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The single supervisory mechanism – a step towards a European banking union

Speech by Yves Mersch, Member of the Executive Board of the ECB,
University of the Deutsche Bundesbank,
Hachenburg, 27 June 2013

Dear Mr Böhmler,

Dear Professor Keller,

Ladies and Gentlemen, Students,

In June last year, the heads of state and government of the European Union (EU) decided to launch a banking union in Europe. This project is perhaps the largest and most important since the founding of the European monetary union.

Due to the impact of the acute pressure that the financial markets were exerting on the euro area, a timetable was even adopted.

Both steps demonstrated how Europe’s political leaders stand together and take resolute, joint action in times of crisis.

Before I discuss the details of this project and provide an overview of the preparatory work being done by the European Central Bank (ECB), let me give you my key messages for this evening right now:

  1. Even if the need for short-term stabilisation measures has since eased, we must not lose momentum regarding reforms for greater long-term stability.

  2. The various elements of the banking union are symbiotically linked. To forget or dilute individual parts endangers the success of the whole project.

Stability and stabilisation of the monetary union

Let me start with the differences and similarities between stability and stabilisation.

If a leaking ship gets into troubled waters, its crew has overcome two challenges at the same time: first, to keep the ship on course and to ride out the storm, i.e. secure the cargo and close the hatches and portholes so that they are waterproof. These are the stabilisation measures. Second, the holes have to be filled and leaks repaired so that the ship is not threatened with sinking when waves have died down. That is about the stability.

Although the stabilisation measures are sometimes more urgent, restoring long-term stability is no less important.

Let me apply this idea to a repeatedly discussed point of contention in the macro economy. If aggregate demand falls, it makes sense for the state to intervene temporarily via debt-financed stimulus programmes. But it cannot do this permanently; it must over the long term consolidate its budget in order to ensure the sustainable stability of public finances.

In other words, John Maynard Keynes’s comment, “In the long run we are all dead” is true. But it must not be confused with Madame Pompadour’s remark: “Après moi le déluge”.

***

Europe, and especially the euro area, has been facing a double challenge for nearly six years. The global financial crisis which broke out in September 2008 and which grew into the sovereign debt crisis in the euro area in 2010 called for ever more extensive stabilisation measures: economic stimulus programmes and aid loans from governments and the international community as well as aggressive cuts in interest rates and unconventional monetary policy measures by the central bank were repeatedly required order to keep the economy from crashing into deflation.

In parallel, extensive repairs were initiated on the institutional foundations and governance framework in order to secure the long-term stability of the monetary union.

Crisis management in the euro area was first institutionalised in the form of the European Financial Stability Facility (EFSF) in Luxembourg. Previously, the ad hoc crisis measures had to be organised by individual countries and the International Monetary Fund (IMF). Since October last year the European Stability Mechanism (ESM) has permanently replaced the temporary EFSF.

In addition, the governance framework has been strengthened in the euro area. In future, excessive imbalances in public budgets and balances of payments of the Member States are to be more effectively avoided. The Stability and Growth Pact has been strengthened and procedures implemented to avoid macroeconomic imbalances; and it was agreed to transpose the debt and deficit limits of the Stability and Growth Pact to the national legislation of all Member States.

These long-term, preventive measures gain far less attention than the acute crisis interventions – from both financial markets and the general public. A government official wading through a flooded area in rubber boots in order to get an on-the-spot impression is the focus of attention. The mayor of a neighbouring town who raised and strengthened the dykes in his community years ago and thus avoided a flood is rarely mentioned in the news.

Banking union combines stabilisation and stability

The construction of a European banking union should be seen in this context.

The banking union combines both stabilisation and stability.

It should break the negative feedback loop between banks and sovereign debtors and curb the increasing fragmentation of European financial markets, thus ensuring a sustainable supply of credit to the real economy.

It would be a misjudgement to believe that a monetary union could function without a banking union over the long term. The single monetary policy is still accompanied by a regime of national banking regulation, supervision, resolution and deposit insurance.

The crisis has painfully exposed this design flaw in the monetary union.

Let us briefly recall how the crisis started: the banking sector was in difficulty because it had taken on excessive risks, invested in complex financial products and was too leveraged. Some banks could therefore no longer tap the capital and interbank market.

At the same time, the plight of the banks in some countries was exacerbated by precarious budgetary situations.

On the one hand, confidence in the ability of certain states to support their banks dwindled in the face of high budget deficits and debt levels. This made the risk of default by the banks of these countries greater.

On the other hand, the problems in the banking sector in some countries posed a heavy burden on the national budget. Public funds had to be mobilised to recapitalise distressed institutions.

If it is possible to break these negative feedback loops between banks and sovereign borrowers, this will lead to a significant stabilisation of Europe’s banking landscape. At the same time, Europe’s banking sector will become more stable in the long run.

Integrated European banking

But it’s not just about this acute problem. The crisis has also exacerbated an already smoldering, structural problem. While the money and bond market was immediately and fully integrated with the introduction of the euro, the interest rates on corporate loans never fully aligned. Thus, even before the crisis, a company had to pay a different interest rate for the same loan from a German bank than from a Portuguese bank. In other words, there was no European banking market.

A similar picture emerges when one looks at the market for bank mergers in Europe. Most mergers take place within a country. Cross-border mergers between banks in different countries of the euro area were and still are the exception. The necessary consolidation of the banking sector is thus taking place nationally, but not at European level. In an integrated financial market, however, national boundaries should play no role in merger or investment decisions.

But within a monetary union an integrated banking market is of crucial importance. Let me mention just three reasons for this:

First, it promotes access to new capital.

Second, an integrated banking market is a spur to competition. Greater competition means that the existing capital is allocated more efficiently. Firms’ financing conditions improve.

The beneficiaries of these two points are, in particular, small and medium-sized companies with no access to the capital market. The investment climate becomes more favourable, contributing to economic growth.

And third, an integrated banking area increases the effect of monetary policy. This is especially true in an economy such as the euro area, in which about 80% of the financing of the real economy is via the banking sector. Monetary policy thus becomes more predictable, more homogeneous in its effects and more effective overall.

Overview of the single supervisory mechanism

The goal of the proposed banking union is to break the negative feedback loops between banks and sovereign debtors, and to put a stop to the increasing fragmentation of European financial markets and, over the long term, to fully integrate them.

The institutional framework of the banking union comprises two key elements:

  1. the unified supervisory mechanism under the auspices of the ECB, and

  2. a European restructuring and resolution mechanism to consolidate or to wind up banks that are no longer viable.

I’ll consider both these points below. Let me start with the single supervision.

All banks in the euro area and credit institutions in those Member States which enter into close cooperation arrangements are covered by European supervision, the single supervisory mechanism, SSM. EU Member States which have not (yet) adopted the euro can however opt to transfer supervision to the SSM. This emphasises the EU dimension of the project.

One reason why the single supervisory mechanism was assigned to the ECB is because of its well-established European perspective. One cannot assume that a central supervisory authority would permit the banks of some countries to hide risky assets. The denationalisation of supervision can greatly help to strengthen the trust of investors and depositors.

The ECB will directly call for and take over the supervision only of large, systemically important financial institutions. Nevertheless, some national supervisors must follow the ECB’s regulations, guidelines and instructions in respect of the smaller banks which are subject to “indirect” supervision.

In addition, the ECB may at any time demand and take over the direct supervision of smaller banks. According to current plans, central supervision will become operational in the second half of next year.

Even if the starting gun hasn’t been fired, preparations are well under way. The ECB is working closely with the national supervisory authorities. Strategic preparations are being guided by a high-level group, chaired by the President of the ECB. At the technical level, a supervisory task force has been charged with the preparatory work. All competent national authorities are represented in both groups.

In addition, a project team has been set up, whose members are leaders in the fields of supervision and financial stability. The purpose of this team consisting of staff from the national authorities and the ECB is to promote communication and cooperation within the system.

The technical work has been divided into five areas. The focal points are: the creation of a “map” of the banking system of the euro area, discussion of legal issues, development of a single supervisory model, coordination of the comprehensive assessment of credit institutions and preparation of a future model for supervisory reporting for the SSM.

The preparatory work for the balance sheet analysis of the supervised banks is of particular importance. The regulatory text envisages the SSM carrying out a comprehensive assessment of the banks it directly supervises. This is the litmus test for the banks.

In this context, it is useful to proceed in three stages.

  1. First, the systemically important banks are subject to a centrally coordinated risk analysis. Use can certainly be made of the previous work of national supervisors. In this way, the most relevant asset classes and portfolios in the trading and banking books can be identified.

  2. Then the bank’s assets at any given time are analysed and evaluated specifically from a risk perspective. This asset quality review is the responsibility of the ECB. However, effective implementation will require the involvement of the national supervisory authorities. To accomplish the regime change to a credible single supervision, the asset quality review must be thorough and uncompromising. Recourse to external experts here will increase credibility vis-à-vis market participants.

  3. Finally, the banks will be rigorously checked to see how robust they are in respect of possible future stress scenarios. This stress test will be conducted in close cooperation with the European Banking Authority (EBA).

The single resolution mechanism – a necessary complement

However, the common banking supervision is only one element of an effective banking union. For the SSM to work, it must be complemented by a single resolution mechanism. This will be entrusted with winding up non-viable banks.

For the supervisor to make such a judgement objectively, that judgement must also be enforceable. This requires a separate authority which intervenes directly in the banks to divide up losses between shareholders and creditors and which has access to public funds in order to bridge funding gaps.

Without this body it is almost inconceivable to wind up a bank in an orderly way. The supervisor, especially when the function is entrusted to the central bank, could face a predicament. On the one hand, there is the danger of contagion and panic in the financial markets. On the other hand, an attempt to keep ailing banks artificially alive with central bank liquidity could lead to a zombification of the banking landscape.

Regulations supplement institutions

Institutions need rules and instruments. The single supervisory mechanism will ensure that EU-wide regulations are respected. It operates under the acronym CRD IV/CRR and will come into force on 1 January 2014.

The legal framework under which troubled banks and securities firms or non-viable institutions are to be resolved in an orderly fashion will be defined in a European directive (Bank Recovery and Resolution Directive, BRRD).

Legal certainty and confidence about the liability cascade is crucial in order not to unsettle investors and depositors.

Last night, the EU finance ministers agreed on liability rules for banks. Deposits up to €100,000 are untouchable. The state or the ESM should therefore fill shortfalls in bank balance sheets only above a certain threshold. Member States can use their discretion here.

The political compromise is neither strictly bound by rules nor completely discretionary. Thus, a central authority is to decide on concrete implementation to ensure that the remaining room for manoeuvre is used appropriately and is not subject to national interests.

The Member States still have to negotiate with the European Parliament on the Directive. This process should be completed as quickly as possible.

***

Ladies and Gentlemen,

Financial market tensions have clearly eased since last summer. The euro break-up scenario is no longer an issue. To return to my initial imagery: the storm has subsided.

Associated with that, the acute need for ad hoc interventions has declined – even if the euro area economy is still only modestly recovering.

Yet there is still a need to continue urgently with the structural repair work on the institutional framework of the monetary union.

To ensure that the European ship remains stable over the long term and stays on course, there should be no delay to the repairs needed and no slackening. The calm waters should be used. The agreed timetables for building a European banking union bank must be respected. And it should not be forgotten these elements of the banking union are interdependent and form part of a common regime.

Thank you for your attention.

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