A new IMF Staff Discussion Note provides opinion and advice on the euro area banking union. It reiterates the urgent need for a single regulatory, resolution, and deposit insurance mechanism. The present legal and institutional reality falls well short of it and even last year’s adopted directives and plans only deal with the harmonization of rules and the creation of a single supervisory mechanism (SSM). A credible euro area-wide resolution and deposit insurance seems to be still a distant goal. The ESM’s ability to bear recapitalization losses, whether from “legacy assets” or not, remains uncertain.

A Banking Union for the Euro Area, IMF Staff Discussion Note, February 2013

The case for euro area banking union

“A banking union—a single supervisory-regulatory framework, resolution mechanism, and safety net—for the euro area is the logical conclusion of the idea that integrated banking systems require integrated prudential oversight.”

“In the years preceding the crisis, large capital flows within the euro area fuelled the build-up of sovereign and private sector imbalances. The subsequent deterioration of balance sheets and reversal of flows has forced very sharp economic contractions and financial market fragmentation. Borrowing costs of sovereigns and national private sectors have diverged widely and persistently, cuts in monetary policy rates have had limited or no effects in several economies, and adverse sovereign-bank-real economy dynamics have been prevalent across the region.”

“Moving responsibility for potential financial support and bank supervision to a shared level can reduce fragmentation of financial markets, stem deposit flight, and weaken the vicious loop of rising sovereign and bank borrowing costs… without common resolution and safety nets and credible backstops, an SSM (single supervisory mechanism) alone will do little to weaken vicious sovereign-bank links… To delink weak sovereigns from future residual banking sector risks, it will be important to undertake as soon as possible direct recapitalization of frail domestically systemic banks by the European Stability Mechanism (ESM).”

The present reality

“Banking supervision in the EU is the prerogative of national authorities. While EU directives have set minimum internationally-agreed standards, supervisory handbooks and approaches vary across member states…”

“Banks can place deposits and refinance eligible assets with the Eurosystem and, if collateral constraints bind, resort to emergency liquidity assistance (ELA) from their national central banks. While the ECB’s Governing Council has authority to ensure that lender-of-last-resort activities by national central banks do not interfere with common monetary policy, losses arising on ELA remain the responsibility of the national central banks, which exacerbate sovereign-bank linkages.”

“Existing [deposit insurance] schemes are national, with varying coverage limits, contributions, and fund sizes. Most schemes are underfunded. The EU Directive on Deposit Guarantee Schemes has set minimum standards on coverage (EUR100,000 per depositor per bank) and the pay-out period. The European Commission (EC) has proposed harmonizing national schemes with the possibility of borrowing arrangements across national schemes and with adequate safeguards.”

“Elements of an EU supervisory structure were established in 2011. While regulation remains the prerogative of the EC, technical standards on sectoral microprudential regulation are tasked to the European Supervisory Authorities, the European Banking Authority (EBA), the European Securities and Markets Authority, and the European Insurance and Occupational Pensions Authority.”

Building blocks for euro area banking union

“The Capital Requirements Regulation (CRR) and Capital Requirement Directive (CRD IV) [approved by the EU Council in May 2012]…aim to create harmonized prudential rules that would apply to all banks in the EU (compliant with Basel III). National authorities may impose systemic risk buffers…and…may temporarily impose stricter requirements… The CRR/CRD IV aims to strengthen elements of supervision (e.g., supervisory planning, on-site inspections, and more robust and intrusive supervisory assessments) and harmonize sanctions.”

“The European Commission (EC) presented a plan on September 12, 2012, on the elements of a new SSM that could begin operating in 2013. It called for adoption by end 2012 of European Union (EU) legislative proposals establishing a harmonized regulatory set up, harmonized national resolution regimes for credit institutions, and standards across national deposit insurance schemes. On December 13–14, 2012, the European Council agreed that the SSM would come into operation in March 2014 or one year after the SSM legislation enters into force, whichever is later. Once the SSM legislation is adopted, ESM direct recapitalization could occur, with the ECB supervising the bank in need of assistance.”

“The ECB would directly supervise banks accounting for about 80% of euro-area banking assets, including banks with over €30 billion in assets or 20 percent of national GDP, or if otherwise deemed systemic (e.g., given cross-border reach). At least the three largest banks in each member state would be directly supervised, with the ECB retaining the power to bring any bank under its supervision if deemed necessary.”

“The EU Council recognized the importance of a single resolution mechanism with adequate powers and tools. This mechanism is to be based on financial sector contributions and backstop arrangements that recoup taxpayer support over the medium term, and the EC will make a proposal in 2013.”

The difficulties with the plan

Differences of views on cost sharing for resolution and deposit insurance and the legacy problems of the crisis could delay progress… The term ‘legacy assets’…has been very controversial, reflecting concerns that creditor countries could be expected to put capital into unviable banks.”

“Although the Treaty establishing the ESM provides for the possibility of losses, such losses are not expected in its financial operations, including bank recapitalization. As a bank investor, the expectation is that the ESM must be careful to take balanced risk positions. It likely could not provide capital that a patient investor would not expect to recover over time. Thus, capital needed to bring a systemic bank out of insolvency (i.e., to bring it from negative to nonnegative equity) would in the first instance need to be provided by shareholders and creditors, and then by the national government, with any remaining shortfall covered by the ESM.”

“Under Article 127(6) of the Treaty, the ECB is able to take on specific supervisory tasks without treaty change, upon a unanimous decision of the European Council and after consultation with the European Parliament and the ECB. The EU Council agreement vests in the ECB exclusive authority for a wide range of supervisory tasks. While Article 127(6) provides a legal basis, it has been interpreted expansively in order to establish the SSM. The draft SSM regulation carefully attempts to specify the ECB remit, but litigation risks may in principle not be excluded, as any financial institution confronted with a supervisory decision by the ECB could bring a case before the European Court of Justice on grounds of lack of competence.”