Banking union: A federal model for the European Union with prompt corrective action

Jacopo Carmassi, Carmine Di Noia, Stefano Micossi, 20 September 2012

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The European Commission has published its proposals for the transfer of supervisory responsibilities to the ECB providing a comprehensive and courageous ‘first step’ towards a European banking union (the other steps being European deposit insurance and resolution procedures). Yet, on a number of issues the commission’s chosen path raises questions that should be brought out in the open and fully recognised before final deliberation by the council.

Contents of banking union

In a highly integrated financial system, such as in the EU, taming moral hazard and excessive risk taking requires:

  • A consistent set of regulatory incentives, based not only on common rules;
  • Integrated supranational powers in banking supervision; and
  • Deposit insurance and crisis management, including resolution.

The three functions are intimately interconnected, and only their joint management can eradicate the expectation of national bailouts from the system and thus establish proper incentives against reckless risk taking by banks in the internal market. The commission proposal covers bank supervision and part of crisis management, but not deposit insurance and resolution.

Deposit insurance should only protect depositors and never be used to cover bank losses and shield bank managers, shareholders, and creditors. Furthermore, deposit insurance must be centralised to provide not only equal incentives to bank shareholders and managers with ex-ante funding and risk-based fees throughout the internal market, but also full risk pooling and an adequately funded insurance fund across the banking system at EU level, so as to be able to cushion large shocks affecting one of the largest cross-border banks. The accumulation and pooling of funds would only start within the new system, and thus not affect accumulated insurance funds, in line with transitional arrangements proposed by Gros and Shoenmaker (2012). A separate section of the European Stability Mechanism (ESM) could well perform this purely financial function, while all the supervisory actions relating to risk assessment and other controls of insured entities should be brought under the ECB supervisory powers.

As to crisis management powers, they must be attributed to the EU level in order to establish a credible threat that bank shareholders and managers will be fully liable for the consequences of imprudent behaviour and will in no circumstances be bailed out by national authorities with taxpayers’ money, so as to fully eradicate from the system all possibility for supervisory forbearance at national level. However, as we shall argue, while this requires strong common resolution rules, it does not require all resolution powers to be moved to the EU level.

An important matter to be decided here is where to place the borderline between supervisory corrective action and resolution proper. The commission proposal (Article 4.1k) includes, among supervisory powers to be transferred to the ECB, early intervention “including recovery plans and intra-group financial support arrangements”, with the proviso that these powers will be exercised “in cooperation with the relevant resolution authorities”. It would be preferable, however, to bring under the ECB all crisis management measures that do not involve winding up the banks, including: the power to order the suspension of dividends, recapitalisation, management changes, asset disposal and bank restructuring, up to the creation of a ‘bad’ bank. The need for the ECB to coordinate with national resolution authorities would vanish. With these powers in the hand of the ECB – as they are under the US FDIC system and in some EU member states – deterrence would be sufficiently strong and supervisory forbearance at national level would be precluded.

Resolution would become a residual function that, under common rules preventing national authorities from making good the losses of shareholders and creditors, may well be performed by national authorities of the parent company according to national rules.

This approach does not eliminate the need for a European banking resolution fund. Rather than covering losses emerging from liquidation, its task should be to provide capital, in case of need, to the ‘good bank’ carved out by (European) supervisors to preserve deposits, sound commercial loans and other assets, and worthy systemic functions relating to the payment infrastructure (Carmassi et al. 2010). In view of its limited scope, such a fund would not have to be very large; its resources could be raised by means of a small surcharge over the deposit insurance fee and be managed by the ESM together with the deposit insurance fund.

The centralisation of administrative powers does not require that they be always exercised at the central level for all banks and in all circumstances; indeed, a ‘federal’ organisation in the exercise of these powers seems desirable and even necessary. What is important, however, is that the legal powers of supervisory decisions reside firmly at the supranational level, closely following the legal set up of competition policy.

The scope of application of the regulation

The commission has taken the view whereby the decision to centralise supervisory powers at the ECB would in the main apply to EZ members, while non-euro participants could join the common supervisory mechanism under a ‘close cooperation’ arrangement entailing reduced membership rights. This approach is not required by the Treaty and entails a risk of segmentation of the internal market in banking and financial services.

In this regard, it should be noted that the proposal (Article 127(6) is not restricted to the EZ and may therefore apply to all EU members – as made explicit by the transitional provisions of Article 139(2c) which mentions other provisions of Article 127 that do not apply to member states ‘in derogation’ (i.e. not using the euro), but not its sixth paragraph.

Indeed, one sees no reason why the new common rules on supervision should not apply to the entire EU membership, keeping in account that most arguments requiring banking union are valid independently of using the euro – the main exception being those relating to the proper functioning of the monetary policy transmission mechanism. Should some countries decide not to participate and threaten to exercise their veto power to block the decision, then it would perhaps be preferable to offer them an opt-out rather than excluding all non-euro member states from a banking union from the outset.

The institutional set up

The ECB is at present responsible for carrying the monetary policy function and in addition, its president chairs the European Systemic Risk Board, which is responsible for macroprudential stability and for which the ECB also provides a secretariat. Microsupervision, the subject of the commission proposal, is an entirely different matter since concern for individual banks’ safety and soundness may at times come into conflict with monetary policy goals. Thus, the effective separation within the ECB of the new microsupervisory powers from macromonetary policymaking is of paramount importance in order to preserve the integrity of both functions.

In this regard, the Commission proposal does not go far enough, in that the new function is set up as an internal function of the ECB, exercised with delegated powers from the governing council of the ECB and under its “oversight and responsibility”. Under such a setup, separation seems hardly guaranteed and there is a high risk of contamination between the two functions.

An alternative to be considered is the creation within the ECB of a separate and independent governing council responsible for bank supervision, mimicking the structure of the ECB's governing council, and therefore comprising an executive board and the heads of national supervisory structures. The executive board would include six members appointed by the EU Council with the same procedure as for the ECB executive board, and in addition the vice-president of the ECB, the chairs of EBA and ESM – which is the common fund in charge of financial assistance to the member states and, in our scheme, the management of deposit insurance and resolution funds. In this manner, there would be an institutionalised connection, but no subordination, within the ECB, of the monetary policy and bank supervision functions. The commission could attend the meetings of the governing council as observer, as in the commission proposal. The ECB Vice-President would chair the executive board of the new supervisor and would report to the governing council of the ECB – thus ensuring full and effective mutual flow of information – and the EU Council and Parliament on the execution of supervisory tasks. But the supervision governing council would not receive instructions by the monetary policy governing council.

As envisaged by the 12 September commission communication on banking union – but perhaps not fully yet reflected in legislative texts – EBA would remain in charge of ensuring not only a single rule book, but also uniform supervisory practices (the 'handbook'); this task will be of paramount importance for preserving the integrity of the internal market. At all events, once it is accepted that the new supervisory arrangements apply in principle to the whole union, full and effective coordination with EBA would be better guaranteed by the presence of its chairman as a full voting member in the executive board of the ECB supervisory board; in this manner, EBA would partake in overseeing and enforcing the uniform application of common banking rules.

The third aspect that must be modified in the commission proposal concerns the relationship between the Union and the national supervisory structures. Under the commission proposal, the ECB would acquire “exclusive competences” in carrying out the tasks listed in Article 4.1, and build up a new administrative structure for its fully centralised exercise. An alternative institutional set up to the commission proposal, more in tune with the road map, is offered by the network model for the enforcement for EU anti-trust law (Articles 101 and 102 TFEU) contained in Council Regulation 1/2003. Under that model the centralised enforcer (the commission) and national authorities have parallel competence to apply EU rules in individual cases; the allocation of cases is governed by guidelines set out by the European level. The beauty of this system is that cases are almost automatically handled at the right level and any unnecessary centralisation of powers and duplication of structures is avoided, in full accordance with the principle of subsidiarity.

A point that deserves specific consideration in this context concerns the role of Colleges of Supervisors of cross-border banking groups – that would be supervised on a consolidated basis, as already envisaged in the commission proposal (Article 4.1i). In the commission proposal, these bodies would disappear for banks concentrating their activities solely in the EZ, but would remain to manage home and host relations between euro and non-euro jurisdictions. In our approach, the colleges would survive in all cases and become an executive arm of the ECB for all cross-border union banks. The establishment of union supervision offers the opportunity to turn them into effective supranational supervisory structures, acting under instructions by the ECB, with full powers to control and inspect all branches and subsidiaries of cross-border banking groups. The colleges would deliver their supervisory reports, including any proposal for remedial action, to the ECB Supervisory Board, which would deliberate on the report conclusions and recommendations, and entrust the colleges for their implementation.

Supervisory approach

The financial crisis highlighted, among many regulator failures, a widespread tendency by national regulators and supervisors to side with their troubled banks in hiding information from the public, delaying loss recognition and postponing corrective action, thus magnifying eventual losses (Carmassi and Micossi 2012). Transferring supervisory powers to the union level should go most of the way in removing from the system supervisory forbearance; however, the system would be strengthened further by the adoption of Prompt Corrective Action as under the US FDIC system, which entails stronger incentives for supervisors to act in the general interest of depositors and investors and eschew capture by regulated entities.

Two features of the system are worth stressing. The first one is reliance on public indicators of bank capital weakness to signal the need for corrective action, based on a set of preannounced thresholds corresponding to remedial actions of increasing intensity. The second is an obligation for supervisors to act when the thresholds are crossed: in other words, supervisory action is mandatory.

Thus, there should be a system of capital thresholds requiring supervisors to act with remedial measures of increasing intensity as the specific threshold are trespassed; however, the precise application of instruments within each 'capital zone' should involve some discretion by supervisors, who would have to motivate their decisions. Or, more flexibly, the system could entail a presumption, rather than a rigid obligation, to act and apply measures appropriate to each capital zone, with full public accountability of the specific choices made.

As to the capital indicators, the FDIC has referred to a combination of risk-weighted and unweighted capital ratios. However, overwhelming new evidence has shown that risk-weighted capital ratios are not reliable indicators of weakening capital and risk positions of banks requiring enhanced supervisory action; straight (unweighted) leverage ratios, on the other hand, seem to provide consistent forecasts of emerging trouble sufficiently in advance for supervisors to intervene timely (Haldane 2012). One additional finding by this literature is that in building these ratios, and attendant capital thresholds triggering supervisory action, reference should be made to the evolution of the market value of equity relative to book value (cf. also Calomiris and Herring 2011).

In conclusion

The European Commission has prepared a courageous and comprehensive proposal for the centralisation with the ECB of supervisory powers, within the context of a banking union that will comprise also deposit insurance and resolution. The proposal would be greatly strengthened by enlarging its scope of application to the entire Union, rather than an undetermined EZ-plus union membership; that EBA should remain in charge of all secondary rule-making in the domain of banking, including supervisory standards, and to this end its chair should be included in the new supervision executive board; and that supervisory standards should be broadened to include all crisis management powers under a prompt corrective action system à la FDIC. Our blueprint for the governance of banking union under this approach is depicted in our figure.

Figure 1. The institutional architecture of the European banking union

References

Calomiris, C and R J Herring (2011), “Why and How to Design a Contingent Convertible Debt Requirement”, Working Paper No. 11-41, Wharton Financial Institutions Center, April.

Carmassi, J, E Luchetti, and S Micossi (2010), “Overcoming too-big-to-fail: A Regulatory Framework to Limit Moral Hazard and Free Riding in the Financial Sector”, CEPS Paperback, CEPS, Brussels, March.

Carmassi J and S Micossi (2012), “Time to Set Banking Regulation Right”, CEPS Paperback, CEPS, Brussels, March.

Goodhart C and D Shoenmaker (1995), “Should the Functions of Monetary Policy and Banking Supervision Be Separated?”, Oxford Economic Papers, 47:539-560.
Gros, D and D Shoenmaker (2012), “European Deposit Insurance: Financing the transition”, CEPS Commentary, Brussels, 6 September.

Haldane, AG (2012),”The dog and the frisbee”, paper presented at the Federal Reserve Bank of Kansas City’s 36th economic policy symposium, “The Changing Policy Landscape”, Jackson Hole, Wyoming, 31 August.

Lannoo, K (2012), “The Roadmap to Banking Union: A call for consistency”, CEPS Commentary, Brussels, 30 August.
 

 

Topics: EU policies, International finance
Tags: ECB, European Commission, financial regulation

Jacopo Carmassi
Researcher, Assonime; and Fellow, Wharton Financial Institutions Center
Deputy Director General and Head of Capital Markets and Listed Companies at Assonime
Stefano Micossi
Director General of ASSONIME; Professor at the College of Europe; Member of the Board of CEPS, BNL – BNP Paribas and CIR Group; and Chairman of Scientific Council of the School of European Political Economy, LUISS

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