Happy Birthday, Banking Union

The European Banking Union turns 10 in November. It provided for the transfer of powers in banking supervision from national authorities to the European Central Bank (ECB)- The process had begun a little earlier, in the years from 2010 to 2012, when the sovereign debt crisis hitting Italy, Spain, Portugal and especially Greece,  and threatened to undermine the foundations of the single currency. However the first pillar of the banking union, the Single Supervisory Mechanism, become operational in November 2014. In those times the spread with Deutsche Bunds was like crazy and was the talk of all the newspapers. We discuss about the European Banking Union, its functions and prerogatives, as well as the state of a process still in progress, in this interview with Brunella Bruno, Professor of Economics of Financial Markets at the Department of Finance of Bocconi University.

Let's go back to the years that preceded the big bang of 2014. What was political sentiment in the European Union and what were the main concerns?

In those years, the vulnerabilities of some eurozone countries clearly emerged, such as the high public debt of Greece and Italy and the speculative excesses in the real estate markets of Spain and Ireland. As a result, the interest rate differential on treasuries between the most vulnerable countries, including Italy, and the financially more solid ones, such as Germany, widened. To give an idea of ​​the extent of the problem, at the end of 2012 the yield differential between Italian BTPs and ten-year German Bunds exceeded 5% (today it is around 1.2%). In these situations, the wider the spread, the lower is the price of treasuries issued by “weak" countries. If an Italian bank holds many BTPs whose prices fall due to the perception of greater risk of the debt issued by the Italian government, the fragility of the state can translate into a fragility of the banks that hold those securities. This creates a vicious circle, known as a bank-sovereign vicious loop, between sovereign risk and banking risk, in which the fragility of the government has repercussions on the banking system and vice versa. A vicious process that needed to be avoided to safeguard the stability of the single currency. This gave rise to crucial questions: if the banking system of a member country falls into crisis, what will be the repercussions for the Monetary Union? What entity should support a banking system in difficulty without resorting to taxpayers' money? Well, that was the context.

Which has therefore produced the European Banking Union based on three pillars, even if the process is not yet complete- Where are we at?

The three pillars are the Single Supervisory Mechanism and the Single Resolution Mechanism, which are fully operational, and the European Deposit Insurance Scheme, which has not yet come into being. All of this is obviously based on a common set of rules. All the Member States of the euro area are members of the Banking Union and, on a voluntary basis, some countries of the EU which although outside the euro have decided to sign close cooperation agreements with the ECB. For example, in October 2020 Bulgaria joined the European banking supervision through “close cooperation”.

What does the Single Supervisory Mechanism consist of? What are its functions?

The Single Supervisory Mechanism - which brings together the ECB, in the role of central supervisor, and the national supervisory authorities (such as the Bank of Italy) - grants and revokes banking licenses, conducts inspections, sets capital requirements, dictates guidelines on risk management, and recommends the most efficient governance models. Single supervision is exercised over the credit institutions of the euro area and, as we said before, also of the non-euro EU member states that have choosen to join it. However, not all banks fall under the eye of the single supervisor, but only the most significant banking groups. The criteria for determining whether a bank is "significant" - and therefore subject to direct supervision by the ECB – depends on the size (assets exceeding 30 billion euros), the economic importance and the cross-border activities of a bank. In total, this involves around 110 banks (there are currently 113, and the list is updated annually) representing over 80% of the banking assets of the euro area.

A necessary response from Europe not to one, but to two nearly consecutive global crises.

Certainly. It is no coincidence, in fact, that the US economy, which suffered greatly from the subprime mortgage crisis of 2007-2009, recovered more quickly than the EU economy, which was hit by two consecutive crises. In some European countries, the 2007-2009 crisis and the sovereign debt crisis in the subsequent years highlighted how problems and vulnerabilities can quickly spread not only from the banking system to the national economy, but also to other national economies and financial systems in the Union. In turn, economic crises tend to affect the health of banks: when the economic climate deteriorates, entrepreneurs have a harder time repaying their loans. There is therefore a close link between the performance of the economy and the solidity of banks’ balance sheets. This is also why the ECB has taken on the role of supervisor of the main European banks.

But not before a careful review of the balance sheets of the banks themselves.

Yes, an intense review of banks’ assets by the ECB was necessary, assessing the banks it would shortly supervise. This is because the evaluation criteria for certain assets varied from bank to bank and from country to country, also as a result of the different styles of supervision adopted by national authorities. The examination of asset quality, carried out in 2014 before the transfer of single supervision to the ECB, was essential to ensure transparency and comparability. Once this phase was completed, the ECB implemented its supervisory activity consistently across banks and countries.

Did the process work? In particular, what did it determine?

The ECB proved to be a strict and demanding supervisor that had the merit of making the European banking system more solid, because it was better capitalized, with higher liquidity indicators and fewer impaired loans. The latter, for example, represented a huge problem for Italy. In 2015-2016, the euro area had one trillion euros of impaired loans, of which a third were held by Italian banks. Almost 20% of our banks' credit portfolio was impaired, a very serious situation because a bank afflicted by problem loans stops carrying out its main activity - collecting deposits and granting loans - to focus on debt recovery. Today, also thanks to the rigorous interventions of the ECB in this area, that 20% has dropped to a more tolerable 5%.

The banks that fall under the supervision of the ECB, as we said before, are around one hundred. The banking system of the Union, however, is much larger. What happens to the other banks?

There are about 2,000 banks in the eurozone. Excluding the 130 significant institutions that we have talked about, the lesser ones continue to be supervised by the national central banks, under the coordination and ultimate responsibility of the ECB. The ECB maintains "indirect" supervision over the latter, to ensure that there are no excessive regulatory differences between significant and less significant banks. The ultimate goal of the Banking Union is therefore to safeguard the soundness of the European banking system through a coherent system of rules and controls on banks operating in different countries. This should result in less fragmented European banking and capital markets: so-called financial integration, that is, the integration between the financial markets of different countries, is an indirect objective, a desirable consequence of a veritable monetary and banking union.

If, despite all the preventive measures provided for in the first pillar, a crisis arises, the second pillar, the Single Resolution Mechanism, intervenes. What does it do exactly?

Its mission is to ensure an orderly resolution of ailing banks, with minimal impact on the real economy and public finances of the participating countries. Strict rules and careful supervision make it less likely that a banking crisis will occur or be resolved through the use of public funds. Consider what happened in Ireland starting in 2007, when the collapse of the real estate sector put the most exposed banks in difficulty, which required a huge intervention by the Irish government to bail them out, leading to a sharp increase in public debt. In general, the first pillar (single supervision) has been the most successful. On the second (resolution and crisis management) there is still work to be done.

The third pillar, still to be implemented, the European Deposit Insurance Scheme, provides for a stronger and more uniform level of insurance coverage in the euro area, ensuring that the level of depositors' confidence in a bank does not depend on the location of the bank. Where are we now?

It really is the missing piece and, at the moment, there does not seem to be any major progress on the horizon. The cause seems to lie in the lack of agreement on how to share the burden of a common deposit insurance, given the presence of banks belonging to different countries (currently, the deposit protection mechanism is national in nature). We can, however, make a reflection. If the delay in the construction of the third pillar were actually attributable to the fear felt by the fiscally more virtuous countries of having to bear the costs of the banking crises of financially weaker states, this concern should be mitigated by the general strengthening of the European banking system. The first two pillars of the Banking Union should ensure that, with increasingly solid banks, both the probability of a crisis and the risk that a banking crisis becomes unmanageable decrease. In these circumstances, the need for intervention by the European Deposit Insurance Scheme would be consequently reduced.