health of all banks that come under its direct supervisory authority to make sure they still deserve their banking license. It consists of two components, an Asset Quality Review (AQR) and a stress test.”

“Banks need to pass an 8 percent capital threshold under the baseline scenario and a 5.5 percent threshold under the adverse stress scenario. If they don’t, they will have to quickly present plans to bridge the capital gaps in six months for shortfalls under the baseline scenario and in nine months for shortfalls under the adverse scenario.”

Even where the AQR has led to uncovering inadequate practices, the ECB will probably shy away from imposing accounting restatements on banks except in the most egregious cases. But in many more cases, it could ask the banks to change their future accounting and valuation practices, perhaps starting with the financial statements of December 31, 2014, which will be disclosed in the first quarter of 2015. Some balance sheet corrections may take even longer.”

The benefits

“It is increasingly clear that the banking decisions of June 29, 2012, were the critical enabler of the memorable announcement four weeks later by ECB President Mario Draghi that “within our mandate, the ECB is ready to do whatever it takesto preserve the euro—and believe me, it will be enough,” and of the Outright Monetary Transactions (OMT) program that was subsequently announced by the ECB in September.”

“Once in the supervisory driving seat…the ECB can safely be expected to put an end to the national ring-fencing of capital and liquidity that has been imposed by national supervisors…Such ring-fencing is most often not publicly acknowledged by supervisory authorities, but it has been a widespread practice over the past three or four years, and a severely damaging one…Ending it will make a significant contribution to the defragmentation of the financial space in the banking union area.”

“The ECB as a supervisor is likely to gradually dismantle one of the key components of the bank-sovereign vicious circle, namely the large home bias in sovereign debt portfolios held by banks, especially medium-sized and unlisted ones. It is not unusual that banks would hold the equivalent of more than half of their core regulatory capital in bonds issued by their home-country governments… Unlike domestic national supervisors, the ECB can be expected to impose increasingly low exposure limits on such linkages and to encourage banks to diversify their sovereign-debt portfolios and reduce their home bias.”

“Banking union may also have impact on broader structures of Europe’s financial system, and contribute to its rebalancing away from its current overreliance on bank intermediation. Under the previous regime, national authorities favored the expansion of banks over that of nonbank intermediaries and disintermediated credit markets, and occasionally even repressed the latter with burdensome regulation… The current emphasis on developing asset-backed securities (ABS) markets, which is immediately motivated by monetary policy considerations, may thus be the shape of larger things to come.”

The deficiencies

“Significant aspects of banking policy remain outside the scope of banking union. The most obvious case is deposit insurance which… remains a national competence and thus a probable propagator of the bank-sovereign vicious circle in at least some systemic crisis scenarios, as illustrated in Cyprus in early 2013. The same is true of resolution funding: In spite of gradual buildup and ‘mutualization’ of ‘national compartments,’ the Single Resolution Fund will remain too small and unwieldy to represent an adequate European-level resource in systemic banking crisis scenarios. An initial decision to allow the European Stability Mechanism (ESM) to recapitalize banks directly, which was announced on June 29, 2012, was then effectively reversed, and the likelihood of this possibility being activated in the future is low.”

“The Single Resolution Mechanism itself is single in name only, with a complex and untested decision-making framework that preserves significant discretionary autonomy for national resolution authorities, as well as some legal risk.”

“There might be conflicts between the ECB’s supervisory function and its broader macroeconomic, monetary policy, and financial stability responsibilities. Some of the Eurosystem’s national central banks have taken significant financial risks under Emergency Liquidity Assistance (ELA) decisions and may incur losses in some bank restructuring scenarios that could follow the identification of large capital gaps. More broadly, the ECB may be concerned that the disclosure of large capital shortfalls may trigger systemic financial instability,”


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