Banking union and ambiguity: Dare to go further

Sylvester Eijffinger, Rob Nijskens, 23 November 2012

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On September 12, the European Commission published a proposal to establish a banking union in the Eurozone1. This proposal delegates the supervision of large cross-border banks to the ECB. The ECB will also be responsible for supervising smaller banks, in cooperation with national supervisors. The European Banking Authority (EBA) can coordinate this through the proposed Single Supervisory Mechanism.

What consequences do these new developments have for the ECB’s functioning, reputation and credibility? We review the proposed new supervisory regime in the light of the ECB’s three demands (Asmussen 2012):

  • The primary mandate (price stability) must remain unaffected.
  • Monetary policy has to remain independent.
  • The ECB has to have access to all instruments necessary for banking supervision.

ECB involvement in banking supervision

The European Commission proposes that the ECB will ultimately be responsible for all banking supervision in the Eurozone, starting with banks deemed most important to the proper functioning of the system. Delegating microprudential supervision to the ECB has several pros and cons (Padoa-Schioppa 2000, Eijffinger 2009). Firstly, the ECB has an interest in a stable financial system for the transmission of monetary policy. It can ensure this with macroprudential oversight via the European Systemic Risk Board (ESRB), but assessing systemic risks is made easier by microprudential information. Secondly, the ECB possesses significant expertise on the financial sector. Finally, the ECB is an independent body and thus will be less prone to regulatory forbearance than national regulators.

Will monetary policy remain separate from bank supervision?

However, the ECB’s new task may lead to conflicts with its primary mandate. This means that monetary policy has to be organisationally separated from bank supervision, which may prove to be a hard nut to crack. This is may be especially hard considering the fact that the ECB has only one instrument, the interest rate. Consequently, the ECB is demanding new instruments, including access to microprudential information, intervention rights and the right to close non-viable banks. There are also reputational risks for the ECB: a bad performance in its role as a supervisor may reflect badly on its reputation as an inflation fighter.

Critiquing the proposed rules and structure

How will the banking union, with the ECB at its centre, be set up? According to the Commission's proposal, the ECB should start supervising the most systemically relevant banks from 1 July 2013 onwards. After 1 January 2014, the ECB should be responsible for supervising all banks in the Eurozone. This, however, is unfeasible. There are simply too many banks to supervise. Instead national supervisors, not the ECB, should remain ultimately responsible for the supervision of smaller, non-systemic banks. Coordination of this supervision is facilitated by the ESRB (the macro) and the EBA (the micro), and this holds for Eurozone as well as non-Eurozone member states. Furthermore, political independence should be enhanced and the accountability rules improved (Masciandaro et al. 2011). National supervisors should not only be accountable to national parliaments, but also to the European Parliament. This will level the playing field; there is less scope for banks to ‘game the system’ by choosing the most favourable regulator. Figure 1 schematically explains the supervisory structure that we envisage.

Figure 1. Schematic overview of the new supervisory structure in the Eurozone

Liquidity and solvency instruments

Because the ability to control interest rates is also useful for financial stability, the Commission proposal aims to officially appoint the ECB as a lender of last resort. However, this new responsibility may be accompanied by conflicts of interest between financial and monetary stability. As long as both objectives can be achieved with one instrument – e.g. both require lower interest rates – everything should be fine. However, as soon as inflationary pressures rise whilst financial stability is low, the two objectives conflict.

That said, it is certainly true that the ECB will have more control over the banks it assists with liquidity because it can credibly impose explicit conditionality.

The Commission proposes that the ECB will also have a solvency instrument. In coordination with national resolution authorities it can take microprudential early intervention measures. However, in practice it might be difficult to distinguish where early intervention finishes and resolution begins. This may cause quarrels over national sovereignty as resolution efforts are still funded by member states (see the German discontent with the proposal). Politicians have to reach a consensus on a truly European resolution mechanism; the cases of Fortis and Dexia demonstrate why. This should be funded by banks paying premiums based on systemic risk (Huertas and Nieto 2012, Schoenmaker and Gros 2012).

Constructive ambiguity

However, we should go even further than burden sharing and delineate new operational procedures. How will the ECB act as a supervisor? To establish an incentive-compatible supervisory and resolution system it is important that the ECB is sufficiently credible. This credibility facilitates building confidence in regulation and thus helps the ECB in carrying out its new supervisory task. It may be difficult to maintain this credibility if the ECB’s reputation is impaired by mistakes or spill overs from monetary policy.

We suggest a solution (Eijffinger and Nijskens 2012); the ECB should adhere to a policy of ‘constructive ambiguity’ ex ante. This can serve as a solution to forbearance. In a liquidity provision context (though this can also be applied to early intervention measures) constructive ambiguity means that the ECB can commit to a mixed strategy. Never bailing out is too costly and therefore not credible, while always bailing out leads to obvious moral hazard problems. This strategy leads banks to behave more safely on their own by holding more liquid reserves and having a higher capital ratio.

Why adhere to ambiguity?

Adhering to ambiguity gives the ECB the possibility to retain discretion until the moment that assistance is necessary, thereby providing banks with the incentive to behave prudently. To see how this works, consider two polar cases. If the ECB states that all banks will always be assisted, banks take too much risk. On the other hand, if the ECB announces it will never bail out any bank, banks become risk averse and relinquish their function of risk and maturity transformation. Therefore, by being ambiguous ex ante, the ECB can induce banks to take the appropriate amount of risk.

An important prerequisite for ambiguity is that the ECB has a sound reputation and is credible. As the ECB is an independent, reputable institution it is reasonable to assume that it is also credible; this means it is able to pursue constructive ambiguity. However, some caution has to be exerted. As Cukierman notes, too much uncertainty about assistance can lead to risk-averse behaviour, e.g. flight to safety, and can intensify panics (2012). Careful expectations management is therefore needed, leading to a tradeoff between ambiguity and transparency. To make this ambiguity strategy democratically sound, the ECB should be accountable to the European Parliament.

Conclusions

The European Commision’s proposal assigns to the ECB the task of systemic bank supervision, and ultimately the responsibility for bank supervision in the whole Eurozone. It also suggests new microprudential early intervention powers for the ECB.

Several components are missing from this picture. First, the ECB can never supervise all 6000 banks in the Eurozone. Non-systemic banks should be supervised by national supervisors in a harmonised framework which is set up by the European Banking Authority. Second, supervision must be separated from monetary policy to avoid conflicts of interest. Furthermore, European-wide deposit insurance and resolution funds have to be created. This is an important political issue as many member states, but mainly Germany, will not accept the ECB as supervisory authority while resolution is funded at the national level.

Will ambiguity be applied?

Finally and perhaps most importantly, how will the ECB assume its supervisory task? Will ambiguity be applied? Until now, Mario Draghi, president of the ECB, does the utmost to be as clear and transparent as possible, and no sign of ambiguity is to be seen in the liquidity domain. Perhaps this will change when the ECB is also responsible for supervision and is able to impose more conditionality on banks receiving assistance. Adhering to constructive ambiguity can then give banks the appropriate risk taking incentives.

References

Asmussen, Jörg (2012), “Die Finanzmarktunion als Element einer stabilen Währungsunion?”, speech delivered at Handelsblatt, Frankfurt am Main, 4 September.

Cukierman, Alex (2012), “Monetary Policy and Institutions Before, During, and after the Global Financial Crisis”, Paolo Baffi Centre Research Paper, 115, July.

Eijffinger, Sylvester C.W. (2009), “What role for the ECB on financial market supervision?”, Briefing Paper for the Monetary Dialogue, March.

Eijffinger, Sylvester C. W. and Rob Nijskens (2012), “A Dynamic Analysis of Bank Bailouts and Constructive Ambiguity”, CEPR Discussion Paper, 8953, April.

Huertas, Thomas and Mario J. Nieto (2012), “Banking union and bank resolution: How should the two meet?”, VoxEU.org, 26 August.

Masciandaro, Donato, Maria J Nieto and Marc Quintyn (2011), “Will they Sing the Same Tune? Measuring Convergence in the new European System of Financial Supervisors” in Eijffinger, S & D Masciandaro (eds.) Handbook of Central Banking, Financial Regulation and Supervision, 485-530, Edward Elgar Publishing.

Padoa-Schioppa, Tommaso (1999), “EMU and Banking Supervision”, International Finance, 2(2), 295-308.

Schoenmaker, Dirk and Daniel Gros (2012),”A European Deposit Insurance and Resolution Fund - An Update”, Duisenberg School of Finance, policy paper, 26.


1 The European Parliament’s recent Monetary Dialogue with the ECB provides a more detailed assessment of the proposal: http://www.europarl.europa.eu/committees/en/econ/publications.html?id=ECON00005

Topics: EU institutions, EU policies
Tags: banking union, ECB, interest rates, supervision

Professor of Financial Economics and European Financial Integration at Tilburg University and CEPR Research Fellow.
PhD candidate at the Department of Economics, Tilburg University