Under acute pressure, many members of Europe's currency union have undertaken courageous economic reforms. As reflected in their improving fundamentals, these countries are better equipped to face global competition today than at any time since they adopted the euro. In the second quarter of 2013, the eurozone emerged from recession and even those hardest hit by the downturn are bottoming out.
Editor's choice
This is not just a result of the cyclical pendulum swinging back. Their minds focused by the crisis, European leaders have embarked upon a comprehensive renovation of their institutions. The joint governance and surveillance that underpin monetary union have been much reinforced. While more efforts by member states are still needed, fiscal and economic policies in the euro area are far more integrated today than in the first decade of European monetary union, resulting in the gradual reduction of economic imbalances. Economic convergence is back on the agenda.
A giant leap
Perhaps the most impressive architectural change under way in Europe is the establishment of a banking union. The eurozone crisis had the potential to prise the continent apart. Instead, it has ushered in the most ambitious step towards European integration since the launch of the euro itself. With it, the creation of a single market for financial services, initiated in 1999, would find its completion.
The banks did not play a unified role in the sovereign debt crisis. In Ireland and Cyprus, a hypertrophied and damaged banking sector left the countries with a bill they could no longer honour. In Greece, the banks fell prey to the apparent collapse of the state’s creditworthiness. In many places, burst property bubbles left banks suffering losses and sent tax revenues plummeting.
While the crisis played to different scripts in different countries, there can be no lasting recovery anywhere without a healthy banking sector. Only profitable, well-capitalised banks can fulfil their role as lenders to the economy. And only well-regulated, supervised and incentivised banks can play their part in ensuring an efficient allocation of capital throughout the continent.
A key to recovery
Just over a year ago, my government was among the first to suggest that, in order to achieve this objective, Europe needed a banking union comprised of two core elements: a supranational supervisor for the region’s largest banks, and unified rules and efficient mechanisms governing the resolution of troubled financial institutions. A mandatory bail-in regime would ensure that those who fund the banks would have to share the costs of their mistakes in the future – and would know this before they invested. Chances and risks had to be reunited, wrong incentives to be stopped.
The case for a single supervisory mechanism was easy to make. The subprime crisis had already revealed that in many cases, national governments, supervisors and central banks had shown a tendency to minimise the scale of banks’ problems for too long in the hope that they would solve themselves – a behaviour known as “gambling for resurrection”.
A supranational supervisor with sufficient resources and clear responsibility for overseeing the continent’s largest banks would be less likely to let problems fester until they were too entrenched to be addressed easily. A single resolution regime based on clear bail-in rules, meanwhile, would create stronger incentives for banks, their owners and their creditors neither to take nor to tolerate excessive risks. And it would better protect taxpayers should a bank still fail.
A lot has been achieved at the national level. Germany, for instance, has equipped itself with its own resolution regime and bank levy. Yet another reaction to the crisis has also been for banks to retrench onto their domestic turfs, fragmenting the once integrated single market for financial services. Although we are seeing a timid reversal of this worrying trend today, a banking union could help further restore the coherence and homogeneity of the single market for financial services.
Looking forward
The banking union is thus on course to becoming a pillar of the EU. Ideally, it should prevent or at least considerably mitigate the impact of future banking crises not just for the next few years but for decades to come. However, it emphatically is not and cannot be a mechanism to redistribute the burden of yesterday’s crisis among its participants. Whatever legacy issues come to light now will have to be tackled nationally.
And while the banking union will include a limited joint fiscal backstop for member states in the shape of loans or capital from the European Stability Mechanism, these will be last-resort instruments to be used in extreme circumstances after other sources of capital (shareholders, creditors, industry-financed backstops, national fiscal backstops and so on) have been exhausted – and that only subject to appropriate policy conditionality. The banking union will not be a vehicle to merely mutualise existing liabilities or spread the cost of past rescues across more shoulders.
Rapid progress
So, how much progress has been made? Considering the geological pace at which European legislation normally moves, the banking union has advanced at breakneck speed.
Last December, only three months after the European Commission had tabled its first blueprint for a European supervisor, the EU member states agreed on the necessary legislation for the Single Supervisory Mechanism (SSM), followed last April by an agreement with the European Parliament. The concrete preparatory work is now well under way.
The European Central Bank (ECB) in Frankfurt is expected to start its supervision work in the second half of next year, and will be responsible for directly overseeing cross-border and systemically relevant banks across the eurozone. It will apply one unified rulebook derived from the Basel III agreement for all banks. Smaller and purely domestic banks will continue to be supervised at the national level.
This division of labour (the ECB will initially supervise directly roughly 130 eurozone banks) will ensure that the supervisor has enough resources to conduct in-depth, hands-on supervision. It will also avoid the muddying of responsibilities that caused many a supervisory failure in the run-up to the subprime crisis.
Work on establishing a Single Resolution Mechanism (SRM) is less advanced and the undertaking far more complex. There is a broader spectrum of opinion among the member states about the institutional make-up of the mechanism, its exact prerogatives, the role of national resolution authorities, and how to apportion the cost of resolutions. The European Commission’s proposal on the SRM, released in July, will need major amendments before the European Council can reach an agreement.
This should not come as a surprise. Building a resolution mechanism at a continental level is a high-stakes exercise that raises numerous economic, technical and legal challenges.
Criteria to fulfil
Beyond the minutiae, my view is that in order to succeed, the SRM will need to fulfil four requirements: First, it must protect the fiscal sovereignty of the member states and shield taxpayers thanks to a clear bail-in regime. Second, it should set finely calibrated incentives conducive to keeping banks healthy in the long term, not least by deterring governments from enacting policies likely to fuel asset price bubbles or damage bank balance sheets. Third, it must establish fast and predictable mechanisms to deal with those problems that do materialise. Finally, it will have to be legally unassailable.
At the broadest possible level, a well-designed SRM should, as far as possible, remove incentives for anyone whose actions can bear on a bank’s health (from managers to owners, creditors, but also governments, legislators and central bankers) from letting excessive risks accumulate in balance sheets or delaying the elimination of those problems that do arise.
In cases where a cross-border resolution, restructuring or insolvency has become unavoidable, the SRM should facilitate and expedite fair and reasonable agreements between national authorities, ensuring that the process does not get bogged down in parochial rivalries or clashing interests.
Finally, it should be built on such legal foundations that its decisions cannot be successfully challenged in courts.
Targets to meet
If one agrees on these goals, a number of conclusions follow.
The first is that, as a deterrent to excessive risk-taking, any resolution set in motion should require a bail-in element along the lines described in the recently adopted Bank Recovery and Resolution Directive. Industry-financed funds followed by national and European fiscal backstops should only form a second, third and fourth line of defence in the interest of boosting the mechanism’s credibility. Bank managers, owners or creditors will not price risk realistically as long as they have any reason to expect that taxpayers will underwrite their salaries, equity or investment when insolvency threatens.
Second, the SRM should strike a delicate balance between centralisation and delegation. It should be centralised enough to ensure swift agreement in complex cross-border resolutions yet leave enough margin of manoeuvre for national authorities to execute these resolutions in an area – insolvency law – that has yet to be properly harmonised.
Third, and in order to make resolution decisions hard to challenge, the SRM should not be given more competence than necessary and can be justified under the current EU treaties. The powers granted to any central authority and the capacity of any central industry-financed resolution fund should be limited and well defined. It would be a fatal mistake to anchor the SRM on tenuous legal foundations and one that could end up toppling the entire edifice.
Such a banking union – a supranational supervisor flanked by a tightly coordinated system of resolution authorities with a central board ensuring consistent and effective implementation of cross-border resolution, and a system of national resolution funds, backed by clear bail-in rules and buttressed by last-resort national and mutual fiscal backstops – is as far as we should go under existing treaties.
Carefully crafted, it would work. But should all EU member states agree to a small number of narrowly defined treaty changes, it could go much further. Such amendments would not only allow for the creation of a truly centralised resolution authority but also for a more efficient and clearer separation between the supervisory and monetary functions of the ECB. This would make it much easier for EU member states outside the eurozone to join and thus avoid fragmenting the European single market for financial services.
Such a banking union could ultimately grow to fill the borders of the single market, as it indeed should do in the logic of European integration.
Wolfgang Schäuble is Germany's finance minister.
