Creating the EMU without a Treasury, fiscal transfers or EU-wide banking regulations was always an Alice in Wonderland venture in which it was assumed that all the pieces would eventually fall into place, or would “retrofit.” The initial ineffective and misleading response to the debt crisis and bail-out in Cyprus in mid-March proved that Germany has to bear the brunt of decision-making, and reinforced the urgent need for monetary and budgetary convergence.
The EU's initial proposal to tax all bank deposits, including those under €100,000 appeared to violate the principles laid out at the end of last year in the EU Commission’s "Roadmap towards a Banking Union". These would not only honour the "harmonised level of €100,000 per depositor, per institution effective as of December 31, 2010", but would further harmonise and simplify protected deposits, faster payouts and would add cross-border guarantees. The ensuing outrage and market confusion led to a re-calibrated plan to only apply haircuts to deposits over €250,000, which mainly meant non-Cypriot depositors.
Creating a banking union will not just establish another agency or governing body. As the debate on budgetary and fiscal harmonisation rages on, it will have to confront the much wider question of how to redefine core European institutions, and how to break what some have termed “the vicious cycle of banks and sovereigns.”
Over the last decade, European banks have grown in size and influence. The Financial Times economics commentator Martin Wolf pointed out in October of last year that in the U.S. bank assets are nearly 80% of gross domestic product, but in the EU they are close to 350%. The U.S.-driven financial crisis and the EU’s sovereign debt crisis both revealed the true extent of the banks' exposure to sovereign debt, and also the influence of cross-border banks and the weakness of national governments to supervise or monitor their activities and their balance sheets. Among the challenges that face an EU banking union is not whether it can resolve the crisis, but whether EU-wide oversight can rein in the banks’ powers and create regional levels of disclosure and accountability.
Ideally, a banking union will have the tools and authority to prevent future banking crises through sound rules of disclosure, and supervisory powers able to address the issue of “too-big-to-fail” banking conglomerates, now euphemistically re-named systematically important financial institutions, or SIFIs. The European Central Bank (ECB), the EU Commission, the UK’s Financial Stability Board and in the United States the Federal Reserve have all acknowledged the need for a new framework that allows mega-banks to fail without the burden falling on taxpayers if endemic shock to fragile economies is to be averted. But this whole question has been a work in progress for almost 20 years.
Creating common rules and principles for all EU member states’ banking sectors was initiated by the Lamfalussy Plan of 1994, which in turn paved the way for the European Financial Services Action Plan. The purpose was to develop rules applicable to all aspects of the financial sector, but it maintained domestic supervision for financial institutions. By 2005 there was discussion of whether cross-border corporate activities should come under broader EU-wide regulation with retail sectors remaining under national supervision. There was never discussion on how to expand the powers of the ECB nor a clear definition of "lender of last resort" in a worst case scenario.
In the EU, reactions to the 2008 financial crisis ranged from the De Larosière Plan of 2009 to similar reports in the UK that emphasised the need for stricter rules on off-balance sheet items, the clarification of home and host country obligations in case of failure, greater transparency on non-traditional banking instruments and transactions. But as long as the core problem of national versus supranational powers was not clearly delineated, legal responsibility has remained hard to untangle.
The proposed EU banking union has been described as part institution-building and part an attempt to finally break the vicious cycle between banks and sovereigns. Its triple objectives are to establish under a single supervisor EU-wide rules on stronger standards on bank capital and liquidity; harmonisation of national Deposit Guarantee Schemes and recovery and resolution measures for banks in crisis. If adopted, this structure would be the first case of a true transfer of sovereignty between national and European regulatory authorities.
The framework presented last December set out a timetable for eurozone-wide banking supervision by the ECB, to be in place by the end of 2014. The ECB’s legal powers to begin the process of taking over supervision of all eurozone banks came into force at the beginning of this year, and will gradually expand in scope until the close of 2014. The ECB is to be granted sweeping authority over some 6,000 eurozone banks, with national central bank supervisors abdicating almost all their powers to the ECB, which is to have the authority to withdraw banking licenses, fine non-compliant lenders and require all eurozone banks to join in the new union.
Eurozone countries’ central banks will still have the oversight responsibility of bringing problem banks to the ECB's attention, but the question remains whether they will agree to function only as reporting agencies, devoid of all power to regulate their own banking sectors. The redefinition of central bank powers is core; how to reconcile the original ECB mandate limited to price stability and monetary policy over the eurozone with its expanded powers of oversight and supervision over all European banks?
When the ECB was founded, the models of the U.S. Federal Reserve, Germany’s Bundesbank and the Bank of England were invoked. The Frankfurt-based ECB adopted the governing structure of the Federal Reserve Board and the hardline monetary policy of the Bundesbank, but it did not adopt the supervisory model of the Bank of England nor, like the Federal Reserve, did it codify supervisory powers in its charter.
Although the EU’s Maastricht treaty leading to the creation of the euro demanded the independence of central banks, it never specified precisely the ECB’s powers of supervision and oversight. Yet designating the ECB as oversight and supervisory authority is the wisest choice. Through all the market volatility of the financial and sovereign debt crisis, the ECB, the Bank of England and the U.S. Federal Reserve have proven to be the adults in the room: cautious and pragmatic, yet ready to step in when necessary.
The crisis of 2008 forced the ECB, like the Federal Reserve, to assume new powers on an ad hoc basis. Since the setting up in 2010 of the “Troika” of the EU, IMF and ECB to bail-out Greece, the ECB has expanded its role to recapitalise over a thousand banks in the EU through long-term refinancing operations.
The banking union's most important challenges are therefore both technical and political. It has to set up guidelines on how the ECB will co-operate and intersect with the European Stability Mechanism (ESM) and the European Banking Authority (EBA). The newly enacted ESM is the rescue fund that would have the power to re-capitalise banks directly under a deal agreed last June. This would allow the €500bn fund to take on the debt of failing banks once a centralised banking supervisor is established. The ESM would override the responsibility of national exchequers for bank bail-outs and could inject cash directly into, say, Spanish banks and so free Spain of a huge bail-out burden.
The banking union will have to reconcile the ECB’s role with that of the newly created EBA based in London and designated as an umbrella oversight agency for all EU countries, whether or not they are part of the eurozone. But the EBA is already suffering from a loss of credibility after the ludicrous stress tests of 2010 and 2011, which gave pass marks to nearly all Europe’s banks, including the troubled Franco-Belgian Dexia which passed the stress test with flying colours in July 2011 despite having been rescued with taxpayers’ money in 2008, and which in October 2011 spectacularly collapsed!
The relationship with the UK and the City of London is one of the most contentious political issues: will there be co-operation or co-existence in a two tier European banking union between euro and non-eurozone countries?
In July of last year, Prime Minister Cameron stated that the UK would not be part of an EU banking union. But in December 2012, the British government made it clear that London's role as top EU financial market had to be protected, and questioned how to reconcile the role of the EBA in London with the new banking union.
Staying out of the eurozone while maintaining a seat at the table made perfect sense for the British economy which prospered independently. Although tarnished by the near failure of RBS and Lloyds in 2009, the on-going investigation of Barclays in the LIBOR manipulation scandal and struggling to regain competitiveness, the Bank of England has still proven to be a prudent supervisor. The irony is that despite rejecting the single currency, the City of London is the heart of euro financial markets and transactions. Although home to the Bundesbank and the ECB, Frankfurt has never been able to usurp London's role as the financial centre.
When the banking union comes into effect in 2014, it will do so at the same time as reforms which will curb trading activities and impose the de facto separation of retail and investment sectors. Banks throughout the EU will in 2013 also feel the impact of the Basel III rules on stricter capital adequacy requirements.
The Cyprus crisis and subsequent rescue terms have reinvigorated the debate on the efficacity of a banking union, and also on the trust deficit between the banking sector and civil society across Europe. In 2012, the ECB had restored trust and reassured the financial markets in the EU's ability to take charge and stabilise European banking.
Now after Cyprus, the banking union needs to be enacted and implemented on schedule so as to reassure all depositors and all citizens that deposits under €100,000 will not be threatened, and that failing banks will be dissolved in an orderly fashion without additional burdens being imposed on weak economies.
Before Cyprus, the banking union was essential to proving the commitment of the European Union to banking and supervisory convergence. In the wake of Cyprus, the banking union is crucial to proving that trust in the EU-wide banking system can be restored, and more fundamentally that trust in the European Union as a whole should not be in doubt.