Where next for Europe’s banking union?

November 4 marked an important milestone in the Eurozone — the ECB took on direct supervision for the 120 largest banks and indirect supervision for all other banks. This came after a rigorous one-year examination of these banks’ books and subjecting their financial situation to different stress scenarios.1 Compared to the discussions right after the onset of the Global Financial Crisis in 2008, this is quite some progress. Six year ago, economists suggesting that the EU or Eurozone would need a single financial safety net were laughed out of the room by lawyers who pointed to the need for a treaty change and the political impossibility to do so. Six years and no treaty change later, the step towards a single supervisory mechanism can therefore be seen as quite an achievement towards a banking union matching the idea of a Single Market in Banking in Europe. On the other hand, the single supervisory mechanism has not been matched with similar progress on the resolution of weak banks on the European rather than national level, and there has been no move on connecting or joining the deposit insurance schemes across the Eurozone. A banking union on one and half pillars compared to the ideal of three pillars; a glass half full or half empty?

A rigorous health check for the Eurozone’s banking system?

The stress tests in the US in 2009 with subsequent recapitalization (through market or government) have often been credited with the successful recovery of the US financial system and, ultimately, the economy. Unlike the US, Europe has delayed such a rigorous exercise until now, with previous rounds of stress tests criticized as being too soft. The Comprehensive Assessment — a unique exercise — was a year-long process, which involved more than 6,000 ECB staff and consultants going through the books of the 130 largest banks in the Eurozone. The ECB adjusted non-performance exposures and asset values  — and so capital positions — and it subjected banks’ balance sheets and capital positions to a stress test. Compared to previous stress tests, this exercise was combined with an asset quality review (AQR) to thus set up a proper base on which to compare the outcome of the stress test and the exercise was centrally led by the ECB rather than relying on national authorities. The AQR has shown glaring discrepancies in asset classification across countries, with more than 20 per cent of the reviewed debtors were reclassified as non-performing in Greece, Malta and Estonia and even 32 per cent in Slovenia. Quite some strong evidence for the shortcomings of national supervision within a currency union, where sovereigns with no fiscal capacity to address bank fragility prefer regulatory forbearance!

Overall, the comprehensive assessment identified a capital shortfall of €24.6 billion across 25 participating banks after comparing the projected solvency ratios under the adverse stress test scenario against the threshold of a tier 1 capital to risk-weighted assets ratio of 5.5%. Taking into account capital raisings during 2014, only 13 banks still face a net capital shortfall of a total of 9.5 billion, a rather small number. Among the 13 banks, four are in Italy, three in Greece, two in Slovenia, one in Portugal, one in Austria, one in Ireland, and one in Belgium, thus a certain concentration in crisis countries. The outcome of the Comprehensive Assessment seems to have been exactly what the doctor prescribed — only few banks failed so not to disturb the markets, but enough banks failed so that the test seems rigorous. Many questions have been raised, however, about valuation methods and capital criteria, including about the valuation of financial assets and the fact that deflation is not part of the adverse stress scenario. Critically, the assessment was only done vis-à-vis the risk-weighted capital-asset ratio and not vis-à-vis the leverage ratio, which eventually will also apply to Europe’s banks. 14 of the 130 banks before and 17 banks after the AQR are below the 3% leverage ratio, and that does not take into account yet the effect of the stress tests. Others estimates still have used market-based gauges and found a much higher capital gap (Acharya and Steffen, 2014).

Where next?

The Comprehensive Assessment was designed as entry point to the Single Supervisory Mechanism (SSM) at the ECB. However, contrary to what many economists have recommended, there is no similar Eurozone-level framework on the resolution side. Yes, there will be a Single Resolution Mechanism (SRM) taking effect in 2016, but it is rather a compromise of national frameworks with some kind of rather bureaucratic coordination mechanism. While this second pillar of the banking union comes with a resolution fund (to be built up over time), it is rather small, with a target size of 55 billion Euro, thus too small for any major bank failure and thus leaving the problem of too-big-to-fail unresolved in Europe. The third pillar, a common deposit insurance fund, has been quietly dropped, for the same reason that no public backstop has been established for the SRM. Political resistance to loss-sharing across countries was too great.

Even in a world with high confidence in the competence, independence and integrity of the supervisory institution and process, the shortcomings of these other two pillars will affect the SSM. How credible can a supervisor be in threatening to close a bank if there is no water-tight resolution process in place? Over the past years, we have seen in several occasions when intervention and the resolution of weak and failing banks was delayed because the necessary tools and resources were lacking — the Cypriot banks being the most prominent example.

Will the Comprehensive Assessment and the entry into the Single Supervisory Mechanism revive lending and growth in the Eurozone? Much hope has been pinned on this exercise and this regulatory step, not all of it rational. As the US example and multiple other crisis examples have shown, recognizing and repairing banking losses is a necessary step for recovery. But it is certainly not a sufficient condition. There are other significant barriers to a Eurozone recovery, including the lack of consumer demand and the threat of deflation, which require other policy tools.
So, is the glass half full or half empty? Looking backwards it is certainly half full, compared to the discussions from five years ago. Looking forward, it is still half empty, with the biggest risk being complacency and a rude awakening in the next crisis.

1 The Comprehensive Assessment was done on 130 banks, some of which will not be supervised directly by the ECB, as they are not considered systemically important.

This post first appeared on The World Bank Blog

Author: Thorsten Beck is a Professor of Banking and Finance at Cass Business School in London and Professor of Economics at Tilburg University in the Netherlands.

Image: A huge euro logo is pictured next to the headquarters of the European Central Bank (ECB) before the bank’s monthly news conference in Frankfurt August 7, 2014. REUTERS/Ralph Orlowski