Towards a European Banking Union

Vítor Constâncio, Vice-President of the ECB

(A Few Excerpts of His Speech of 7 September 2012)

Money markets are one of the first markets to be affected if there are doubts about the solvency of an institution. This was clearly witnessed in August 2007, when the emergence of first doubts about the exposure of individual European banks to the US sub-prime mortgage market led to a temporary standstill of that market.

The high degree of interconnectedness affects the impact of supervision and other national policies not only on the domestic banking sector, but also, as an externality, on other countries. This has been captured by the so-called ‘financial trilemma’.

          The concept of the trilemma is adapted from the famous ’monetary trilemma’ on the impossibility of simultaneously achieving three objectives: a fixed exchange rate, capital mobility, and national monetary policy. In a very similar way, but applied to international finance, as put forward by Dirk Schoenmaker (2011) following a model by Xavier Freixas (2003) a ‘financial trilemma’ has been defined, which illustrates the impossibility of achieving three objectives in an environment with globalized financial markets.

These objectives are: first, financial stability; second, financial integration; and third, maintaining national financial policies.

According to the financial trilemma, it is not possible to achieve all three objectives at the same time. The reasoning behind is that with increasing financial integration, pursuing national financial policies will generally not lead to financial stability, because national policies seek to benefit national welfare, while not taking into account externalities of their supervisory practices on other countries. This leads to an under-provision of financial stability as a public good.

A lesson of the trilemma is that it is beneficial for the provision of financial stability to replace national policies with policies at the supranational level, thus geographically aligning supervisory incentives with the effect such supervision has on the financial sector as a whole.

The events of the past few years have demonstrated that Monetary Union in Europe requires a high degree of financial integration, in which financial institutions diversify their assets and liabilities across euro area countries.

This is essential for an effective transmission of monetary policy.

Until the start of the financial crisis and in particular until the beginning of the sovereign debt crisis, there was good progress in all aspects of financial integration. Unfortunately since then we have been facing a continuous development in the opposite direction with fragmentation of markets along national borders. Even more than that, we observe a reversal of flows with capital going to core countries and away from the periphery.

Benefits of allocating supervisory powers to the central bank –

• Being responsible for monetary policy creates for the central bank an intrinsic and deep interest in a stable financial system. Such stability can be jeopardized through the failure or break-up of an individual financial institution.
• There is a close relationship between micro-prudential control of individual financial institutions and the assessment of risks to the overall financial system, which constitutes the central bank’s macro-prudential responsibility.
• Information-related synergies exist between the supervision of banks and the oversight of payment systems, which is a task usually allocated to the central bank.
• Central banks have a lot of expertise on the financial sector, because of their role in monetary policy and oversight as well as their general interest in financial stability.
• The operational independence of the supervisory agency is important for effective supervision. Here, I refer to independence from political interference, and I have in mind situations in which local politics may have an interest in the avoiding bank resolutions for political reasons. This independence would be emphasized by allocating the supervisory responsibility to the central bank.

Potential downsides of having central bank involvement in banking supervision –

• There is the issue of reputation risk of the central bank (an argument brought forward by Charles Goodhart): the monetary policy function of the central bank requires that it maintains a high level of credibility and reputation, since it is essential to keep expectations of rising inflation at bay…This risk is overemphasized. The tasks of maintaining price stability and of supervising banks are very different in nature, and their results are easily measurable and distinguishable.
• Possible conflicts of interest between the different central bank functions. At the heart of this argumentation is the question whether the central banks’ concern for the health of banks would jeopardize its price stability objective…To me, the solution to these concerns lies in the organizational structure of the central bank. A situation, in which the central bank puts at risk price stability in favour of financial stability, is not conceivable if the central bank is given a clear hierarchical mandate that places price stability before other concerns.

Around a decade ago, the situation was quite different, and there was a tendency towards separation of the two functions. The recent trend, however, points towards combining both functions under one roof. This trend reversal can be observed also outside the euro area. For instance, in the UK, the FSA was founded in the late 1990s, but recent proposals aim at re-allocating it under the umbrella of the Bank of England. In the US, the FED was also given an extension of its mandate regarding supervision.

The euro area supervisory jurisdiction will need to be matched by two further institutional evolutions:

• The move towards a unified bank resolution scheme. Quite naturally, this is an integral element of the banking union, which must have a resolution authority to close or restructure banks whenever appropriate.
• A deposit insurance scheme – ensure that decisions that are taken at the supranational level affect depositors in all countries in the same way, thus ensuring a level playing-field…The scheme would thereby also foster financial integration…At the moment, deposit protection schemes in the euro area are still fragmented along national borders. While there have been waves of harmonization – for instance in 2009, a uniform minimum coverage of EUR 100,000 was introduced -, they still display significant regional differences.