The principle of the Banking Union is easy to state: it transfers the supervision of Eurozone banks, and the power to wind them up, to European authorities, using a common European fund financed by European banks. This project was launched in June 2012 during Spain’s crisis, when Eurozone  leaders vowed to “break the vicious circle between banks and sovereigns”, represented in the adjacent graph. For example, in Ireland the collapse of the banks almost bankrupted the state, and in Greece the quasi insolvent state wrecked the banks. The circle worked in both ways.

The Banking Union is based on three pillars:

  • Firstly a single rulebook: the Bank Recovery and Resolution Directive (BRRD) harmonizes the supervision and resolution rules in the Eurozone, and the Deposit Guarantee Schemes (DGS) guarantees a reimbursement to citizens by national governments of up to €100,000 in case of bankruptcy.
  • Secondly a single supervision mechanism (SSM): the European Central Bank (ECB) directly supervises the largest banks (banks that hold 85% of Eurozone assets) and coordinates the whole system. The SSM passed through the European Parliament in 2013 and will be implemented by the end of the year.
  • Thirdly a single resolution mechanism (SRM): if a bank faces financial distress, the ECB will report it to the Single Resolution Board (SRB) based in Brussels and funded by levies on banks (€55billion over eight years, in order to cover approximately 1% of the total assets).

The Board will make decisions such as appointing a special manager or increasing the bank’s capital. The whole process is designed to take place in only 48 hours. With this system, bail-outs (banks saved with taxpayers’ money) should be avoided, as shareholders and large depositors are the first to contribute. The rulebook applies to all 28 member states, while the SSM and SRM are mandatory only for Eurozone members. However, other countries from Europe can choose to participate.

This system should have several positive effects. The sovereign/banks spillover effects should be weakened. Banks’ exante risk-taking should be dampened, as was observed following the creation of the Orderly Liquidation Authority (OLA) in the US in 2010 (see Ignatowski and Korte (2014)).

One should also observe less financial fragmentation, that is cross-border inter-bank lending, and more homebased asset portfolios for banks. The fragmentation of the European financial market was caused by the crisis, but was preceded by a long period of integration that is far from being reversed. This is particularly a problem for monetary policy,  as the transmission of central bank decisions is heavily reliant on an integrated financial market. As fragmenta tion decreases, transmission of policies to where they are most needed will improve (Ruparel 2014). In a steady state, an integrated architecture for financial stability in the euro area would bring a uniformly high standard of enforcement, remove national distortions, and mitigate the buildup of risk concentrations that compromises systemic stability (Goyal et al 2013).  However, the current Banking Union faces several shortcomings that might hamper its action. There is a plain lack of financial resources. The Resolution fund of €55billion will be built over 8 years to backstop a banking sector of more than €30 trillion.

The SRM could only refund a few medium- sized financial institutions. According to Willem Buiter, chief economist for Citi, €1 trillion is needed; according to OpenEurope, between €500 and €600 billion – in any case at least 10 times the amount of the future fund. Moreover, the “too-big-to-fail” problem remains unsolved. If the resolution fund is not well furnished and/or the system is too complex to be efficient and credible, incentives are not sufficient to alter banks risk-taking behavior.

Ignatowski and Korte (2014) observe a threshold-effect: the introduction of the OLA in the US had a significant effect on the overall risk-taking in the banking sector, just not for the largest and most systematically important banks. Laeven et al. (2014) found that the six largest banks (Citigroup, HSBC, etc.) have a distinct, seemingly risky business model: they have lower capital, less stable funding, more market-based activities and are more organizationally complex than smaller banks.

These banks create most of the systemic risk in the current financial system through negative externalities for both financial markets and the real economy. Thus the design of the banking union might need to be complemented with other ex-ante measures to limit large and complex financial institutions’ risk-taking.

In addition, a lot of important data required for the analysis of monetary policy are not available. In particular, much of the data needed to track systemic risk is not published, notably the international dimension and linkages between banks (see Cerutti et al. (2011). In the aftermath of the financial crisis, world decision makers are leading in the dark.

Recent initiatives that aim to improve aggregate banking statistics and gather better institution-level data are welcome, but the complexity of the system means that required data will not be available for some time, notably data concerning shadow banking. The IMF and FSB have jointly issued a report to the G20 finance ministers and central bank governors recommending the creation of a common reporting template for globally systemically important financial institutions (G-SIFIs). Since we do not know how long this transparency and information sharing process will take, the efficiency of the Banking Union’s decisions is presently hindered by this lack of data. The Banking Union seems to be a step in the right direction; in case of financial distress in the banking sector, countries should not be jeopardized, leaving taxpayers to pay the bill.

However, doubts arise on its ability to mitigate future spillovers, notably due to a credibility issue: is a resolution fund of €55billion sufficient to backstop a banking sector of more than €30 trillion? What will really happen if banks do not meet solvency requirements? So far it is hard to judge, but one will soon be able to do so when first resolutions are made.

References: Angelini, P., Grande, G., Panetta, F., 2014. “The negative feedback loop between banks and sovereigns” Bank of Italy Occasional Papers, No. 213 Cerutti, E., Claessens, S., McGuire, P., 2011. “Systemic Risks in Global Banking: What Available Data Can Tell and What More Data are needed?” IMF Working Paper, 11/222 Goyal, R., Brooks, P. K., Pradhan, M., Tressel, T., Del’Arricia, G., Leckow, R., Pazarbasioglu , C., 2013. “A Banking Union for the Euro Area” IMF Staff discussion note Ignatowski, M., Korte, J., 2014. “Wishful thinking or effective threat? Tightening bank resolution regimes and bank risktaking” ECB Working Paper Series No. 1659 Laeven, L., Ratnovski, L., Tong, H., 2014. “Bank size and systemic risk”, IMF Staff Discussion Note 14/04