A centralised supervision - a major, but only the first, element of Europe's Banking Union

By Philipp Ruessmann | 15 February 2014

To quote this document: Philipp Ruessmann, “A centralised supervision - a major, but only the first, element of Europe's Banking Union”, Nouvelle Europe [en ligne], Saturday 15 February 2014, http://www.nouvelle-europe.eu/node/1792, displayed on 27 September 2022

Danièle Nouy may not be a well-known name to many Europeans yet, but she has an important role: starting in 2014, the European Central Bank (ECB) will be responsible for the supervision of the major banks in Europe. This is only a first element of the ‘Banking Union’ that Europe has called for since the financial crisis. Others have to follow - otherwise the ‘Banking Union’ will remain toothless.

One of the lessons learned from the financial crisis – and a major flaw within the setup of the European Monetary Union (EMU) – has been the centralisation of monetary policy to the central level (ECB) and decentralized (national) supervision and resolution authorities of banks. National regulators were responsible only for supervising their own banks although banks were majorly engaged in other countries – especially within the euro area. Over the last years, attempts of correcting this flaw have been made, resulting in an initial proposal to create a ‘Banking Union’ that would consist of a Single Supervisory Mechanism (SSM), a Single Resolution Mechanism (SRM) and harmonized depositor protection schemes. Although all of these elements are necessary to form a full Banking Union, only the first part is now finally on its way. After undertaking an ‘Asset Quality Review’ this spring and summer, the ECB will be responsible for supervising the largest European Banks. This is where the major weakness can be identified. As members of the ECB Governing Council have already indicated, it is necessary to know in advance who is going to provide capital in case of identified shortcomings of capital requirements in the banks. Since the SRM is not yet in place, the affected member state will most likely have to take care of the capital injection itself.

But why is a ‘Banking Union’ necessary in the first place? In the years before the financial crisis, capital flows throughout Europe have led to large imbalances in the sovereign and private sector, as the figure below reveals (IMF, 2013). French banks, for example, held 22% of France’s GDP worth in Greek banks assets – a massive amount, which made some French banks struggle when creditor participation was called for. And not only French banks were in danger, also the French government since it would have been the one eventually stepping in if French banks would have come into difficulties. At the same time, national authorities were responsible for the stability of their domestic banking system.  In order to be able to evaluate the risk for systemic stability, they needed information from other countries’ authorities.  Experience has shown that this information is not provided in time and authorities tend to disclose certain information (de Grauwe, 2012).  A ‘Banking Union’ is therefore helpful to reduce this form of fragmentation of the European Banking Market.

In a first step, a new structure of supervision came into place in January 2011. A European Systemic Risk Board (ESRB) was established to analyse potential systemic risks within the financial sector – the President of the ECB was also the head of the ESRB.  Three additional, independent European Supervisory Authorities (ESA) have been created to support the ESRB and provide it with information on micro prudential trends. These were important first steps to give more powers to European authorities, but national supervisors were still in charge of the day-to-day supervision including their privileged information (De Grauwe, 2012).  

Especially from the European level the pressure grew towards a further centralised ‘Banking Union’. In 2012, the European Commission promoted the move towards an integrated financial supervision to restore confidence in banks and the euro. This move has to be seen in the light of the bail-out of Spain, whose banks were in need of about €60bn at that time. Within the last 1 ½ years, the EU engaged in a formal negotiation process to legally establish the SSM, which was successful in November 2013. In December, its new head, Danièle Nouy, formerly Secretary General of the French Prudential Supervision and Resolution Authority, was appointed.  Although the institution will be organised within the ECB, it is supposed to be independent from its monetary policy.

Two main tasks for the next month are already challenging before the SSM will supervise ‘significant’ credit institutions and obtain the competence for “specific supervisory tasks which are crucial to ensure a coherent and effective implementation of the Union's policy relating to the prudential supervision of credit institutions” (Council Regulation No 1024/2013 15 October 2013). Besides setting up the organisational requirements over the next month – the new institutions are supposed to be equipped with about 1.000 employees – the ‘Asset Quality Review’ of 124 banks has to be undertaken representing about 85% of the euro areas total banking assets.

In this process, the ECB evaluates the quality of the balance sheets. But that is only part of the exercise. And that’s where the process becomes problematic in some parts. What if the asset quality review reveals some undercapitalization within the banks? These banks would have to be restructured in some way - recapitalized, sold or resolved. Most likely, those banks will not be able to get additional capital from the market – so they will have to ask their governments for help. And as many fear – we are talking about significant amounts of capital shortfall here (Veron, 2013). Since Europe has not yet established a Single Resolution Mechanism (SRM) and raised enough money to resolve struggling banks with this mechanism, those countries will either try to get capital for their banks from the ESM or they have to recapitalise their banks themselves and – most likely – be rescued by the ESM.  The ECB – on the other hand – will not try to risks its own credibility by setting the standards for the review too low.

In any case, the next months are going to be interesting for the further development of the European Banking Union. Especially, as they will show the ‘real quality’ of European Banks, the credibility of the new SSM and the willingness of member states to find an agreement if there are major capital problems within the banks.

To go further

On Nouvelle Europe :

In books :

  • Paul De Grauwe (2012), Economics of Monetary Union, 9th Edition, Oxford UP

On the internet :

Source photo : ECB construction site with the twin tower and the historic market hall in the foreground. Some of the Frankfurt high-rises can be seen in the background (September 2013) on Wikimedia commons