A guide to the recent European banking union deal

Genevieve Signoret & Patrick Signoret

(Pulse aquí para leer esta entrada en español.)

Last Wednesday night 12 December (and into early Thursday 13), European Union (EU) finance ministers agreed on a general approach to establishing a Single Supervisory Mechanism (SSM) for banks. This marks one step in a long path toward a euro area banking union—a necessary condition for a lasting solution to the euro area crisis and for its long-term integrity.

What did the EU ministers agree to? Who’s involved? What does agreement mean for the euro crisis? Why is a banking union necessary, anyway? We’ll answer these and other basic questions in the Q-A that follows.

What did the EU ministers agree to?

All 27 EU finance ministers (who form the Economic and Financial Affairs Council, Ecofin) agreed to establish a single supervisor for the euro area and any other EU country wishing to join the banking union. This will require two regulatory reforms:

First, to confer supervisory tasks on the European Central Bank (ECB). The ECB will create a supervisory board responsible for the overall functioning of the SSM and with direct oversight of the euro area’s largest banks. Its tasks will be kept “strictly separated” from the ECB’s monetary policy tasks.

The December 12 Ecofin statement provides more detail:

The SSM will be composed of the ECB and national competent authorities. The ECB will be responsible for the overall functioning of the SSM. Under the proposals, the ECB will have direct oversight of eurozone banks, although in a differentiated way and in close cooperation with national supervisory authorities. Non-eurozone member states wishing to participate in the SSM will be able to do so by entering into close cooperation arrangements.

The ECB’s monetary tasks would be strictly separated from supervisory tasks to eliminate potential conflicts of interest between the objectives of monetary policy and prudential supervision. To this end, a supervisory board responsible for the preparation of supervisory tasks would be set up within the ECB. Non-eurozone countries participating in the SSM would have full and equal voting rights on the supervisory board. The board’s draft decisions would be deemed adopted unless rejected by the ECB governing council.

Wait a minute. Non-eurozone countries participating in the SSM?

That’s right. The 17-country monetary union (euro area, eurozone) needs to form a true banking union (we’ll explain why below) and will start by setting up a single banking supervisor. But all EU countries are being encouraged to join. First, because the rules for supervising banks are still the same for all EU countries. Second, because a banking union can benefit other EU countries, not least by helping to better separate troubled banks and sovereigns.

The ECB currently only represents the 17 countries in the monetary union. So its supervisory board must expand to give the non-eurozone countries who join “full and equal voting rights”. (Some countries don’t want to be in the SSM either way—we’ll get to that.)

Ok. What’s the second regulatory change agreed to last week?

“Double majority voting” with regard to the European Banking Authority (EBA). Ecofin again:

The EBA would retain its competence for further developing the single rulebook and ensuring convergence and consistency in supervisory practice. The proposals foresee changes to the EBA regulation, in particular as regards voting modalities, to ensure equitable and effective decision-making within the single market. The amendments would ensure that the countries participating in the SSM would not unduly dominate the EBA’s board of supervisors.

To understand that paragraph, you should know that the EBA is the EU authority that sets common rules for banking supervision. It doesn’t carry out the supervision itself. Today, national central banks do the supervising; in the future, the ECB will do that in the euro area and some other countries. But the rules, written by the EBA, will remain the same for everyone.

Countries outside the SSM were worried that countries under a single supervisor—an overwhelming majority—would want to act as a single block within the EBA and effectively set the rules for everyone. The solution was “double majority voting”, which means that EBA decisions must be made not only by a majority of all 27 countries, but also by a majority of the “outs”—the countries that choose to remain outside the SSM. Open Europe explains that the deal “establishes the important principle that the eurozone can’t write the rules for the rest of the EU”.

Does everyone want it?

No. All EU countries are invited to join the Single Supervisory Mechanism, but three have already opted out: the UK, Sweden, and the Czech Republic. They want to supervise and protect their own banks, alone.

So EU countries will divide into three groups:

  1. Eurozone member countries; they’ll be part of the SSM automatically.
  2. Non-eurozone countries who want in.
  3. Non-eurozone countries who opt out.

Is the ECB now the direct supervisor of all euro area banks?

No, not now, and not all banks. The next step is for the EU Parliament to pass the necessary legislation to put these decisions into effect. It’s expected to do so by the end of this year. (Some national parliaments, including Germany’s Bundestag, must also approve legislation. They probably will.) Then the ECB must prepare for its new job. That’ll take at least a year. In fact, the ECB won’t have any direct supervisory role until March 2014 or 12 months after the entry in force of the legislation, whichever is later.

Also, even when the ECB is set up, it’ll have direct supervisory control only over the largest banks: those holding at least 30 bn euros in assets or whose assets have larger than a 20% share in their countries’ GDPs. Right now that means between 150 and 200 banks, out of the euro area’s total of 6,000.

Doesn’t that exclude most local and regional German banks?

Yes. For Germany, that was the whole point of restricting the ECB’s jurisdiction. Germany says those banks aren’t systemically important for the euro area. This was a sticking point during the negotiations: other countries, such as France, insisted that the ECB be given powers immediately to directly supervise all euro area banks. They argued that, though the local and regional German banks are individually small, their combined assets are huge (1 trillion euros, or about 20% of the country’s banking sector assets, quotes El País). But Germany held out and won.

Let’s go back to basics. Why a banking union, anyway?

To break the vicious cycle that euro area banks and sovereigns are caught in. Financial Times explained it last June 18:

The fortunes of banks and their sovereigns are tightly bound together and, in bad times, that can be lethal.

During this financial crisis, EU taxpayers discovered what it means to underwrite these institutions: some €4.5tn of state aid has been approved to European banks since 2008, equivalent to more than one-third of EU economic output.

Banks, in turn, discovered their dependence on their home country. A bank backed by a weak sovereign pays more to raise money. When sovereigns face fiscal troubles, banks also suffer as they are big buyers of their home government’s debt – last year more than 60 per cent of Irish, Portuguese and Greek bonds were held by domestic banks.

In the aftermath of the credit bubble, these ties formed a destructive loop that has bedevilled the eurozone, describing a path to ruination where cash strapped banks eventually drag down the cash strapped sovereigns that were supposed to rescue them.

These ties also hamper the solution. National authorities can be too close or proud to diagnose banking problems early, too reliant on banks as customers of their debt, or too fond of national champions.

The ECB makes some of those same points in its official rationale:

The crisis has highlighted the fundamental incongruity of banking supervision being controlled at the national level in a currency area with a single monetary policy.

[…] A key feature of the present crisis is the increase in the correlation between the cost of funding of euro area banks and that of their respective sovereigns, particularly in some countries under stress. Countries suffering from a loss of market confidence have become progressively more dependent on domestic sources of funding (where and insofar as they are available) and less responsive to common monetary policy impulses. The divergence in bank funding conditions at the national level, in turn, gives rise to cross-country differences in lending conditions.

[…] Against this background, the need to weaken the spillover chain between banks and sovereigns by taking responsibility for the stability of the banking system at the European level becomes evident. Within the framework of improving the institutional arrangements to ensure a more efficient and consistent solution to banking problems across the euro area, a banking union is a necessary step to improve investors’ confidence and to weaken this link between fiscal and banking problems. It would also contribute to achieving a more integrated banking system that supports a full-fledged EMU.

Will the SSM do the trick?

Not by itself. The single supervisor is just one of three crucial pillars in a banking union. The other two—a common resolution mechanism and a common deposit guarantee—are either yet to be thought out or have been practically discarded. Hence, a full banking union is still far off.

In our next post, we’ll talk more about these and other difficulties on the path toward banking union.

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