Without any legal authority over banks, the European Central Bank must act quickly if it is to maintain any influence in its role as a regional regulatory supervisor.

Five years after the Lehman Brothers bankruptcy that contributed to the deepening of the financial crisis, the need for a European banking union seems more urgent than ever. The banking system in the euro area remains undercapitalised, fragile and fragmented. The lingering eurozone debt crisis has amplified these problems and increased the urgency of getting to grips with both the fragmentation problem and the credit crunch hurting small and medium-sized businesses.

It is clearly important for the European Central Bank (ECB) to have a clear view of the strengths and weaknesses of the banks, particularly the large ones, when it takes over the responsibility for supervision in late 2014. Having sound information is evidently important for a supervisor that needs to be taken seriously. Moreover, it would be detrimental to the reputation of the ECB in its new supervisory role if a major bank would collapse shortly after it has taken on its new role.

The asset quality review (AQR) to be conducted by the ECB before it takes banks under its supervisory umbrella is likely to have notable consequences. It is possible, and not unlikely, that the review will reveal that many banks are in a worse condition than is generally believed. If so, steps must be taken to write off asset values and/or increase their equity capital. Some banks may have to be closed down or resolved in such a way that contagion effects are minimised.

At present, the ECB is not in a legal position to request – and enforce – measures to alleviate such situations. Thus, the ECB may find itself in the awkward position of starting its supervisory role with problem banks under its purview without the means to take effective action.

Laying the groundwork

The European Shadow Financial Regulatory Committee (ESFRC) recommends that the effective implementation of resolution and recovery procedures, following a bail-in mechanism based on the Recovery and Resolution Directive – which only comes into force in 2018 – or the adoption of a temporary intervention law, will be essential when the results of the AQR become available in the next 12 months.

The ECB should not accept supervision of banks from countries without effective procedures. It lies in the strong interest of banks to be supervised by the ECB and therefore they can be expected to put pressure on national legislatures to act. The reputation effect for banks shut out from ECB supervision can be strong.

Also, the ECB should enter contractual agreements with national authorities to clarify responsibility between the ECB as supervisor and the national resolution authorities. These contracts could include early intervention and appropriate actions on a national level to avoid actual failures. Furthermore, the contracts should include agreements that restructuring and possibly recapitalisation must not amount to bail-outs of shareholders and unsecured creditors but follow agreed upon rules for bail-ins. As mentioned, the enforcement mechanism for the ECB would be the reputation effects for the banks of countries that violate the contracts.

Finally, the ESFRC notes that the AQR should not be conceived and implemented in the narrow sense that the term 'asset quality review' suggests. The quality assessment should also address the viability of a bank’s business model and its governance structure.

Harald Benink is professor of banking and finance at Tilburg University. He is also chairman of the ESFRC. This article is a shortened version of a statement issued by the ESFRC in Brussels on September 16, 2013 (please see www.esfrc.eu).

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