As the European Parliament and Council accomplished in March 2014 a step towards completing the banking union by backing the proposal for a Single Resolution Mechanism, I will explore in this paper what this European Banking Union means for the systemic risk. First I will approach the notion of systemic risk and then I will detail the construction of the banking union and its limits when it comes to protecting Europeans against systemic risk.
Systemic Risk and some proxies
In Adrian and Brunnermeier (2011), systemic risk is define as the risk that the intermediation capacity of the entire financial system is impaired, with potentially adverse consequences for the supply of credit to the real economy.
Intermediation measure is complex and is the share of the financial institutions in financing non-financial agents. A simple ratio is based on bank credits. Data from Banque de France shows that the decreasing trend of this ratio was rather unchanged by the 2007-09 crisis thus it cannot be used as a proxy :
In the aftermath of the 2007-09 crisis, there are the following proxies to evaluate how financial intermediation was reduced in Europe :
- Laurent Quignon (2013) demonstrated from the ECB data how the transborder interbank loans dropped in the Euro-zone
- Bulletin Banque de France (2011) illustrated the sharp decrease of credits granted to non-financial companies
At the European level, the financial intermediation has been dampened since the 2007-09 crisis for both governments and non-financial companies, but with different level across countries.
- For governments, Greece stands out of the EU group :
- For non-financial companies, Spanish ones have been granted less credits as shown in Fournier 2013:
The European Banking Union
Central banks have the monopoly to regulate the quantity of money in circulation in the economy. With the 2007-09 crisi, the balance sheet of the Federal Reserve (the US central bank) has been multiplied by 4:
This quantitative easing policy, the expansion of the Fed balance sheet through the purchase of government securities primary dealers with newly created money, was aimed at sustaining economic activities by rendering bond investment less attractive.
It is worth mentioning that this quantitative easing policy shifted some risks as follow :
- as bonds interest rate fell, investors have shifted their investment to riskier assets ; as in the run up to 2007 risk had been building up in the background, we might have a similar situation where the 55 trillion dollars added to the economy have foster investment in risky assets whose price could collapse in the event of a shock,
- as there is more money in the economy, there is a risk of inflation driven by investors’ expectations the latter will sell low yield bonds, hence the bonds interest rate could rise sharply that could lead to the feared financial intermediation halt because financing debt is becoming too expensive,
- if the Fed decides to withdraw money from the economy to prevent the risk mentioned in point 2, then there is a risk that assets prices depreciate and some risk taken by investor during the accommodating period could materialize.
The Chair of the Board of Governor of the Fed, Janet Yellen, recently announced tapering and mentioned that quantitative easing could end in 2014.
As mentioned above this can cause asset prices to drop, some risk could materialize in investors portfolios and spillover to the whole economy with runs on financial institution that leads to externalities.
Governing bodies have put in place “macro-prudential capital adequacy requirements that take into account systemic risk” rationale of which are detailed in Korinek (2010).
Some lessons have been learnt with the aftermaths of the 2007-09 crisis. Lehman-Brothers was a non-bank financial intermediary in the United-States of America, and it was a primary dealer. It’s collapse lead Goldman Sachs and Merill Lynch to abandon their status of brokerage firms to become banks. In exchange of stronger regulations, they benefit from the Federal Deposit Insurance Corp. and their ability to borrow emergency funds from the Fed was made permanent.
We see that there were policy moves toward more transparency and stability, these are also at the heart of the European Banking Union project.
On top of those objectives, the European Banking Union is a major step for the European Union, complementing the economic and monetary union.
Here is a snapshot (click to enlarge) that show how the Basel III standards are implemented in European member states participating (Austria, Belgium, Cyprus, Estonia, Finland, France, Germany, Greece, Ireland, Italy, Latvia, Luxembourg, Malta, Netherlands, Portugal, Slovakia, Slovenia, Spain):
The European Banking Union will:
- harmonize rules applied to financial institutions in Europe, hence bringing fairness and more transparency in how banks are regulated across Europe, the single rulebook, parts of which are:
- the CRD IV
- strengthened deposit guarantee schemes
- single supervisory mechanism (SSM)
- single resolution mechanism (SRM)
- incorporate the Capital Requirements Directive (CRD IV) on banks into the European Union legal framework; interestingly, this is still a learning process as “this tool is new for the international framework, it was agreed that data and experience must be gathered before an effective leverage ratio can be introduced as a binding requirement in each jurisdiction.” (source)
- implement Technical Standards with regard to supervisory reporting of institutions, for example, institutions should disclose their leverage ratio as of 1 January 2015;
the single rulebook will be executed by an integrated European supervision (SSM), coordinated by the European Central Bank, the ECB, that will monitor national competent authorities, NCA, like die Deutsche Bundesbank und Banque de France;
- introduce some budget federalism as the costs of potential banking crises will be mutualized, for example there will be a defined resolution mechanism (SRM) with a unique 60 billion € European Resolution Fund that is de facto a cost to European banks; this is defined in a European recovery and resolution framework;
strengthen guarantee of private deposits up to 100 K€, which is a response to the Madoff affair and the Lehman Brothers collapse aimed at preventing bank runs (liquidity risk) and protecting investors;
The European Banking Union aims at reducing the systemic risk via:
- avoid the building up of risk in growth period
- implementing capital requirement, regulatory capital is capital at all times freely available to absorb losses;
- avoiding reliance on credit rating agencies (CRA) requiring each institution to implement its own risk assessment processes;
- implement surveillance mechanism and sanctions threat;
- in case risks materialise, reduce its cost to the real economy
- implementing resolution mechanisms that favour bail-in (investors take losses) rather than bail-out (tax payers are solicited)
- strengthen guarantees and transparency to stabilize the economy, avoiding bank runs and providing confidence for investors to invest in the real economy
The current European Banking Union limits and questions they raise
- The United-Kingdom is not part of the Single Supervisory Mechanism but its financial sectors account for about a quarter of European banking assets. Currently only three countries are declared outside of the SSM (UK, Sweden and Czech Republic), as decisions of the European Bancing Authority has to be reach with a double majority, those three countries almost own a veto power in the EBA decisions. This complexifies the decision mechanism.
- National Competent Authorities (i.e. local central banks) have discretionary power to decide whether some commitment categories will be submitted to the bail-in mechanism. That creates discrepancies across European financial institutions which is against the idea of single rulebook and mechanisms.
- In the same vein, when the ECB decides a banks need to go through the resolution mechanism, the 17 Euro zone member states need to be involved and this could slow down the process and cause problem in a crisis situation where only a limited number of countries would be affected because some countries might refuse that the single resolution fund pay for those banks.
- The Unique Resolution Fund has 60 billion € in reserve but no clear process is detailed in case of a shock that requires more than this amount, hence the link between banks and sovereign creditworthiness still isn’t fully alleviated.
- The Asset Quality Review performed in Europe until October 2014 before the ECB takes over its supervisory role will be closely watched by investors to gauge the European financial market. It is unclear what would happen in case it concludes that there is the need for more regulatory capital than currently available. As an order of magnitude, the IMF estimates that the 2007-9 crisis related loss amount to €1 trillion for European banks alone.
- At an early stage, politics interfere wih the AQR process, as an example, on an Italian bank under difficult conditions, Monte dei Paschi di Siena, an Italian Economy Ministry official announced that “For banks that have been granted EU-approved state aid, like Monte Paschi, stress tests will be run … on the profit and loss statement and the balance sheet as set out in the restructuring plan”. This shows that this process is highly politically sensitive. On the other hand, BlackRock Inc, a giant American asset manager bought some shares in that same bank in March 2014…
- The European Central Bank could have conflicts of interest as it will have the role of supervision and will set the monetary policy in the Eurozone. It could face political pressure to act on the key interest rates to affect price levels to help some banks to pass (or fail) the capital requirements set in the single rulebook.
- The process in Europe is quite unique as some bail-in activities can take place (investors will bear some losses) even before a formal liquidation procedure is put in place for a financial institution. This could divert investors to financial institutions in other jurisdictions like New-York or Singapore, driving much needed capital out of European banks and compounding their frailty. A UK lobby estimates that London could loose 200,000 jobs. More certain, Natixis and Société Général will move their financial market activities out of Paris.
- This early bail-in risk that has to be born by investors will increase the cost of bank senior debt, “a recent survey suggests that under a bail-in regime investors would demand around 90 basis points more for a senior bond issued by a single “A” bank”
- Paul Tucker, former Deputy Governor of the Bank of England, rightly mentioned that if risk isn’t bear by shareholders or bond-holders, then it would be reflected in higher sovereign borrowing cost.
- The above comment lead us to another limit, the lack of fiscal integration in Europe and namely the lack of sovereign debt monitoring across Europe, indeed the Stability and Growth Pact states that “public debt must not exceed 60% of GDP” but with no resolution mechanism in place for states, this rule is obviously not strictly applied by member states as at the end of the second quarter of 2013, the government debt to GDP ratio in the euro area (EA17) stood at 93.4%
- are the costs of being a systemically important financial institution (SIFI) really a deterrent outweighing benefits? Some answers.
- will this then be the end for smaller financial institutions and favour financial giants? Is this desirable from a systemic risk point of view?
- there is a contradiction between incentives to push investors to keep lending to the real economy to foster employment and prevention of a possible credit bubble triggered by quantitative easing policies. Has systemic risk since 2007 decreased in the Euro zone?
- regulating the banking sector is moving some activities to the shadow banking sector, how do the systemic risk contribution of the shadow banking actors compare to the traditional banking sector?
In this post we have presented the status of the European Banking Union and its limits. This raises some questions that need further research, like :
- Can we determine a clear pass-fail criteria to determine if a resolution process has to start for a bank?
- we would need to assess the cost to the system if that process doesn’t start
- we would need to define mesurables
- what is the “right” cost to put on a contribution to the systemic risk?
- what is the link between risk taking and job creation in the real economy?
- we could try to assess how capital venture in the United-States create jobs and how they contribute to systemic risk