Banking union: The view from emerging Europe

Erik Berglöf, Ralph De Haas, Jeromin Zettelmeyer, 16 October 2012



A Eurozone-based ‘banking union’ could be crucial for the survival of the Eurozone and its future stability. It would help sever the much-feared ‘death loop’ between sovereigns that are exposed to losses in their national banking systems and banking systems directly and indirectly exposed to sovereigns. But would it also address the deficiencies of nationally based supervision and resolution of multinational banks which have plagued financially-integrated Europe for the last 15 years? Would it do so particularly from the perspective of emerging European countries, which depend on these cross-border banks much more than countries in western Europe do (Figure 1)? Or could it do more harm than good in this respect?

Figure 1. Asset share of foreign-owned banks in national banking systems

Source: Claessens and Van Horen (2012).

Tensions between actual and institutional financial integration in Europe

Multinational banks have been a force for financial development and economic growth, but they have also exacerbated credit booms, adding to the pain of crises – particularly in emerging Europe (See EBRD 2012 for a survey). Both the prevention and the mitigation of these crises has been complicated by poor coordination and conflicts of interest between the home and host countries of multinational banks. Three problems have stood out (For more details, see Allen et al. 2011, D’Hulster 2011 and EBRD 2012).

First, the presence of two supervisory authorities with diverging interests – in the home country of multinational groups and in the country hosting a subsidiary – can complicate effective oversight, and particularly macroprudential supervision. Home-country supervisors may have little incentive (and often no capacity) to police subsidiaries abroad unless they are ‘systemic’ from the perspective of the group (rather than from that of the host country). Host-country supervisors have this incentive, but may have little information about subsidiaries’ parent banks. They will also find it more difficult to limit subsidiary lending than lending by standalone local banks, as they have little control over parent-bank funding, particularly with fixed-exchange-rate regimes. And even if they manage to exercise some control over subsidiary lending, this can be circumvented if multinational banks replace lending through their subsidiaries with cross-border lending directly from the parent or with lending through non-bank subsidiaries, such as leasing companies.

Second, cross-border banking can complicate crisis management. When problems come to light in either the home or host country, supervisors will generally have an incentive to either retrieve liquidity behind national borders or engage in ringfencing to prevent liquidity or assets from leaving the country. This may have negative externalities on the group as a whole, or parts of it, and give rise to further turmoil.

Lastly, home-host coordination is most difficult in the event of the failure of a multinational bank, resulting in a direct conflict of interest over how to share the fiscal burden of bank resolution. Indeed, it is the anticipation of such a situation that drives the diverging interests of home and host supervisors, both in normal times and during crisis management. In bank resolution the primary responsibility of national authorities is towards domestic taxpayers, ignoring cross-border externalities (for example, if rescuing the parent bank helps the subsidiary, and vice versa). As a result, too little capital is likely to be invested in a failing multinational bank. This may make it difficult to maximise the bank’s value as a going concern, and induce outcomes that are both inefficient and detrimental for systemic stability – such as a breakup and separate nationalisation when the bank would have more value, in a future reprivatisation, as a single entity (See Freixas 2003 and Goodhart and Schoenmaker 2009)1.

Even before the banking union idea gained momentum during 2012, the EU introduced several reforms that were designed to address this problem. Since 2011, coordination failures and disagreements between national banking authorities in the EU can, in principle, be tackled by the European Banking Authority, the EU-level body charged with coordinating and, if necessary, arbitrating between banking supervisors. However, as market pressures on the home countries of several Eurozone banks have intensified with the widening crisis in the single-currency area, some home and host authorities of these banks have undertaken a series of unilateral and seemingly ring-fencing measures, presumably reflecting the fact that the responsibility for resolution, and ultimate fiscal losses, remains national (See EBRD 2012, Box 3.4.). Partly in response to these developments, the ‘Vienna Initiative’ – an informal cross-border coordination group created at the height of the 2008-9 crisis and involving international financial institutions, home and host country authorities, and representatives of the major multinational banks – has recently been revived2.

A recent legislative proposal by the European Commission (EU framework for bank recovery and resolution, June 2012) proposes to address some of these problems by creating ‘resolution colleges’, analogous to the supervisory colleges chaired by the European Banking Authority, and giving it a mediation role between the national authorities sitting on these colleges. However, the European Banking Authority’s scope for resolving conflicts of interest in this area would remain constrained by Article 38 of its regulation, which compels it to “ensure that no decision adopted pursuant to [settlement of disagreements between national authorities in cross-border situations] impinges in any way on the fiscal responsibilities of Member States.” This means that it will not be able to take a decision on a bank resolution issue that determines how fiscal losses are distributed across countries – which, unfortunately, is likely to be the main source of disagreement among national authorities.

Making an Eurozone banking union attractive

By creating an institutional structure that matches the actual perimeter of Europe’s integrated banking system as closely as possible, a European banking union could close these institutional gaps and deal with the home host problem once and for all (at least as far as Europe is concerned). Indeed, this is what several recent proposals aim to achieve, in addition to ‘saving’ the Eurozone3. The question is whether the official proposal that is currently on the table – creating an ECB led single supervisory mechanism that would unlock the possibility of direct recapitalisation of euro area banks from ESM resources – meets this standard4.

The answer is clearly “no”. Since resolution authority would remain at the national level in the foreseeable future, the proposal would not address coordination problems in the area of resolution, which are likely to spill over to crisis management. Nor would it address supervisory coordination failures with respect to multinational banks for which either the parent or a subsidiary is located outside the area covered by the single supervisory mechanism. In addition, two concerns about the proposal have recently been articulated by emerging European countries are either in the Eurozone or see themselves as future members.

One worry is that the ECB might devote less attention to the supervision of a small country’s financial system than a national supervisor. This could happen if the ECB were to focus supervision on large groups (essentially displaying the bias that has been attributed to home country authorities) at the expense of preventing local banking crises which are unlikely to pose a systemic threat to Europe as a whole. Note that there is nothing in the commission’s proposal that would directly give rise to such a bias, as the ECB would have explicit supervisory responsibility for individual financial institutions – including subsidiaries. However, there is scepticism on the side of some countries whether the ECB would have sufficient incentives to focus on the local as well as the union-wide systemic level.

Another concern is that the banking union would give rise to moral hazard, as it would combine a common fiscal backstop (a direct recapitalisation instrument housed with the European Stability Mechanism, as envisaged by the European Council in late June) with national resolution authority. A national resolution authority may not be as robust in, for example, imposing losses on creditors of failing banks as they would be if fiscal losses were borne at the national level. Furthermore, national authorities would also retain other policy instruments (for example, the power to tax and subsidise, and housing policies) which influence the likelihood and fiscal costs of banking crises even in the presence of a very powerful and competent joint supervisor.

Assuming that it is not possible to go for the first-best governance structure in one step – an integrated supervision, resolution, deposit insurance and fiscal backstop at the EU level – the European Commission’s proposal could be complemented as follows to address these concerns.

First, remaining coordination gaps could be mitigated by the creation of one or several cross-border stability groups for emerging Europe, following the example of the Baltic-Nordic Stability Group (see EBRD 2012, box 3.5). Membership would include host country authorities, the ECB, the European Banking Authority, the European Commission, the European Financial Committee (representing the European council), and home country authorities (particularly ministries of finance, but also non-Eurozone supervisory authorities)5. In addition to improving supervisory coordination, these could mitigate coordination problems in a crisis by undertaking crisis management exercises and agreeing ahead of time on how resolution cases would be approached. They would also create a link between resolution authorities and the ECB.

Second, the supervisory function within the ECB should be structured in a way that gives smaller members of the single supervisory mechanism sufficient voice. For example, in addition to a board that takes the main decisions, the supervisory function could be governed by a larger ‘Prudential Council’ that would include representatives of national supervisors, which would exercise oversight over the actions of the executive board (see Véron 2012).

Third, national authorities of member countries could be given the option to impose certain macroprudential instruments, such as additional prudential capital buffers, on subsidiaries and domestic banks. These may be justified, for example, to deal with more volatile credit cycles in emerging European countries, or to offset higher macroeconomic and financial vulnerabilities. The ECB could set minimum buffers and retain a veto over national decisions which are deemed to run counter to system-wide stability.

Lastly, there should be an ex ante fiscal burden-sharing agreement between national fiscal authorities and the Eurozone fiscal backstop that forces the national level to take some fiscal losses if (or indeed before) they are taken at the European level. In other words, the European Stability Mechanism should not primarily cover ‘first losses’ passed on to the taxpayer, but only ‘catastrophic losses’, once the national fiscal burden exceeds a predetermined level (for example, 20 percentage points of GDP).

Bringing in the ‘outs’

By staving off financial chaos in Europe, the banking union would benefit even emerging European countries that are not members of the Eurozone. At the same time, there is a concern among some of these countries that a common fiscal backstop for the Eurozone banking system may tilt the competitive balance against banks which are headquartered outside the single currency area. Although foreign subsidiaries would not be eligible for direct support, they might be expected to benefit indirectly through their parent banks, making it harder for domestically owned institutions outside the Eurozone to compete. A further concern, already mentioned above, is that home-host coordination problems will persist after the creation of the single supervisory mechanism. Non-EU countries could not join the mechanism, and although non-Eurozone EU members could opt in, they are unlikely to do so, since they would be excluded from the possibility of direct recapitalisation by the ESM, and may not want to lose supervisory control. From the perspective of these “outs”, Eurozone home authorities would simply be replaced by one powerful eurozone home supervisor – the ECB.

One obvious remedy for EU countries that see net benefits from banking union membership would of course be to join the Eurozone. However, many of these countries may not yet meet the macroeconomic criteria required for accession, or may wish to retain autonomous monetary policy for some time. For these reasons, it is worth exploring whether the benefits of banking union membership could be extended to non-Eurozone countries in full or in part. Several options are conceivable, none of them simple:

First, the European Stability Mechanism treaty could be modified to allow non-Eurozone members to join join if they also join the single supervisory mechanism – that is, to become full members of the banking union without necessarily adopting the single currency. In addition to access to the European Stability Mechanism, these countries should also be allowed access to euro liquidity (through swap lines with the ECB, see below). The fact that these countries continue to have their own monetary policy and hence an extra instrument to influence credit growth could be addressed by letting national authorities absorb most of the ‘first loss’ should anything go wrong in their banking sectors.

Second, it may be possible to create an ‘associate member’ status in the banking union for non-Eurozone countries. Unlike their Eurozone counterparts, they would not give up supervisory control, nor would they benefit from the European Stability Mechanism. However, the ECB could give them access to euro liquidity – in the form of foreign-exchange swap lines against domestic collateral. In return, national supervisors would agree to share information with the ECB and to a periodic review of their supervisory policies. Swap lines would be committed from one review period to the next, and rolled over subject to the satisfactory completion of the review.

Third, it might be possible to devise a supervisory regime that allows the host country to retain significant supervisory control but at the same time mitigates the coordination problem in respect of multinational banking groups. As described above, although host countries have formal supervisory power over subsidiaries, they have sometimes had limited de facto control because of a lack of information about, and influence over, parent bank funding. One way of mitigating this problem would be to have the ECB share supervisory responsibility for the subsidiaries of multilateral groups in return for giving host supervisors information about, and some influence over, the supervision of the group. The latter could range from normal participation in the single supervisory mechanism (with respect to the group) to the right to be heard.

The first of these options would (at best) apply to EU members only. However, there would seem to be no legal or conceptual reason why the second or third avenues could not also apply to European countries that are not (or not yet) members of the EU.


Recent proposals to unify bank supervision, harmonise resolution frameworks and transform the ESM into a fiscal safety net for banking systems in the Eurozone could go a long way toward arresting the present crisis and addressing coordination failures between home – and host-country authorities within the single currency area. At the same time, they raise concerns particularly among emerging European countries. Potential members worry that the proposed single supervisory mechanism might pay insufficient attention to the stability of national banking systems, and are concerned that banking union membership might lead to fiscal liabilities caused by poor policies elsewhere. At the same time, countries outside the Eurozone fear that domestic banks may lose ground against their Eurozone-based competitors that will have potential access to recapitalisation from ESM resources.

While these concerns need to be taken seriously, they can be overcome. A move towards supranational resolution mechanisms remains essential over the medium term, but if it cannot be achieved in the short term, the proposal could be improved with other means. Moral hazard could be addressed through an ex ante rule requiring countries receiving ESM fiscal support to share banking-related fiscal losses up to a pre-determined level. Coordination gaps can be reduced by cross-border ‘stability groups’ that include home and host country authorities, the ECB and the EBA. Lastly, non-Eurozone countries should be allowed to opt into the ESM if they also join the single supervisory mechanism. Apart from full membership, intermediate options could also be considered which would extend some but not all benefits and obligations of membership to all financially integrated European countries – including countries outside the EU.

Authors’ note: The views expressed in this paper are the authors’ only and do not necessarily represent those of the EBRD. The authors would like to thank, without implication, Bas Bakker, Katia D’Hulster, Achim Dübel, Christoph Klingen, Alexander Lehmann, Piroska Nagy, Lars Nyberg, Peter Tabak, Nicolas Veron and Beatrice Weder di Mauro for comments and suggestions on a longer version of this paper and Jonathan Lehne for excellent research assistance.


Allen, F, T Beck, E Carletti, P R Lane, D Schoenmaker and W Wagner (2011) Cross-border banking in Europe: implications for financial stability and macroeconomic policies, Centre for Economic Policy Research, London.

Claessens, S and N Van Horen (2012), “Foreign banks: trends, impact and financial stability”, IMF Working Paper No. 12/10, Washington, D.C.

D’Hulster, K (2011) “Incentive conflicts in supervisory information sharing between home and host supervisors”, World Bank Policy Research Working Paper No. 5871, Washington, D.C.

EBRD (2012), Transition Report, London.

Fonteyne, W, W Bossu, L Cortavarria-Checkley, A Giustiniani, A Gullo, D Hardy, and S Kerr (2010) “Crisis management and resolution for a European banking system”, IMF Working Paper No. 10/70, Washington, D.C.

Freixas, X (2003) “Crisis management in Europe”, eds. J. Kremers, D. Schoenmaker and P. Wierts, Financial Supervision in Europe, Cheltenham: Edward Elgar, pp. 102-19.

Goodhart, C and D Schoenmaker (2009) “Fiscal burden sharing in cross-border banking crises”, International Journal of Central Banking, Vol. 5, pp. 141–65.

Hellwig, M, A Sapir, M Pagano, V Acharya, L Balcerowicz, A Boot, M K Brunnermeier, C Buch, I van den Burg, C Calomiris, D Focarelli, A Giovannini, D Gros, A Ittner, D Schoenmaker, and C Wyplosz (2012) “Forbearance, Resolution and Deposit Insurance”, ESRB Reports of the Advisory Scientific Committee No. 1/July 2012, Frankfurt.

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1 The fragmentation of the financial conglomerate Fortis, systematically important in Belgium, the Netherlands and Luxembourg, is an example of how limited supervisory cooperation during an acute crisis may result in suboptimal outcomes.

2 The Vienna Initiative 2.0 was launched in the Spring of 2012 and adopted a set of guiding principles for home-host coordination.

3 See Allen et al (2011), Fonteyne et al (2010), Hellwig et al (2012), Pisany-Ferry et al (2012) and Schoenmaker and Gros (2012).

4 See Euro area summit statement, 28 June 2012, and “Proposal for a council regulation conferring specific tasks on the European Central Bank concerning policies relating to the prudential supervision of credit institutions”.

5 In practice, this could be one group in which most business is conducted by smaller committees focused on specific host countries; or possibly three groups focused on emerging European countries in the Eurozone, the non-Eurozone EU, and the EU neighbourhood, respectively. 

Topics: EU institutions, Europe's nations and regions
Tags: EZ banking union

Chief Economist, EBRD and CEPR Research Fellow

Ralph De Haas

Deputy Director of Research, EBRD

Jeromin Zettelmeyer

Deputy Chief Economist and Director of Research, EBRD