Nicolas Véron

Europe's Banking Union Starts on an Encouraging Note

This blog post was published today by Bruegel and the Peterson Institute.

Sunday, October 26 was D-Day for Europe’s banks: At noon in Frankfurt, the European Central Bank (ECB) announced the results of its “comprehensive assessment” of the euro area’s 130 largest banks, including an Asset Quality Review (AQR) and stress tests. Simultaneously in London, the European Banking Authority (EBA) announced the results of these stress tests for a larger sample of banks, including the largest banks headquartered in the European Union but outside the euro area.

This was meant as a cathartic watershed that would allow the ECB to take over its new role as the licensing authority of all the euro area’s banks and direct supervisor of the largest ones, a transfer of authority from national supervisors that will occur on Tuesday next week, November 4. The comprehensive assessment is intended to draw a line under years of unsatisfactory oversight by national watchdogs and to allow the ECB to start from a high level of trust.

On the face of it, these objectives appear to have been met, even though a definitive assessment will only be possible several months from now. The ECB identified 25 banks as having been undercapitalized as of end-2013; of these, 12 have raised enough capital this year to be technically compliant with capital requirements, but the other 13 need to submit recapitalization plans to the ECB within two weeks. Four of these are in Italy: Monte dei Paschi di Siena (MPS) (which may have to lose its independence), Carige in Genoa, Banca Popolare di Milano, and Banca Popolare di Vicenza: This puts a cloud above the Bank of Italy’s reputation as a supervisor, especially as several other Italian banks also appear fragile. Farther west in Lisbon, Banco Comercial Portugues (BCP) is among the other institutions asked to strengthen their balance sheet, or else. In total, the assessment identified slightly more “problem banks” than expected but did not uncover problems so massive that they may trigger systemic instability.

Perhaps more importantly, the ECB (and EBA) flooded the market with a deluge of data, the full analysis of which will take several more days. One not-so-hidden nugget of information is how the banks would have fared if a more rigorous yardstick of capital, known as fully-loaded Basel III, had been used instead of the current “phased-in” measure that Basel III will replace in the European Union in a few years. In that case, a few significant German banks would have failed the test as well. They include HSH Nordbank, a northern German Landesbank that provides wholesale services to local savings banks (Sparkassen), in spite of the guarantees it has received for up to €10 billion from the local governments that are also its main shareholders. This group also includes DZ Bank and WGZ Bank, the two wholesale institutions that serve Germany’s system of local cooperative banks (Volksbanken and Raiffeisenbanken)—possibly the biggest surprise of Sunday’s entire disclosure package. The fact that Germany and Italy, two of the euro area’s biggest countries, are not immune to the ECB’s inquisitiveness suggests that the assessment has been kept reasonably independent from political pressure. In the two other largest countries, France and Spain, most banks passed the test successfully.

Crucially, this exercise must be seen as the beginning of a sequence of policy actions by the ECB—even as, to the thousands of professionals who participated in the process, it may feel like the end point of a long hard slog. To start with, investors and the public will need to be persuaded that there are no more skeletons hiding in the banks’ cupboards. This is likely to take a few months: The credibility of the EBA-led stress tests whose results were announced in mid-July 2011 was later ruined by the problems of Dexia in October 2011, then of Bankia in May 2012. Moreover, some of the AQR’s consequences will only be felt in the banks’ financial statements as of end-2014: For example, more of the €136 billion of additional nonperforming loan exposures identified in the AQR may be written down at that time. Overall, the definitive assessment on the robustness and credibility of the comprehensive assessment, and specifically of the AQR, will probably have to wait until the first quarter of 2015.

Furthermore, the ECB has a lot of followup work on its plate on a number of issues it has signalled it will address gradually after its assumption of direct supervisory authority on November 4. It should gradually tighten the definition of capital to make it fully compliant with the Basel III framework, including on the contentious question of insurance subsidiaries of diversified banking groups (a point on which even today’s “fully-loaded” disclosures are based on a laxer standard than the international accord, and which is particularly sensitive for several large French banks). It should put an end to the widespread practices of geographical ring-fencing of capital and liquidity by national supervisors within the banking union area, an aim that may eventually require legislative changes in Germany and elsewhere. It should vigorously encourage those banks that keep a high home-country bias in their sovereign debt portfolios to reduce it, something that ECB top supervisor Danièle Nouy has already announced. It should encourage cross-border bank acquisitions, and investment in banks by international private equity funds, to decrease the sector’s current fragmentation along national lines. Finally, it should gradually bring smaller banks (mostly German, Austrian, and Italian) into its supervisory fold, as Ms. Nouy’s deputy Sabine Lautenschläger has indicated.

The full economic impact of the comprehensive assessment will depend on these developments still to come. If all goes according to plan, it may unlock some of Europe’s repressed growth, by allowing most banks to lend more freely now that their creditworthiness has been duly checked—even though this will not resolve a number of other problems in Europe’s anaemic economy that contribute to depressed credit demand. Overall, this debut of Europe’s banking union comes five years too late, but better late than never. It is an encouraging start for the most transformative policy initiative that has emerged from Europe’s crisis so far.

The Standoff between France and the EU on Fiscal Policy

Steve Weisman conducted a joint interview of Jacob Kirkegaard and me on the French budget and its possible non-compliance with European fiscal policy arrangements. This was posted yesterday on the Peterson Institute's website, in both audio and video formats. 

Free Flash Cards for Commissioner-designate Jonathan Hill

This was posted today by Bruegel and the Peterson Institute (in two parts: I and II). 

The President-designate of the European Commission, Jean-Claude Juncker, has nominated Jonathan Hill, previously a UK government minister, as Commissioner-designate for Financial Stability, Financial Services and Capital Markets Union. The European Parliament has a veto on the eventual confirmation of the whole Commission, and has used this right in the past to request and obtain the replacement of individual candidates it deemed unfit. As part of the confirmation process, the Parliament’s Economic & Monetary Affairs Committee has quizzed Mr Hill on October 1, and decided to conduct a second hearing session next week. In preparation thereof, President of the European Parliament Martin Schulz has sent a list of questions to Mr Hill on October 2. The 23 questions in that list are copied below.

To enable Mr Hill’s overworked staff to enjoy a rare sunny weekend in Brussels, ready-made answers are suggested here. With due regard to the European Commission’s ever-stretched finances and to avoid any possible perception of conflict of interest, they are provided free of charge.[1]

1. What is your vision of a well-regulated and integrated Capital Markets Union? How do you define the concept, what are its features and what are in your opinion the three most important elements to achieve a Capital Markets Union?

Well these are meaty questions, so I will make a bit of a longish answer. The concept of the Capital Markets Union is the fulfilment of the Treaty’s promise of a single market for financial capital in the EU. The single biggest obstacle to this vision was the fragmentation of the banking supervisory framework, a crucial one given that banking intermediation represents most of the EU’s financial system. Now that this obstacle is being lifted thanks to banking union, we need to go further in creating a single market for capital. Because London is the hub of the EU’s capital markets, this needs to encompass all EU member states in a way that was not as critical for banking union, as Commission President-designate Jean-Claude Juncker helpfully reminded me in my mission letter.

As with banking union, the features of the Capital Markets Union are about regulation, supervision, and crisis management. In regulation, I will seek to fulfil the Larosière Report’s vision of a single rulebook, taking into account the principles of subsidiarity and proportionality with regard to existing national rules that affect capital markets. In supervision, I will review which non-bank financial firms need to be supervised, and for those that need to, whether the national or European level is most appropriate. For example, credit rating agencies and trade repositories are – appropriately, in my view – supervised at the European level by the European Securities and Markets Authority (ESMA). I believe it is appropriate that small audit firms be supervised by national audit regulators, even though I am less sure about firms that belong to the larger international audit networks. Financial consultancies and the like are not supervised at all. I will also review crisis management and guarantee frameworks for those non-bank financial firms that may require a special resolution regime or any other form of intervention process other than court-ordered insolvency in case of failure. I am thinking particularly of financial market infrastructures here, and specifically about central counterparties (CCPs) for which I have promised a recovery and resolution framework in the answers I sent you a few days ago.

As I wrote in these answers, the Capital Markets Union will have to be initiated quickly. But some of its components will take time to elaborate, decide and implement. I will duly consult and listen before entering into detailed proposals. That said, I can already tell you that I see the three most important elements as being:

(1)    An overhaul of the policy framework for capital markets infrastructure in the EU. I said during my hearing on Wednesday that I needed to get the plumbing right, so here we go. All market practitioners know that national barriers to sharing infrastructure, aided and abetted by economic nationalism (the promotion and protection of national champions), are a major factor of unnecessary cost and market fragmentation in Europe. I want Europe to have as efficient, cost-effective and innovative market infrastructure companies as the United States.

(2)    A quantum leap for consumer and investor protection. For example, it is common knowledge that while the EU has adopted common accounting standards by endorsing International Financial Reporting Standards (IFRS), these standards’ implementation and enforcement are not fully consistent across the EU because of separate national audit firms, audit regulators and enforcement authorities. I want us to do better than that.

(3)    An unprecedented EU effort on national insolvency frameworks. These need to be reformed and partly harmonized to allow for better financing of fast-growth companies and securitization of Small- and Medium-sized Enterprises (SME) loans. I know this is a political minefield but I will not shy away from the endeavour. Also, to complete the banking union, I will seek the creation of a single insolvency regime for large banks, perhaps as an alternative option to existing national regimes. I believe this can be achieved without Treaty change.

There are other elements of course, such as new rules on securitization, money market funds and other financial products; a review of possible obstacles to SME and infrastructure financing that may come from our prudential rules (especially Solvency II); and perhaps some work on the taxation of savings, even though I am aware of how difficult it will be to reach any form of harmonization in this latter area.

2. What are the main barriers to creating a Capital Markets Union? What specifically needs to be done for these barriers to be removed? Which ones will you be giving priority and why?

There are all sorts of barriers inherited from the past, and maintained by the pervasive economic nationalism that remains a key driver of our policy framework, in spite of all the lip-service given by member states to their obligations under EU treaties. To remove such barriers, I need to ceaselessly analyse and expose the costs of market fragmentation and the economic benefits of capital markets development, which require a degree of market integration. Let me stress that the objective is not integration or centralization for the sake of it, but to develop our capital markets for the benefit of all EU citizens.

3. If securitisation is to be revived, please outline your view of how it can be made safe and how it will lead to growth and jobs.

Financial activities are based on a trade-off between risk and reward and can thus never be made perfectly safe – otherwise it is the safety of the graveyard, as they say. I believe the recent joint paper of the Bank of England and European Central Bank can be a good starting point for our reflection. I expect to be able to make more specific proposals before the end of 2014.

4. What legislation can be adapted or introduced to support he further development and diversification of capital markets? How would this lead to SME's gaining better access to long-term funding via capital markets?

One instrument is to legislate on specific products or market segments to make sure they are properly monitored and stay within reasonable prudential limits, such as the Commission’s proposal on European Long-term Investment Funds. I will develop more proposals of this kind. However, I believe the framework conditions for capital markets development are even more important, in good Ordnungspolitik fashion as I may say in the language of Master Eckhart. (Or was it Erhard?) Thus my three priority elements as outlined under Question 1.

5. What recommendations would you suggest with regards to digital currencies like bitcoin?

I need more in-depth analytical work on this, and more generally on how technology is rapidly changing the shape of our financial system and the very categories through which we think about finance and regulate it. It is frustrating that people make more mobile payments in Kenya than in most EU countries. I want to be much more ambitious in adapting our financial regulatory framework so that it allows EU citizens to benefit from great new technologies, while providing adequate protection for consumers and against systemic and other risks.

6. What is your opinion on high frequency trading in general and its compatibility with the need to stimulate long term financing?

High-frequency trading is one form of technology-enabled financial innovation. I will consider it in a dispassionate way, and will also look with interest at what the US authorities are envisaging in this regard. There are both investor-protection and financial-stability concerns about HFT, which I take seriously but on which I have not drawn conclusions yet. Having said that, our financial system is vast, and it includes many different segments. I don’t see why the simultaneous existence of HFT and long-term financing should pose a problem per se.

7. The Chair of the European Banking Authority indicated that certain banks might not pass the on-going stress tests. Should this happen, what action would you take?

We are building up the Single Resolution Board and it will be ready for the deadlines set by the Single Resolution Mechanism Regulation. That said, in the next few months the responsibility for addressing the consequences of the European Central Bank (ECB)’s Comprehensive Assessment in terms of bank restructuring and resolution remains at the national level. Of course, I will monitor such developments closely and participate actively in those discussions that have a euro-area or EU dimension in this respect.

8. Could you provide details on how you see the distribution of responsibilities between yourself and Commissioners-designate Moscovici and Katainen in respect of issues in ECON’s field of competence, as well as the distribution of responsibilities between yourself, Commissioners-designate Moscovici and Dombrovskis, particularly with regard to the external representation of matters concerning the euro area?

I will work with Vice President Katainen under the terms set by my mission letter. Commissioner-designate Moscovici will take the lead on the Financial Transaction Tax and other issues of taxation, but I look forward to working together with him on assessing and addressing any possible impact in terms of market integration and financial stability. The teams that are transferred under my responsibility from the European Commission’s DG ECFIN will continue to play their important part in the financial sector assessment work of the so-called Troika. The external representation of matters uniquely linked to the euro area will be a task for Vice President Dombrovskis, assisted by Commissioner-designate Moscovici. Any external representation of matters concerning the banking union are for VP Katainen or (more probably) for me directly, as far as the Commission is concerned. And I will do external representation on EU financial regulation, for example in the Financial Stability Board, IFRS Foundation Monitoring Board, etc., the way my predecessor Michel Barnier did.

9. Taking into account he previous commitments of the Commission, are you in favour of a Single EU Deposit Guarantee Scheme? Will you make a legislative proposal to that effect, and if so when?

Well, as I am sure you well know, there can be no effective deposit guarantee without a potentially unlimited backstop from a credible fiscal capacity. This capacity currently exists at the national level but not at the European level, and is clearly not in my area of responsibility to create one. As soon as such a capacity exists, I will make proposals for a federal – oops, single – deposit guarantee scheme that will be backed by it. In the meantime, there is little more I can do than help implementing and enforcing the existing DGS Directive.

10. Can you make a clear commitment that when legislating for the EU28 you will guarantee the integrity of the single market and neither propose nor support or introduce double majority voting applicable to euro area and non-euro area Member States such as in EBA?

I do commit to the integrity of the single market. Now, as you know, I inherit some tricky issues as the Single Supervisory Mechanism (SSM) regulation and SRM regulation do not treat all member states equally. This was a necessary consequence of the political conditions under which they were adopted, not least the sometimes irrational unwillingness of my country of citizenship to participate in common-interest EU initiatives. (May I quote from the February 2014 report of the UK House of Lords here, paragraph 187: “It would be wise not to close the door on the possibility of some level of [UK] participation in Banking Union in the future, in particular as a means of further promoting and shaping the Single Market in Financial Services and the UK’s position within it”.)

As for double majority voting, it was found appropriate for the EBA last year. But in his mission letter, President Juncker asked me to “review the governance and the financing” of the European Supervisory Authorities, including the European Banking Authority. I will do this with an open mind and you will of course be closely associated with such review.

11. How do you intend to deal with discrepancies between EU and other important jurisdictions, notably USA? Which approach do you intend to take on third-country equivalence decisions? How do you plan to involve the European Parliament in third-country related matters?

This is a very complex area, and I cannot have a one-size-fits-all approach. The current discussion on financial services in the Transatlantic Trade and Investment Partnership does not look promising. I will need to give a serious second look at our objectives and proposals in this respect. The European Parliament will of course be involved in policy decisions that correspond to a legislative level, but not in individual supervisory decisions, as is common practice in finance.

12. Will you keep the European Parliament fully informed about the work being done in international bodies such as the FSB, Basel Committee, the IASB, and guarantee that unnecessary and unadapted rules for the EU financial sector are being avoided?

I will inform the European Parliament in these areas in line with what I will identify as best practices in other advanced democratic jurisdictions that are members of these bodies. These organizations being global, I cannot commit on their decisions. That said, I will do my best to favour decisions that are aligned with the European interest, and can be implemented in Europe in a fully compliant manner. I will also take a second look at areas in which the EU is currently not fully compliant with the global standard, such as the IAS 39 accounting standard and some aspects of Basel III.

13. What do you think of the proposals on Eurobonds made by the Commission in the Green Paper on the feasibility of introducing Stability Bonds?

I now have a particularly informed view on the subject. I believe that Eurobonds are part of a broader debate about what could be a sustainable fiscal framework for the euro area. I also believe that the sustainability of the current euro area fiscal framework is open to question, even though this will not be in my area of primary responsibility as a Commissioner. Frankly, we know that more debate and evolution of the national consensus is needed in Germany before this issue can move significantly, so I’ll stop there and let Chancellor Angela Merkel take the lead.

14. What do you think about payment regulation and the fact that payments in the Member States to suppliers should be done within 60 or 90 days at most?

I like the idea, but need to check whether this falls within my responsibility or is on a colleague’s turf.

15. You agreed that the problem of “to-big-to-fail” banks is important and persists. Can you outline how you intend to address it through legislation currently on the table and, potentially, new initiatives? Can you outline what a healthy European banking system looks like?

As for the January proposal of the European Commission on banking structural reform, I will consult extensively before taking a stance. I am sure you will also soon undertake hearings of your own. I have two clear objectives for this legislation. First, it should be a genuine single rulebook, at least inside the banking union area and I believe also for the EU as a whole: some recently adopted national legislation may need to be modified as a consequence. Second, it should facilitate not impede the resolvability of banks, even though I know full well this is easier said than done. Having some convergence with the so-called Volcker Rule in the US would be nice as well, though not a must-have. For the rest, I have an open mind.

Beyond this text, I am following with particular attention the FSB work on bank resolution and still believe a globally consistent framework can be agreed upon there, in which case I will work at its compliant adoption in the EU. A healthy European banking system should be diverse, well-capitalized, well-managed and well-supervised.

16. The IMF is warning about an uncontrolled rise of shadow banking activities. You stated a need to be vigilant of the risks such activities entail but also to distinguish economically useful activities of this kind from others. Can you outline how you propose to detect these activities, assess their utility and ensure the application of the principle of “same risks, same rules”? In this regard, what is your opinion about the key provisions regarding the Commission legislative proposal on Money Market Funds?

There is no such thing as a typical shadow banking activity. The generally accepted (though arguably incorrect) use of the term refers to all non-bank finance. This encompasses myriads of market segments, defined by what they are not (namely, banks) not by what they are. We need to be humble as regards assessing what you call their economic usefulness: economists have not yet come up with a working macroeconomic model of the financial sector, and are unlikely to do so for a while yet. That said, I will do my best. Money Market Funds are one of these segments, and I believe the Commission proposal’s key provisions are reasonable.

17. You made several references in your written and oral answers to ECON about the possibility that we “may have got it wrong” in certain aspects of financial markets regulation and their interactions to the detriment of the real economy. Can you provide some examples of areas where this could be the case? Can you outline how you propose to detect such cases?

I believe the third regulation of credit rating agencies (CRA III) is a good example of politically motivated regulatory overkill. Some aspects of the European Market Infrastructure Regulation (EMIR) also appear to require review in light of the experience of their early implementation so far.[2]

I will ask an independent task force of highly respected luminaries to do an in-depth review of overlaps, underlaps, inconsistencies, unintended consequences, and mere bad drafting of currently applicable legislation and rules, with the aim of having a comprehensive report by early 2016. Without wanting to boast about UK experiences, I believe the Independent Commission on Banking (also known as Vickers Commission) provides a good benchmark in methodological terms. It had a temporary secretariat for a period of up to a year, formed of very capable technocrats seconded by various public authorities, and gave an extensive look at the academic and other analytical literature not just at the legal or political context. Such features could inspire me for the review task force.

18. You mentioned in your written responses that one of the key features of this parliamentary term will be the renegotiation of the relationship between the UK and EU. As a senior member of the UK government, you will be fully aware of any contentious areas in the financial services portfolio. Could you outline what they are and what strategy you would suggest to deal with potential conflicts between UK and EU objectives?

Put simply, the City of London serves the entire EU (and to an extent as well, the global economy) but is primarily supervised, and largely regulated, by the UK government and its agencies. There is a tension there. The EU interest, the UK interest and indeed the interest of the City (though I won’t pay any attention to the latter) are aligned on many topics, but not all. Systemic risk management is a good example of misalignment, as sadly illustrated by the ongoing lawsuit by the UK against the ECB on its so-called location policy for CCPs. My strategy is simple. I will work entirely for the EU interest, within the framework of EU institutions that give a significant voice to the UK government and citizens. I believe that a strong, internationally competitive and properly supervised City of London is absolutely in the EU interest.

19. You committed yourself to the principle of proportionality. Can you outline measures and proposals you want to put forward in order to ensure that small and low complexity financial actors will not be pushed out of the market because of regulatory burden?

This is a case-by-case question. For example, the Alternative Investment Fund Managers Directive has size thresholds under which some provisions do not apply. If I decide to propose a revision of AIFMD, I will certainly keep the principle of such thresholds.

20. Could you provide the committee with a complete list of the financial services clients you personally, or the companies in which you held directorships or shares, worked for?

See Appendix A. [Appendix A still to be drafted.]

21. Do you agree that financing of the three European Supervisory Authorities wholly by the sectors they supervise, as indicated in the mission letter by President-elect Juncker, is simply taxation through the back door?

Well, financing them out of the EU budget is also taxation through the back door, or maybe the front door depending on your perspective. These are public institutions, and their funding cannot be based on voluntary donations. My understanding of my mission letter is that the funding should be changed to make it more predictable, more sustainable and less prone to frequent political negotiation. Such change would be appropriate and indeed needed for independent supervisory authorities. As I said before, their governance needs to change as well, supporting their independence and mandate to serve the European public interest.

22. Could you provide us with a specific figure/estimate on the size of the implicit funding subsidy for Too Big to Fail Banks by taxpayers in the EU and how you envisage removing that subsidy by means of banking regulation?

Economic studies suggest this implicit subsidy is evolving over time and generally decreasing of late. I do not have a more specific quantitative snapshot at this point, but will work at reducing it further. See also Question 15.

23. In relation to the Commission proposal on Benchmarks, there is significant pressure to extend or increase the number of definitions of benchmarks. Do you take the view that it is appropriate to have different supervisory rules for different benchmarks, depending on their importance, which could give rise to regulatory arbitrage, or do you think it is better to have a simple supervisory rule that applies to all benchmarks?

I am instinctively wary of one-size-fits-all solutions to complex challenges, but your point on the risk of regulatory arbitrage strikes me as well-taken as well. I will also look at having a framework on benchmarks which is compatible with evolving requirements and practices outside the EU.

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[1] It should be noted that unlike Mr Hill, the author has no political affiliations or commitments. Therefore, these prepared answers for Mr Hill do not necessarily reflect the personal opinions of the author.

[2] N.B. The author is an independent board member of the global trade repository arm of DTCC. More disclosures are on www.bruegel.org. 

Banking Union in Nine Questions: Interparliamentary Conference Testimony

On Tuesday 30 September, I participated in an Interparliamentary Conference bringing together representatives from parliaments of (almost) all EU member states as well as the European Parliament, hosted by the Italian Chamber of Deputies at Palazzo Montecitorio in Rome. My written statement takes stock on banking union, its past, present and future. It was also posted by Bruegel and the Peterson Institute.