The Single European Market in banking in decline – ECB to the rescue? 

Daniel Gros, 16 October 2012

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The prudential rules for banks are in principle the same throughout the EU, as they are codified by various EU directives and regulations. In reality, however, these supposedly common rules are implemented by national supervisors today in such a way as to ‘balkanise’ the Eurozone’s banking markets.

These barriers impede the recycling of northern surpluses to the periphery, thus aggravating the crisis. This problem applies both to the rollover of the large accumulated stocks and the continuing flows of cross-border claims. The stocks result from the credit boom years up to 2007-8 during which enormous cross-border claims built up because banks were quite willing to recycle the current-account surpluses of the northern part of the Eurozone (i.e. Germany, Netherlands, Belgium and, effectively, Switzerland) which, cumulated over the last decade, amounted to almost €2,000 billion. The flow problem is that this area (of which Germany accounts for the biggest part) continues to run large current-account surpluses, which reflect a continuing excess supply of domestic savings (relative to domestic investment) of around €200 billion per annum.

Most of the northern excess savings have been (and continue to be) intermediated by regulated entities (predominantly banks, but also insurance companies). The regulatory and supervisory environment for these entities determines, to a large extent, how this surplus is invested, and therefore what part is available to finance the rollover of existing foreign debt and the continuing current-account deficits of the Eurozone periphery.

Interbank lending

An interesting case of how a tightening of regulation leads to unintended consequences is the application, since 2010, of the large exposure limits to interbank lending. This has de facto affected cross-border lending in particular, because before the crisis many cash-rich small banks in northern Europe were investing their surplus in southern Europe, usually via the only one partner they knew and trusted in each country. During a time when banks were considered safe it did not make sense for smaller banks (like the German Sparkassen) to distribute interbank risk over many partners. Moreover, until 2010 interbank lending (for up to three years) was exempted from the limit that the exposure to any one counterparty could not exceed 25% of capital (under the large exposure directive).

However, from the end of 2010 the large exposure limit is applied to interbank exposure as well. In practice this meant little for large institutions, but a lot for smaller ones. This change in the treatment of interbank lending might explain why interbank lending in general, and particularly across borders, continues to decline so much. This is a good example how a tightening of regulation during the bust is procyclical.

Moreover, supervision, i.e. the differential application and interpretation of common rules, can severely segment capital markets. National supervisors have to protect the interests of their home country, rather than the stability of the Eurozone’s banking system. This implies that during times of financial stress they have an interest in keeping capital and liquidity within their home country – thus rendering the recycling of northern surpluses even more difficult.

Intra-group transfers

A priori one would think that at least within multinational banks funds can flow freely.This is not the case.

Many countries are at the same time host to subsidiaries and home country to large banks with subsidiaries abroad. In times of crisis, most supervisors, however, adopt an asymmetric attitude. They ‘encourage’ their home banks with subsidiaries abroad to repatriate as much capital and liquidity as possible, especially when the subsidiary is located in a country under financial stress. But at the same time, most supervisors also ‘encourage’ the subsidiaries of foreign banks on their home turf not to send any funds to their parent banks abroad, especially when they are located in countries with high-risk premia. Given that supervisors can easily make life miserable for any bank under their watch, this ‘moral suasion’ is usually effective.

This attitude of national supervisors is rational given that they typically have little direct information about foreign banks and given that it is their duty to protect the interests of their country, not that of the Eurozone as a whole.

The result of this ‘ringfencing’, as it is called, is gridlock, forcing the ECB to become the de facto clearer of the interbank market: for example the subsidiary of an Italian bank in Germany which is not allowed to transfer funds to its mother company in Italy will deposit its surplus fund at the Bundesbank. The Italian mother then will access the ECB’s lending facilities to obtain the funding it needs. But the German supervisors are also pushing German banks with subsidiaries in Italy to source funding locally. This implies that even the Italian subsidiaries of German banks have to have recourse to financing from the ECB. The ECB thus has to substitute also the ‘internal’ capital market which was supposed to work within multinational banking groups. This is not only costly (as the ECB charges more for its borrowing than it pays for its deposits), but also leads to a generalised reduction in liquidity because the ECB requires collateral for all its lending.

Cross-border lending

This constitutes another area where differences in the attitude of national supervisors have an important impact.

The cross-border exposure of northern banks to the private sector in southern Europe is much larger than that to the public sector. It is here that existing regulation is increasing the cost of cross-border exposure given the ratings downgrades of the periphery. As a good example one can take the case of a country which is downgraded from AA to BBB (like Spain). Under the standardised approach the risk weight is only 20% for counterparties in AA-rated countries, but 100% for BBB-rated countries. A fall in the rating from AA to BBB therefore implies a jump of 80 percentage points in the risk weight. At a cost of capital of 25% this is equivalent to an increase in the effective cost of lending by two full percentage points. In practice this means a higher cost for cross-border lending, because Spanish supervisors are unlikely to apply this rule to domestic lending by Spanish banks whereas German supervisors are very likely to apply this rule to German banks lending to counterparts in Spain.

Conclusions

The main message is that the desire to protect the home turf in northern Europe has bottled up large amounts of savings there, thereby contributing to the severity of the Eurozone crisis. More generally, existing prudential rules have difficulties coping with a situation when country-specific macro-risk factors dominate individual idiosyncratic risk.

The creation of a ‘single supervisory mechanism’ headed by the ECB could have an important macroeconomic impact because the ECB would not penalise cross-border lending in the way national supervisors do today. The ECB would certainly not try to block intra-group transfers (provided that it was satisfied that the entire group was solvent). Moreover, the ECB would evaluate the risk weighting of cross border lending on the basis of the strength of the borrower, and not the rating of the country. A banking system supervised by the ECB would thus be able to provide again a mechanism to recycle excess northern savings into the Eurozone periphery.

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

Director of the Centre for European Policy Studies, Brussels