European Banking Union Another Brick in the Wall of the European Financial System

Lukas Feiner, BSc

European Banking Union Another brick in the wall of the European Financial System

A fundamental analysis of the current state and future outlook of Europe's new supervisory framework

Master's Thesis

to be awarded the degree of Master of Science in Business Administration at the University of Graz, Austria

supervised by o. Univ.-Prof. Dr. Edwin O. Fischer Institute of Finance

Graz, June 2015 Author's Declaration

Unless otherwise indicated in the text or references, or acknowledged above, this thesis is entirely the product of my own scholarly work. Any inaccuracies of fact or faults in reasoning are my own and accordingly I take full responsibility. This thesis has not been submitted either in whole or part, for a degree at this or any other university or institution. This is to certify that the printed version is equivalent to the submitted electronic one.

Graz, June, 2015 (Feiner Lukas)

Acknowledgments

I would like to express my appreciation to my advisor, Prof. Dr. Edwin Fischer, for giving me the opportunity to work on this highly topical issue and for his con- tinuous support throughout the entire process of developing this thesis.

Furthermore I would like to thank Dominik and Meredith, two prospective inter- preters, whose valuable linguistic advice has facilitated writing this thesis in English.

I would like to thank my loved ones for their great support and assistance at finalising this work and throughout my educational career in Graz.

Content

List of figures ...... IV

List of abbreviations ...... V

1 Introduction ...... 1

2 Definition and European rationale...... 3

2.1 Pillars of a Banking Union ...... 3 2.2 Lessons learnt from the Global Financial Crisis ...... 5 2.3 Reformation of the international banking system ...... 6 2.3.1 Reforms outside the Eurozone ...... 6 2.3.2 Banking reorganisation in the U.S...... 7 2.3.3 Excursus 1: Banking system US and Europe compared ...... 8 2.4 A Banking Union for Europe ...... 10 2.4.1 Problems of the European banking sector ...... 11 2.4.2 Effectiveness of the monetary policy of the ECB ...... 14 2.4.3 Reintegration of the European banking system ...... 15 2.4.4 Fixing longstanding problems ...... 15 2.5 Short-term crisis management vs. long-term structural changes ...... 16

3 Evolution of the Banking Union in Europe ...... 18

3.1 Historical outline ...... 18 3.2 EBA and ECB - sharing of responsibilities ...... 21 3.2.1 The Single Rulebook - Foundation of the Banking Union...... 23 3.2.2 The Single Supervisory Handbook ...... 24 3.3 Geographical Scope ...... 24 3.4 Opt-in and Opt-out ...... 26 3.5 The U.K. and the Banking Union ...... 29 3.5.1 Possible institutional conflicts ...... 29 3.5.2 Effective Banking Union without London ...... 30 3.5.3 Banking Union and a withdrawal of the U.K. from the EU ...... 30

4 Single Supervisory Mechanism (SSM) ...... 32

4.1 Supervising principles ...... 32 4.2 Legal basis of the SSM ...... 34

4.3 The functioning of the SSM ...... 36 4.3.1 Distribution of tasks between ECB and NCAs ...... 36 4.3.2 Classification as significant or less significant ...... 37 4.3.3 Joint Supervisory Teams ...... 38 4.3.4 Excursus 2: The Role of the Austrian FMA in the SSM ...... 39 4.4 Progress in the operational implementation ...... 41 4.5 Results of the first comprehensive assessment in November 2014 ...... 42 4.5.1 Rationale ...... 42 4.5.2 Excursus 3: Stress test - baseline and adverse scenario ...... 43 4.5.3 Results ...... 43 4.5.4 Excursus 4: European stress test for Austrian banks ...... 46

5 Single Resolution Mechanism (SRM) ...... 47

5.1 European resolution prior to the SRM ...... 48 5.2 Linkage between banking and sovereign crisis ...... 49 5.2.1 Statistical evidence ...... 49 5.2.2 An illustration - the Spanish Caja Debacle ...... 50 5.3 Bank Recovery and Resolution Directive (BRRD) ...... 52 5.3.1 Legal background and scope ...... 53 5.3.2 Recovering proceedings and early intervention ...... 54 5.3.3 Resolution process ...... 54 5.3.4 Bail-in ...... 55 5.3.5 Cooperation and coordination ...... 56 5.3.6 Resolution financing at European level ...... 56 5.4 SRM within the Banking Union ...... 57 5.4.1 Single Resolution Board (SRB) ...... 58 5.4.2 Single Resolution Fund (SRF) ...... 59

6 Deposit Guarantee Schemes (DGSs) ...... 61

6.1 Deposit protection in the EU ...... 61 6.1.1 Preface - panic in Cyprus 2013 ...... 61 6.1.2 Directive 94/19/EC - Minimum harmonisation in the EU ...... 62 6.1.3 Directive 2009/14/EC - Unified coverage level ...... 62 6.2 Calls for a Single Deposit Guarantee Scheme ...... 63

6.3 Directive 2014/49/EU - maximum harmonisation of national schemes .. 64 6.4 Funding of DGS ...... 65 6.4.1 Target funding levels and composition ...... 66 6.4.2 Risk-based approach of DGS funds ...... 66

7 Conclusion ...... 67

Annex 1 ...... 69

Annex 2 ...... 70

Annex 3 ...... 74

Bibliography ...... 76

III

List of figures

Figure 1: Three-pillar model of the European Banking Union ...... 4 Figure 2: Regulatory Architecture in the U.S...... 8 Figure 3: Comparison of Return on Equity and Price-to-book ratios ...... 9 Figure 4: Overbanking in Small Euro area countries ...... 13 Figure 5: Evolution of the European Banking Union (Milestones) ...... 19 Figure 6: Geographical scope of the Banking Union ...... 25 Figure 7: Status quo: opt-in and opt-out ...... 26 Figure 8: General principles of the SSM ...... 33 Figure 9: Tasks within the SSM ...... 36 Figure 10: Functioning of the JST ...... 38 Figure 11: Supervisory architecture in Austria ...... 40 Figure 12: Gross AQR adjustment by country ...... 44 Figure 13: Median projected adverse scenario reduction in CET1 by country ..... 45 Figure 14: Stress test - failing banks and shortfall by country ...... 45 Figure 15: Stress test - results for Austrian banks ...... 46 Figure 16: Statistical evidence (U.S. and Spain) ...... 50 Figure 17: Basic principles of the BRRD ...... 53 Figure 18: Liability cascade in the bail-in procedure ...... 55 Figure 19: Composition of the Single Resolution Board ...... 58

List of abbreviations

Abbreviation Notation APCR Autorité de contrôle prudentiel et de résolution (France) AQR Asset Quality Review BRRD Bank Recovery and Resolution Directive BSpG Bausparkassengesetz (Austrian Building Society Act) CET1 Common Equity Tier 1 CDS Credit Default Swap CRD Capital Requirements Directive CRR Capital Requirements Regulation DGS Deposit Guarantee Scheme EBA European Banking Authority EBU European Banking Union ECB European Central Bank EDIRA European Deposit Insurance and Resolution Authority EFSF European Financial Stability Facility EFSM European Financial Stability Mechanism EIOPA European Insurance and Occupational Pensions Authority ESCB European System of Central Banks ESFS European System of Financial Supervisors ESM European Stability Mechanism ESMA European Securities and Markets Authority ESRB European Systemic Risk Board EU European Union FDIC Federal Deposit Insurance Corporation Fed Federal Reserve FMA Financial Market Authority (Austria) FROB Fondo de reestructuración ordenada bancaria (Spanish bank rescue fund) FSB Financial Stability Board GDP Gross Domestic Product

HypBG Hypothekenbankgesetz (Austrian Mortgage Banks Act) ICB Independent Commission on Banking (U.K.) IFRS International Financial Reporting Standards IMF International Monetary Fund Inc. Incorporated (U.S.) JST Joint Supervisory Team NCA National Competent Authority NCUA National Credit Union Administration (U.S.) OCC Office of the Comptroller of the Currency (U.S.) OeNB Österreichische Nationalbank (Austrian Central Bank) PCBS Parliamentary Commission on Banking Standards (U.K.) PfandbriefG Pfandbriefgesetz (Austrian Mortgage Bond Act) Plc. Public limited company (U.K.) PRA Prudential Regulation Authority (U.K.) RWA Risk Weighted Assets SME Small and medium-sized enterprise SRB Single Resolution Board SRF Single Resolution Fund SRM Single Resolution Mechanism SSM Single Supervisory Mechanism TFEU Treaty on the Functioning of the European Union U.K. United Kingdom U.S. United States of America US-GAAP United States - Generally Accepted Accounting Principles ÖVAG Österreichische Volksbanken AG

VI 1 Introduction

1 Introduction

Since the financial crisis started in 2008, the European Commission has worked hard to learn all the lessons from the crisis and create a safer and sounder financial system in Europe. That is why the EU Member States1 agreed in June 2012 on creating a Banking Union in order to complete the Economic and Monetary Un- ion in Europe. At the core of the new Banking Union is the centralised application of EU-wide rules for banks in the Eurozone, and any non-euro Member States that voluntarily want to join, to make systemic banking crisis less likely and to contribute to economic recovery in Europe. It became clear at the very latest after the statement of Mario Draghi to "...do whatever it takes to preserve the Euro2" it became clear, that the European Central Bank (ECB) plays a much greater role in the European financial system than eventually intended at its foundation. Within the Banking Union, however, the ECB will act as a central hub for supervisory activities as well as for resolution decisions, making it into a considerably powerful institution compared to other European Union Institutions.

Although "banking union" is a term that recently became widespread by the media and politic discussions, only few do know exactly what it means and eventually question why Europe considers forming another Union. When examining the ex- planations provided by politicians and central bankers, it seems that "banking union" is rather a term of art, without precise meaning. In theory the term "banking union" refers to a structure under which nations coordinate their banking systems in at least three ways: Common regulation and supervision of the banking system, common management of the resolution process for troubled banks and a common deposit guarantee fund.3

As the first pillar of the Banking Union, the Single Supervisory Mechanism, entered into force in November 2014 and the second pillar, the Single Resolution

1 See: European Commission (2014a), p. 1. 2 Speech by Mario Draghi, President of the European Central Bank, at the Global Investment Con- ference in London on 26 July 2012. https://www.ecb.europa.eu/press/key/date/2012/html/sp120726.en.html, Date of Access: May 2015. 3 See: Elliot, D. (2012), p. 6.

1 1 Introduction

Mechanism, was introduced in January 2015 and shall be applied by 2016, the Banking Union is currently a highly relevant issue for the European banking system and will become even more important in the next few years.

The primary aim of this work is to bring together all of the different aspects that come along with the European Banking Union and identify the major changes for the supervisory architecture of the European banking system. It is important to be aware of the different approaches to the topic, which are on the one hand the long- term striving for a completion of the single market in financial services in the EU, and on the other hand the short-term crisis management, especially for the crisis- torn Eurozone countries. A historical overview of the evolution of the Banking Un- ion shall be given in order to draw attention to the political obstacles during the built-up phase. Subsequently, the major tools of the Banking Union shall be de- scribed and evaluated with regard to their effectiveness and potential to manage current crisis in the Eurozone. Based on this theoretical framework I will try to evaluate whether the Banking Union in its current state can or cannot achieve its major objectives, which are: resolving the existing bank weaknesses, restoring the effectiveness of the monetary policy of the ECB and reintegrating the European banking system in order to make future banking crises less likely to occur.

2 2 Definition and European rationale

2 Definition and European rationale

The banking system is vital for the European financial infrastructure as banks sup- ply approximately three quarters of all credit. Choices about how much credit banks provide and to whom, strongly affect the economic performance of national economies, which makes the banking system critical to the functioning of the wider economy in Europe. The supervision and regulation of European credit institutions is therefore a balancing act between the following major objectives:4  Dealing with the short-term euro crisis versus long-term improvement of the Single Market in financial services in the EU.  The trade-off between economic growth and financial safety, as requirements for safety might also involve higher economic cost.  The efficiency of supervisory centralisation versus the benefits of local knowledge by national competent authorities.  The efficiency of a single regulator versus the benefits of multiple (regional) specialised regulators.

2.1 Pillars of a Banking Union

The creation of the Banking Union marks the most important milestone in Europe- an integration after the completion of Economic and Monetary Union. Providing a renewed foundation for financial stability, the Banking Union shall help to make future financial crises less likely to occur and identify risks before they arise. As shown in Figure 1, the Banking Union is built on three pillars: the Single Supervi- sory Mechanism (SSM), the Single Resolution Mechanism (SRM), and a system of harmonised Deposit Guarantee Schemes (DGS).5

4 See: Elliot, D. (2012), p. 6. 5 See: Austrian Central Bank (2015), http://www.oenb.at/en/Financial-Stability/bankingunion.html, Date of Access: May 2015.

3 2 Definition and European rationale

Figure 1: Three-pillar model of the European Banking Union Source: Austrian Central Bank (2015), "http://www.oenb.at/en/Financial-Stability/banking- union.html", Date of Access: May 2015.

The SSM, which will be explained in detail in Chapter 4, addresses the ECB and the national supervisory authorities of the participating countries to ensure the effectiveness of banking supervision and cross-border cooperation. The SRM (see Chapter 5) is based on the ECB statement on the European Bank Recovery and Resolution Directive (BRRD) stating that, “…all financial institutions should be allowed to fail in an orderly manner, safeguarding the stability of the financial system as a whole6”. The SRM shall therefore provide the right incentives to financial market participants and minimise public costs of a bank going bankrupt. The harmonised Deposit Guarantee Schemes (DGS) (see Chapter 6) ensure that savings and investments up to €100,000 are guaranteed across the EU.7

A special feature of the European Banking Union is its harmonised technical foundation. The European Banking Authority (EBA) is the competent authority to ensure effective and consistent prudential regulation and supervision across the EU banking sector. It is, thus, the task of the EBA to issue the Single Rulebook and

6 See: ECB Opinion, 29 November 2012, (CON/2012/99), http://www.ecb.int/ecb/legal/pdf/c_03920130212en00010024.pdf, Date of Access: May 2015. 7 See: Speech by Benoît Cœuré, 23 May 2013, http://www.ecb.europa.eu/press/key/date/2013/html/sp130523.en.html#3, Date of Access: May 2015.

4 2 Definition and European rationale the Single Supervisory Handbook (see Sections 3.2.1 and 3.2.2). The Single Rulebook spells out rules for improving banks’ capitalisation and liquidity levels (i.e. CRR/CRD IV and BRRD) as well as their resolution in case of failure. The Single Supervisory Handbook, on the other hand, sets out the supervisory approaches and methodologies to be uniformly applied by all competent authorities in the EU.8

2.2 Lessons learnt from the Global Financial Crisis

The bankruptcy of Lehman Brothers Holdings Inc., formerly the fourth-largest investment bank in the U.S., in September 2008 marked the beginning of a financial collapse that hit Europe only a few weeks later. In November 2008 the G20 meeting in Washington had already identified the main problems of the international banking system, which proved to be partly true in the development of the crisis in Europe:9 1. Too big to fail: This problem refers to banks being so large and interconnected with the global economy that their failure would be disastrous to the whole economic system. As a consequence the States (i.e. taxpayers) have to act as a lender of last resort to avoid the inestimable economic consequences of a bank failure. This inevitably led banks to cause sovereign debt crises and gave systemically important banks the chance to blackmail governments all over the world. 2. Universal banking system: In response to the Great Depression of the 1930s, the so-called Glass-Steagall Act was introduced in 1933 in order to establish a two-tier banking system: investment banking was from then on separated from normal banking business in the United States only. Unfortu- nately such a separation did not take place in Europe leaving behind a uniform banking business where traditional deposits could be used for specu- lative investment activities.

However, the EU, respectively the Eurozone countries, had to learn further painful lessons especially when the global financial recession turned into a debt crisis that almost put the European Monetary Union on the verge of collapse. The Eurozone,

8 See: Austrian Central Bank (2015), http://www.oenb.at/en/Financial-Stability/bankingunion.html, Date of Access: May 2015. 9 See: Breuss, F. (2013), p. 2

5 2 Definition and European rationale as well as the entire European banking system, were successively confronted with new challenges (see Section 2.4.1), which were to be dealt with largely by the ECB. Although the ECB officially resisted it for years, it gradually became the lender of last resort for Eurozone countries in major distress. Unfortunately the ECB was not equipped to act as such, as it had no powers to intervene in national affairs concerning supervision and resolution of banks.10 This is largely why Euro- pean policymakers called for a Banking Union and a centralisation of supervision and resolution.

2.3 Reformation of the international banking system

Before the Banking Union as one specific solution approach within Europe will be discussed in detail, a short overview of structural banking reforms outside the Eu- rozone shall be given.

2.3.1 Reforms outside the Eurozone

Great Britain, EU member but outside the Eurozone, has attempted to regulate its extensive banking sector itself after the bankruptcy and nationalisation of Northern Rock Plc. in September 2007. Northern Rock was notably the first British bank that experienced a true bank run since 1866.11 Consequently, the British government established the Independent Commission on Banking (ICB) under Sir John Vickers to make recommendations for structural improvements of the UK banking system. Unfortunately, the Libor scandal of 2012 made clear that previous efforts to regulate British banks were insufficient. The Parliamentary Commission on Banking Standards (PCBS) was therefore appointed to report and make recommendations on the professional standards and culture of the UK banking sector. The Govern- ment strongly endorsed the PCBS’ and the ICB's principal findings and issued the Financial Services (Banking Reform) Act 2013. Principal features of the Act are:12

10 See: Beck, T. (2012), p. 19. 11 See: The Economist (2007), http://www.economist.com/node/9832838, Date of Access: May 2015. 12 See: HSBC (2014), UK Banking Reform, http://www.hsbcnet.com/gbm/about-us/financial- regulation/uk-banking-reform, Date of Access: May 2015.

6 2 Definition and European rationale

 It gives the Government the power to require banks to increase loss- absorbing capacity and it gives preference to depositor claims over other unsecured creditors in the event of bank insolvency.  It empowers the Prudential Regulation Authority (PRA) to force banks to separate their retail and investment banking activities (i.e. "ring-fencing of core activities").  It imposes higher standards of conduct on the banking industry (e.g. a new certification regime for bank employees in “significant-harm functions" as well as criminal offence in case of reckless misconduct).

The financial crisis was relatively well mastered in the private banking stronghold of Switzerland. The Swiss reformation approach is particularly noteworthy. Swit- zerland has two very large banks (UBS and Credit Suisse) in relation to GDP and therefore established a Commission on Banking Reform. The Swiss Commission recommended much higher capital requirements than that for the Basel III baseline for the banks that were classified as too big to fail. The authorities have taken several measures to contain risks, including prudential measures to tighten lending standards and conditions, and the recent activation of the countercyclical capital buffer. The Swiss financial sector swiftly adapted to the more stringent regulatory environment and in addition to that a new law for banking resolution ("Banking In- solvency Ordinance") went into effect in 2012.13

2.3.2 Banking reorganisation in the U.S.

In the United States, the reorganisation and reform of the banking sector was faster than in Europe. On the one hand, both the resolution of insolvent banks and the banking supervision are subject to already long-established rules. Additionally, by the so-called Volcker Rule of 2010 the Dodd-Frank Act legally introduced again a lenient form of the two-tier banking system. Parts of the Volcker Rule that prohibit banks to trade on their own account and participate in hedge funds as well as private equity funds were adopted in late 2013.14

13 See: IMF (2013), p. 2 and Vickers, J. (2013) p. 6. 14 See: Breuss, F. (2013), p. 3.

7 2 Definition and European rationale

The United States has historically provided several authorities for each category of financial regulation, rather than a single agency with authority for all financial markets, activities, and institutions (see Figure 2).

Figure 2: Regulatory Architecture in the U.S. Source: Murphy, E. (2013), p. 2.

Notwithstanding the fragmentation in the American regulatory architecture, the Federal Reserve (Fed) remains the superior competent authority. The Fed regulates, like the ECB does now, bank holdings and subsidiaries that are considered systemically important. As it is also the lender of last resort to member banks the Fed may initiate resolution processes to shut down or restructure troubled banks. The Federal Deposit Insurance Corporation (FDIC) operates the deposit insurance fund, see DGS in Europe, to provide aid to federally and state chartered banks. The Office of the Comptroller of the Currency (OCC) and the National Credit Union Administration (NCUA) act as supporting regulatory authorities specialised in the regulation of thrift institutions and credit unions in the U.S.15 In the Banking Union, these tasks will remain in the hand of national supervisory authorities (i.e. supervision of less significant banks).

2.3.3 Excursus 1: Banking system US and Europe compared

U.S. banks have indeed recovered significantly from the 2008-2009 sub-prime crisis period. As a consequence, the U.S. banking system has outperformed the euro area banks by profitability as well as by stock market valuation (see Figure 3). This

15 See: Murphy, E. (2013), p. 13.

8 2 Definition and European rationale was achieved mainly thanks to lower loan losses, stable fee and commission income and higher trading income. Euro area banks, on the other hand, are still struggling with weak profitability and losses caused by the second wave of the Global Financial Crisis that has hit the Eurozone countries particularly hard. To some extent, the higher levels of uncertainty for euro area banks can be traced back to the continuing negative feedback loops between euro area sovereigns and banks. The close links between sovereigns and banks in the euro area have resulted in a much closer correlation between bank and sovereign credit default swap (CDS) spreads than in the United States (see Chapter 5.2.1).16

Figure 3: Comparison of Return on Equity and Price-to-book ratios Source: ECB (2013), p. 29.

Comparisons are quite appealing as they put country-specific banking sector developments into a global context and provide international benchmarks for individual banking groups. Nonetheless, it is important to be aware of differences in the structure, role and activities of American and European banks when comparing them. Some of the key distinguishing features between the euro area and US banking sectors are:17  Differences in structure and size: The euro area banking sector in per cent of national GDP is several times larger than the U.S. banking sector (see

16 See: ECB (2013), p. 29. 17 See: ECB (2013), p. 30.

9 2 Definition and European rationale

also Section 2.4.1). This mainly reflects the greater role of bank versus capital market-based intermediation in the euro area economy. In addition to that, the shadow banking system (not included in common statistics) is much more important in the U.S. than in Europe.  Differences in bank balance sheet structure: European and American banks are subject to different accounting standards (IFRS vs. US-GAAP) affecting the reported values of assets and liabilities.  Differences in income structure: U.S. banks strongly rely on fee and commission income, whereas interest income is the main source of revenue in the euro area banking sector. Larger U.S. banks are even more focused on investment banking activities and rely, hence, on profits from trading activities.  Differences in cost structure: Loan loss provisions decreased substantially for U.S. banks due to the relatively quick recovery of the U.S. economy from the aftermath of the Global Financial Crisis. In the euro area loan loss provisions remained high due to the weak economic situation.

In summary, both U.S. and euro area banks have made significant progress in balance sheet repair since the outbreak of the financial crisis. While euro area banks still lag somewhat behind in reducing their balance sheet leverage and reliance on wholesale funding, related indicators cannot be expected to fully converge in any case, given the current macroeconomic conditions and the persistence of structural differences across the Atlantic.18

2.4 A Banking Union for Europe

Since the Global Financial Crisis started in 2008, the European Commission has worked hard to learn all the lessons from the crisis in order create a safer and sounder financial sector in Europe. The Commission proposed a series of new rules to better regulate, supervise, and govern the financial sector so that in future taxpayers would not have to take responsibility for banks' mistakes again. As the financial crisis evolved and turned into the Eurozone debt crisis in 2010/11, it

18 See: ECB (2013), p. 39.

10 2 Definition and European rationale became clear that those countries, which shared a common currency, had to bear significant risks due to their interdependence and the limited influence of the ECB and the European System of Central Banks (ESCB). That is why, in June 2012, Heads of State and Government agreed to create a Banking Union as a completion of the Economic and Monetary Union.19

There are at least four main reasons why some of the Member States committed themselves to a Banking Union. To a great extent the implications of these various reasons are consistent. However there are also tensions, especially when it comes to the prioritisation between tackling short-term problems and taking structural measures to complete the long-term integration of the Single Market (see Section 2.5). The reasons, which will be explained in detail in the following sections, are:20  Dealing with existing and future bank weaknesses that contribute to the euro crisis.  Restoring the effectiveness of the monetary policy of the ECB.  Reintegrating the European banking system.  Fixing long-standing problems within the Single Market in banking and financial services in the EU.

2.4.1 Problems of the European banking sector

In the years preceding the Global Financial Crisis in 2008/09, the banking land- scape in Europe had undergone major changes. Global financial institutions grew bigger in size and scope leading to an increase in the organisational complexity. New savings alternatives to bank deposits (e.g. money market mutual funds) and new opportunities for borrowing (structured finance, securitisation etc.) emerged. Commercial banking, which has had a long history in Europe, moved increasingly away from customer relationship-based banking, where loans are granted and then held until maturity, to the “originate and distribute” model, where granted loans are pooled, securitised and then sold to investors around the world.21

19 See: European Commission (2014a), p. 1f. 20 See: Elliot, D. (2012), p. 6. 21 See: Liikanen Report (2012), p. 88f.

11 2 Definition and European rationale

On the basis of these macroeconomic developments, a number of specific problems can be highlighted that destabilised the European banking system:

Leverage and limited ability to absorb losses Prior to the crisis, the significant expansion of European banks was primarily funded by an increase in leverage, whereas their equity capital base remained con- stantly low. Banks' balance sheets grew at a much faster pace than their capital and deposit base, leading to capital stocks that were effectively unable to absorb losses, e.g. due to an unpredicted fall in asset prices. Their increased reliance on short-term funding also increased banks' exposure to liquidity shocks. Appendix I shows European banks' exposure to credit risk immediately after the financial crisis.22

Too large banking sectors in small Eurozone countries The banking crisis in Cyprus has shown dramatically that some Eurozone Member States have a much too large banking sector compared to their economic performance. In the euro area, domestic banking sector assets, on average, equal close to 270% of GDP in 2012 while it is only 72% in the United States. However, the dispersion across European countries varies tremendously, from 4% of GDP in Estonia to over 400% of GDP in Cyprus (see Figure 4). In addition, some of these countries (e.g. Cyprus and Ireland) had a business model limited only to the banking sector, which made them greatly vulnerable during the Global Financial Crisis and the subsequent euro crisis. As a consequence of the prevalent banking crisis the size of the domestic banking sectors in the euro area has decreased significantly in some Member States since 2008. For example, the size of the Belgian domestic banking sector has declined by half resulting from banking consolidation across borders and bank deleveraging.23

22 See: Liikanen Report (2012), p. 90. 23 See: Breuss, F. (2013), p. 7.

12 2 Definition and European rationale

Figure 4: Overbanking in Small Euro area countries (Bank Assets as a share of GDP in %) Source: ECB (2013), p. 30

Great linkages in European banking In the years leading up to the financial crisis, banks increased significantly in size and complexity. For the largest banks, this increase coincided with an expansion of investment bank activity, such as brokerage or trading activities, which made it more difficult for the bank management to exercise control throughout the organisation. European banks also became strongly interconnected while at the same time using complex financial instruments (e.g. derivatives, structured finance, etc.). The strong linkages between banks increased the risk of negative spill-over effects and contagion in case of a banking crisis and became therefore an unpredictable source of systemic risk. The increase in complexity and interconnectedness also had the effect of making it very difficult to resolve banks in an orderly manner, without triggering further financial turmoil (see Appendix Ia).24

High public debt through bank bailout In the EU, banks of systemic importance25 have been supported by public funds in the form of capital injections, guarantees and liquidity support. The net costs of the bank bailout programs are primarily reflected in a cumulative increase in the national debt. From the financial crisis on to 2012, bank bailouts added up to 520

24 See: Liikanen Report (2012), p. 88ff. 25 See Shapter 2.2 on "too big to fail"

13 2 Definition and European rationale billion euro in the Eurozone (or 5.5% of GDP), while increasing the budget deficit of the euro area by 0.7% of GDP at its peak in 2010 and amounted in 2012 still for 0.6%.26

Lack of EU institutional framework Basel II enforced the use of banks' internal models for calculating risk potentials and corresponding adequate capital requirements. However, there was insufficient supervision and challenge (e.g. stress testing) of those models, enabling banks to significantly reduce risk-weighted assets and the real amount of capital held. Be- yond that European banks used the opportunities created by EU law on the single market for financial services by expanding cross-border activity, leading to an increase in size, complexity and interconnectedness of the European banking system. The arrangements governing the Single Market for financial services, notably the institutional architecture as well as safety nets, have not evolved accordingly. As a result, while banks became increasingly transnational in nature, the institutional governance arrangements remained largely national.27

2.4.2 Effectiveness of the monetary policy of the ECB

The primary task of central bank’s monetary policy is to influence key financial institutions and markets to change the price and availability of credit. The process by which central bank moves are translated by the financial sector into changes in lending conditions is referred to as the “monetary transmission channel". When the monetary transmission channels are working effectively, central bank moves trans- late fairly rapidly and effectively into changes in credit conditions for the ultimate customers. Yet the opposite is true for most of the euro area, as the ECB's actions for improving lending conditions are failing to take effect.28

Banks dominate the financial system in Europe, providing about three quarters of all credit to the private sector. Unfortunately, most banks today are still suffering from the after-effects of the financial crisis, which renders them unwilling to lend even to creditworthy businesses, except at high rates. On top of this, they are

26 See: Breuss, F. (2013), p. 9. 27 See: Liikanen Report (2012), p. 90f. 28 See: Elliot, D. (2012), p. 7.

14 2 Definition and European rationale adjusting to a wide range of regulatory changes, many of which are not yet fully defined. The uncertainty about the future regulatory burden increases banks’ cau- tion about lending. The ECB wants to encourage more lending in order to foster economic growth in this time of recession, but the serious problems in the banking sector make the monetary transmission channel ineffectual. An effective Banking Union would help restore normal banking operations and make ECB actions easi- er.29

2.4.3 Reintegration of the European banking system

During the financial crisis the integrated European money markets have temporari- ly disintegrated into a series of national markets, as banks were suddenly unwilling to lend to banks in other countries, due to higher perceived counterparty risks. The re-emergence of national money markets presents a grave challenge for the ECB, since its traditional monetary policy instruments only allow it to influence the price and availability of euros in the Eurozone as a whole. Under the current conditions, moving its policy interest rates for the euro area has quite different and furthermore unpredictable effects in different countries. This disintegration of the Europe- an banking market obviously destroys many of the advantages envisioned when the EU moved to create a unified financial market. The institution of a banking union is therefore intended to restore confidence in the banking system all across the Eurozone, allowing funds to flow freely across borders again. 30

2.4.4 Fixing longstanding problems

Observers have been arguing for years, even prior to the financial crisis, that a truly unified European banking market requires much stronger European-level institutions to supervise banks and to manage the resolution process. However, national authorities were reluctant to hand in substantial control over their own banks to the ECB or other supranational institutions. Instead, politicians and supervisors of the Member States collectively resisted cross-border banking mergers and equal application of rules in all EU countries. Even when they agreed on the establishment of the EBA in response to the severe financial crisis, they ensured that it

29 See: Elliot, D. (2012), p. 8. 30 See: Elliot, D. (2012), p. 8.

15 2 Definition and European rationale started with very little authority for direct action. The supremacy of national supervisory authorities and governments fostered the continuation of national banking markets with significant variations between them. Paradoxically, this disintegration has come back to haunt the Eurozone, and the EU, as the financial markets now treat many of these national markets differently from each other, helping to fuel the euro crisis especially in the southern European countries.31

On the positive side, the euro crisis obviously provided the impetus to overcome sovereign interests of the Member States and organise European banking more intelligently. Virtually all of the steps being considered toward a banking union would also assist in furthering the single market in financial services.32

2.5 Short-term crisis management vs. long-term structural changes

While many politicians rely on a banking union as a crisis-management tool to address current problems concerning public over-indebtedness and lack of confidence in the banking system, there are several reasons to not use it in this manner. First, building up the necessary structures for a Eurozone regulatory and bank resolution framework cannot be done overnight, while a financial and economic crisis needs immediate attention. Second, the current discussion on Banking Un- ion is overshadowed by distributional discussions between northern and southern Member States, as bank fragility is currently concentrated in the peripheral countries.33

The construction of a banking union for Europe needs to address at least the following three very different dimensions. First, there is the immediate need for crisis resolution, because a sound and efficient banking system is the most important component of the future vision for the European single market in financial services. Resolving the banking crisis is therefore critical for the Eurozone. Second, there is the medium-term task to strengthen the currency union with a banking union.

31 See: Elliot, D. (2012), p. 8. 32 See: Elliot, D. (2012), p. 9. 33 See: Beck, T. (2012), p. 40.

16 2 Definition and European rationale

Monetary and financial stability are too closely interlinked to leave bank regulation and supervision on the national level. And thirdly, there is the need for broader reforms of cross-border regulatory cooperation concerning the resolution of large multinational banks, which are currently seen as system relevant and therefore too big to fail. This agenda, however, goes far beyond the Eurozone and even beyond the EU.34

34 See: Beck, T. (2012), p. 41f.

17 3 Evolution of the Banking Union in Europe

3 Evolution of the Banking Union in Europe

The integration of bank regulation, as a complement to the Single Market in financial services and the Monetary Union, is an EU political issue dating back to the 1990s. It took, however, more than two decades, accompanied by several financial downturns that brought the European financial system to the edges of a complete collapse, until policymakers agreed to form a Banking Union. In order to fully un- derstand the motivation behind the political commitments and the new regulatory framework this chapter shall give an overview of the historical development as well as the political tensions and disagreements which lead to the current shape of the Banking Union.

3.1 Historical outline

The evolution of the European banking sector in the first few years of the new mil- lennium was characterised by an increase in complexity due to innovative financial products and large takeovers, such as the purchase of HypoVereinsbank by Unicredit, resulting in pan-European banking groups. However, it took almost a decade until a high-level expert group chaired by Jacques De Larosière, former President of the ECB, called for stronger coordination of supervision within the EU in order to deal with the financial crisis originating from the Lehman collapse in 2008.35

35 See: De Larosière, J. (2009), p. 4ff.

18 3 Evolution of the Banking Union in Europe

Figure 5: Evolution of the European Banking Union (Milestones) Source: Own Representation

The year 2010 was characterised by intense efforts to tackle the economic crisis, which has meanwhile hit the European continent with its full strength. A variety of government bail-out packages were put together, accompanied by state guarantee running into the billions of Euros. The best-known and at the same time the most extensive aid package at European level is the European Financial Stability Mech- anism (EFSM) together with the European Financial Stability Facility (EFSF) which entered into Force in May 2010 covering a €500 billion fund to support Eurozone countries close to the edge (e.g. Greece, Portugal and Ireland). This temporary mechanism and the facility were both transformed into the permanent European Stability Mechanism (ESM) in 2011. At the same time, the European System of Financial Supervision (ESFS) entered into operation, covering the establishment of the European Banking Authority (EBA), the European Insurance and

19 3 Evolution of the Banking Union in Europe

Occupational Pensions Authority (EIOPA) and the European Securities and Mar- kets Authority (ESMA).36

The Euro Area Summit of June 29 2012 can be considered as the hour of birth of the European Banking Union. The heads of the Eurozone countries stated, that ".. it is imperative to break the vicious circle between banks and sovereigns37". The summit further noted, that an effective single supervisory mechanism has to be established, involving the ECB with the possibility to recapitalise banks directly. In the autumn of that same year the European Commission released an official proposal for a Single Supervisory Mechanism, which was accepted by the Council in December 2012. However, it soon became clear that the Banking Union project would not be supported by all EU Member States. Still in 2012 the U.K. and Swe- den made it clear, that they will not join the Banking Union (see Chapter 3.4).38

In the following year, the preparations for the SSM proceeded in full swing: the ECB took over the competent authority under the SSM and released an interim list of 140 banks, which were considered as systemically important and therefore should be under the direct oversight of the ECB. In addition to that, Euro leaders, like Mario Draghi, President of the ECB, continually noticed that a single supervisory mechanism as well as a single resolution mechanism is crucial for the functioning of a European Banking Union. Subsequently, the European Commission released a proposal for a Single Resolution Mechanism in Summer 2013. Finally, Council Regulation (EU) No 1024/2013, also called SSM Regulation, came into force in November 2013, providing the legal framework for the SSM in Europe.

In 2014 great political efforts were made finalise the legal framework of the Bank- ing Union at European level and to start the implementation process. In March 2014 Euro leaders were able to reach a final conclusion on the SRM and the

36 See: European Commission (2015), European Financial Stabilisation Mechanism (EFSM), http://ec.europa.eu/economy_finance/eu_borrower/efsm/index_en.htm; EFSF (2015), About the EFSF, http://www.efsf.europa.eu/about/operations/index.htm and European Commission (2015), Financial Supervision, http://ec.europa.eu/finance/general- policy/committees/index_en.htm, Date of Access: May 2015. 37 See: Statement of the Euro Area Summit of 29 June 2012. 38 See: European Commission (2015), Single Supervisory Mechanism, http://ec.europa.eu/finance/general-policy/banking-union/single-supervisory- mechanism/index_en.htm, Date of Access: May 2015.

20 3 Evolution of the Banking Union in Europe related Resolution Fund, which has a target level of €55 billion and shall be filled by 2024 (8 years after coming into force in 2016). In addition to that, a Bank Reso- lution and Recovery Directive (2014) was proposed by the European Commission, in order to harmonise national resolution schemes in Europe (see Chapter 5.3). The most important milestone in the history of the Banking Union so far is certainly the official takeover of banking supervision of significant banks under the SSM by the ECB on 4 November 2014. The ECB shall be from now on the central hub concerning the direct and indirect supervision of all banks in the Eurozone. Prior to that, the ECB conducted a comprehensive assessment to evaluate the status quo for the significant banks in the euro area (see Chapter 4.5).39

The future milestones are characterised by the finalisation of the SRM and the striving for an agreement concerning the centralisation of national deposit guarantee schemes. As both the Resolution Fund and the Single Deposit Guarantee Scheme are associated with a mutualisation of risks and related costs passionate political debates within the Member States of the Banking Union will continue.

3.2 EBA and ECB - sharing of responsibilities

For different reasons, explained in detail below, several Member States, like the United Kingdom, Sweden and the eastern non-euro Member States decided to remain outside the Banking Union. The relationship between euro area countries, which decided to form a Banking Union and the rest of the Member States became meanwhile a delicate political issue. After all, the EBA was created in 2011 to coordinate the operations of all national supervisors within the EU, in order to ensure frictionless functioning of the single market in banking in Europe. When the euro states agreed on the first step towards a banking union, namely to create the SSM, there were legitimate concerns that this would upset the balance of powers between the EBA and the ECB. Under the SSM the ECB takes the place of all the national supervisors of the participating countries. Given the fact that Eurozone banks account for about 70% of all EU bank assets, 22% for the United Kingdom

39 See: European Commission (2014), Finalising the Banking Union, http://europa.eu/rapid/press- release_STATEMENT-14-119_de.htm, Date of Access: May 2015.

21 3 Evolution of the Banking Union in Europe and the remaining 8% for the other ten non-Eurozone countries. This implies that in many cases the ECB could simply overrule the board of the EBA.40

In order to prevent that from happening and to confirm the competences of the EBA, a series of decisions were adopted during the build-up phase of the Banking Union: I. The SSM shall not call into question the role and responsibilities of the EBA. Instead, a close cooperation between the Authority and the ECB will be particularly crucial in some areas, e.g. stress testing, supervisory handbook.41 II. The EBA plays the key role in building, developing and contributing to the consistent application of the Single Rulebook (see Chapter 3.2.1).42 III. In order to promote best supervisory practices in the internal market the single rulebook has to be accompanied by a European supervisory handbook on the supervision of financial institutions, drawn up by EBA in consultation with the competent authorities (see Chapter 3.2.2).43 IV. The voting arrangements within the EBA were modified in order to ensure the proper functioning of EBA and adequate representation of all Member States. The so-called double majority voting requires a majority from both the participating and the non-participating Member States of the SSM to adopt a decision within the Board of Supervisors.44

To summarise, the EBA could be considered an “umbrella authority", due to its wide regulatory scope of duties. Regulation No. 1093/201045 empowers the EBA: to mediate and settle disagreements in cross-border situations between competent authorities with binding effect (Article 19), to participate actively in the development and coordination of effective and consistent recovery and resolution

40 See: Gros, D. and Schoenmaker, D. (2014), p. 3. 41 See: SSM Regulation No. 1024/2013 (2013), recital 31 and 32; and Regulation No. 1022/2013 amending the EBA Regulation No 1093/2010, recital 4. 42 See: SSM Regulation No. 1024/2013 (2013), recital 31 and 32; and Regulation No. 1022/2013 amending the EBA Regulation No 1093/2010, recital 4. 43 See: Regulation No. 1022/2013 amending the EBA Regulation No 1093/2010, recital 7. 44 See: Regulation No. 1022/2013 amending the EBA Regulation No 1093/2010, Article 1 (24) amendment of Article 44. 45 Regulation (EU) No 1093/2010 of 24 November 2010 establishing the European Banking Author- ity.

22 3 Evolution of the Banking Union in Europe plans (Article 25), procedures in emergency situations and preventive measures to minimise the systemic impact of any failure, especially of cross-border banking groups (Article 18), and to ensure a coherent functioning of colleges of supervisors (Article 21).46

3.2.1 The Single Rulebook - Foundation of the Banking Union

According to the EBA the Single Rulebook aims to provide a single set of harmonised rules, which supervisory institutions throughout the EU have to respect. The European Council created the term "Single Rulebook" in 2009 as a collective name for the regulatory framework that should complete the Single Market in financial services. European banking legislation prior to the Single Rulebook was based on a Directive, which left room for significant divergences in national rules leading to legal uncertainty and enabling banks to exploit regulatory loopholes. The Single Rulebook currently covers:47  Capital Requirements Regulation (CRR): EU-wide binding implementation of the Basel III framework for improvement of the quantity and quality of capital in the banking system.  Capital Requirements Directive (CRD IV): Rules and standards of the Basel III framework that have to be transposed into national law by all EU Member states.  Bank Recovery and Resolution Directive (BRRD): Harmonised rules and standards for the restructuring and resolution of troubled credit institutions that have to be transposed into national law by all EU Member states (see Chapter 5.4).

The Single Rulebook is key for Europe as it ensures uniform application of the most fundamental rules for the functioning of the single market. The European Au- thorities are well aware of the fact that credit and economic cycles are not always synchronised across the EU and therefore created a certain degree of national flexibility by allowing Member States to require their institutions to hold more

46 See: Morra, C. (2014), p. 10. 47 See: EBA online (2015), Why do we need a Single Rulebook?, http://www.eba.europa.eu/regulation-and-policy/single-rulebook, Date of Access: May 2015.

23 3 Evolution of the Banking Union in Europe capital, also in form of countercyclical capital buffers, than the union-wide minimum levels.48

3.2.2 The Single Supervisory Handbook

In addition to the Single Rulebook the EBA was mandated to produce a Single Supervisory Handbook (or Manual) to encourage supervisory convergence in Eu- rope. The manual reflects best supervisory practices across the EU, but is not legally binding. Within the SSM a more detailed supervision manual was developed, which lays down the supervisory approach to be taken by the SSM including on off-site and on-site reviews, risk assessments and model validations. In order to avoid discrepancies, the ECB and the EBA are supposed to cooperate closely to ensure that these two projects are fully consistent.49

3.3 Geographical Scope

The way in which the financial crisis has hit the European Union and subsequently caused a severe euro crisis that has been going on since 2009 has made it clear that a Banking Union is necessary to stabilise and protect the monetary union. For this reason, the primary rationale of the euro leaders was to create a Banking Un- ion only for the euro area countries50. However, there would also be a rationale for creating a Banking Union for the EU28 in order to provide a true single market in financial services as targeted by common EU law. Apart from current short-term crisis management in the euro area, the recreation of the Single Market should be the fundamental goal behind the proposals for an EU framework for a Banking Un- ion.51

It is a matter of political discussion whether the potential economic benefits of mu- tualising banking policy could outweigh its costs in terms of shared sovereignty and mutualisation of risks for the Member States. There have always been

48 See: EBA online (2015), Single Rulebook and flexibility?, http://www.eba.europa.eu/regulation- and-policy/single-rulebook, Date of Access: May 2015. 49 See: Speech by Vítor Constâncio at a Public Hearing on Financial Supervision in the EU, May 24 2013. 50 The euro area currently (May 2015) consists of 19 states including: Austria, Belgium, Cyprus, Estonia, Finland, France, Germany, Greece, Ireland, Italy, Latvia, Lithuania, Luxembourg, Malta, the Netherlands, Portugal, Slovakia, Slovenia, and Spain. 51 See: Pisani-Ferry, J. et al. (2012), p. 7.

24 3 Evolution of the Banking Union in Europe

Member States, U.K. in particular, that have clearly indicated their unwillingness to be bound by a Banking Union as they do not see it as necessary for the functioning of the Single Market. Political reservations also existed within the euro area, but here they were resolved by the powerful argument, namely that the absence of a Banking Union undermines the functioning and perhaps even the very existence of the Monetary Union.52

The International Monetary Fund (IMF) has gotten to the heart of this discussion by stating that “...while a banking union is desirable at the EU2753 level, it is critical for the euro 1754”. Figure 6 provides an overview of the state of play for the geographical scope of the Banking Union in Europe.

Figure 6: Geographical scope of the Banking Union Source: Own representation

For the reasons explained above the proposal of the European Commission recommends that the Eurozone countries mandatorily join the Banking Union while other EU members have the possibility to join voluntarily, with the agreement of the ECB. According to the Commission, the Banking Union is the last missing

52 See: Pisani-Ferry, J. et al. (2012), p. 7. 53 Note that it is now EU28 since Croatia joined the EU in 2013, and Euro19 as Latvia joined the Eurozone in 2014 and Lithuania in 2015. 54 See: Concluding Statement of IMF, 21 June 2012, https://www.imf.org/external/np/ms/2012/062112.htm, Date of Access: May 2015.

25 3 Evolution of the Banking Union in Europe piece to complete the Economic and Monetary union, to finally manage the euro crisis and to ensure the future existence of the euro. This approach maintains the possibility to eventually include the entire EU in the Banking Union, while it recog- nises that current political realities will not allow this in the near future.55

3.4 Opt-in and Opt-out

While the Eurozone countries have no other choice than joining the Banking Un- ion, all the other EU countries can voluntarily join (opt-in) the Banking Union or stay out (opt-out). Since the decision to form a Banking Union in June 2012, there have been intensive discussions within the rest of the EU28 countries about whether to join or not. Figure 7 gives an overview of the basic attitudes of the remaining countries towards the Banking Union, which shall be discussed below:

Basic Country Motives Attitude Bulgaria officially asked to join SSM after the national Corpbank Bulgaria opt-in scandal in 2014. First non-euro country to eventually join the banking union. Romania opt-in Romania is a candidate to join the euro by 2019. Central bank explicitly recommends Romania to join the Banking Union.

Denmark opt-in Central bank wants Denmark to join the Banking Union. Possible referendum to reach majority decision.

Croatia opt-in Croatian Central Bank wants to join Eurozone, and therefore also the Banking Union, as soon as possible.

Central bank criticises centralised Banking Union. Poland has Poland opt-out signed up for the euro, and therefore ultimately for the Banking Union, but without formal date. Czech Czech Rep. refuses mutualisation of risks through deposit guaran- Republic opt-out tee scheme. Unless changes in the overall architecture are made, Czechs will stay out of Banking Union. Hungary opt-out Hungary is cautious and still waiting for a final picture of the Bank- ing Union to decide on.

Sweden Sweden wants to stand apart from the Banking Union for “the fore- opt-out seeable future" and therefore joins the U.K. outside Europe bank union. Britain opt-out The U.K. officially refused to join the Banking Union. (see Section 3.5)

Figure 7: Status quo: opt-in and opt-out Source: Own representation

55 See: Elliot, D. (2012), p. 16.

26 3 Evolution of the Banking Union in Europe

U.K. and Sweden stay outside

London (see Section 3.5) and Stockholm, the two biggest banking centres outside the euro area, expressed their strong objections to the limited rights given to non- Eurozone members. In detail the two countries were concerned that the euro area countries might dominate the relevant regulatory and supervisory authorities, namely the EBA and the ECB. For this reason Anders Borg, then Swedish finance minister, proclaimed in December 2012 that Sweden would stand apart from the Banking Union for “the foreseeable future56”.

Eastern Europe for more participation

Eastern European countries outside the Eurozone were particularly worried about their role in a Banking Union that has a strong orientation towards western Euro- zone banks. According to them, the debate about the Banking Union - which was primarily induced to manage the EU's sovereign debt crisis - has centred on Euro- pean Union institutions and big Eurozone economies such as Germany and France. Although, countries like Poland or the Czech Republic have their own view on the future structure of the European banking system and therefore want to participate in the process of creating the laws and regulatory procedures. However, they are still anxious for their voices to be heard, as numerous of the most weighty discussions about Banking Union are taking place within the ECB and the Eu- rogroup, from which most of eastern Europe is excluded.57

For this reason the six eastern EU countries outside the euro area initially decided to stay out of the Banking Union, although some of them have already changed their minds for different reasons.

Poland, Europe's sixth largest economy, repeatedly criticised the new Banking Union by stating that it would centralise macroprudential powers, which should be according to Marek Belka, Poland’s central bank governor, in the hands of those who best know the local conditions (i.e. national central banks). Although Poland

56 See: FinancialTimes.com (2012) http://www.ft.com/intl/cms/s/0/f5af041e-43ac-11e2-844c- 00144feabdc0.html#axzz3R9o9Nbx4, Article of 11. December 2014. 57 See: Reuters.com (2013), http://www.reuters.com/article/2013/09/26/us-eeurope-investment- bankingunion-idUSBRE98P0JC20130926, Article of September 26, 2013.

27 3 Evolution of the Banking Union in Europe has already signed up for the euro, and therefore ultimately the currency’s Banking Union too, it has not set a formal date for joining yet.58 The Czech Republic has taken a similar point of view by arguing that a mutualisation of losses made by other banks through the SRM and the DGS is inacceptable. The Czechs therefore want to stay out of the Banking Union unless significant changes are made.59 Hun- gary is on the same side referring to the dominant role of euro area countries within the regulatory framework of the Banking Union. Nevertheless, Hungary has to strengthen its national financial regulatory framework in order to protect taxpayers from bearing banks' losses anyway, as it intends for an opt-out. 60

Bulgaria is an exceptional case as it initially supported the eastern European countries at the refusal of the Banking Union. Due to the financial scandal concerning the local Corporate Commercial Bank (Corpbank) in 2014 for which a substantial state-funded bailout was necessary in order to prevent a bank run and financial collapse, Bulgaria found itself compelled to join the SSM. It will therefore be the first candidate to officially opt-in at the Banking Union. 61 Romania and Croatia both shared the eastern European scepticism about the western dominance in the Banking Union, but they both want to join the euro area and consequently the Banking Union too. While Romania62 is already a candidate to join the euro area by 2019, the Croats63 are still preparing for an adoption of the euro as soon as possible.

58 See: FinancialTimes.com (2014), http://www.ft.com/cms/s/0/ba6537d2-5905-11e4-a722- 00144feab7de.html#axzz3R9o9Nbx4, Article of October 21, 2014. 59 See: Reuters.com (2012), http://www.reuters.com/article/2012/10/17/us-eu-summit-czech- idUSBRE89G0NF20121017, Article of October 17, 2012. 60 See: BudapestBusinessJournal.com (2014), http://www.bbj.hu/economy/eu-closer-to-banking- union;-hungary-on-the-fence_74634, Article of January 20, 2014. 61 See: Reuters.com (2014), http://www.reuters.com/article/2014/07/14/bulgariabanking-president- idUSL6N0PP4RF20140714, Article of July 14, 2014 and news.yahoo.com http://news.yahoo.com/bulgaria-plans-join-eu-banking-union-061638266.html, Article of July 15, 2014. 62 See: European Commission (2015), Romania and the euro, http://ec.europa.eu/economy_finance/euro/countries/romania_en.htm, Date of Access March 2015, and Speech by Mugur Isărescu (2014) http://www.bis.org/review/r140716c.pdf. 63 See: faz.net http://www.faz.net/aktuell/wirtschaft/im-gespraech-kroatiens-notenbankchef-vujcic- wir-wollen-den-euro-so-schnell-wie-moeglich-12264324.html, Article of June 28, 2013.

28 3 Evolution of the Banking Union in Europe

Denmark between economic and political motives

Although Denmark refused to be in the Eurozone, its national central bank strongly recommends joining the Banking Union, arguing that staying away would increase costs for foreigners wanting to invest in the country. The commercial banks' lobby group however, favours a wait-and-see approach, and political surveys show that most Danes reject the idea of national banks being regulated by the ECB. The only appropriate solution would be a referendum for which no target date exists yet. 64

3.5 The U.K. and the Banking Union

Although the British government supports the creation of a Banking Union amongst euro area members, there is concern in the U.K. that its creation might endanger the status of the City of London as the main financial centre of the EU, and as a global financial centre. Since the financial services industry in London contributes significantly to the GDP of the U.K., the interests of the City matter particularly for the British government. Regarding its role vis-à-vis the euro area, the financial centre of London is sceptical towards regulatory authorities that are majority-led by euro area countries, i.e. particularly the ECB. As far as London's global role is concerned, there are also fears that, by creating a Banking Union, the euro-area countries might impose changes to the Single Rulebook in order to strengthen the EU single market. This in turn might reduce the attractiveness of London compared to other global financial centres like New York, Hong Kong or Shanghai.65

3.5.1 Possible institutional conflicts

In theoretical terms, there is no reason why the European Union institutions, e.g. the Council, Commission, Parliament etc., could not continue to function as they have, even if only the euro area countries form a Banking Union. However, there are serious doubts as to whether this would work out that way in practice. For example, there exists a strong pressure emanating from the ECB as the dominant banking supervisor for 19 or more of the EU nations. Hence, it might be very

64 See: Reuters.com (2015) http://www.reuters.com/article/2015/01/23/denmark-banking- referendum-idUSL6N0V22ZT20150123, Article of January 23, 2015. 65 See: Pisani-Ferry, J. et al. (2012), p. 8.

29 3 Evolution of the Banking Union in Europe difficult for the EU level institutions to make different choices than the ECB. Gen- erally speaking, there is a strong incentive to coordinate decisions within the Euro- pean Union in order to avoid regulatory arbitrage and the appearance of dishar- mony to the outside world. Thus, the Brussels-based institutions would always have to consider the views of the ECB, representing the majority of the EU countries. As a result, there is likely to be a substantial shift of power from EU and national level institutions to Eurozone institutions, in regard to banking.66

3.5.2 Effective Banking Union without London

By this time there is consensus that the Banking Union can succeed without the U.K.’s participation, as long as there is sufficient coordination between the British institutions and those of the Banking Union. The EBA, situated in London, plays a key role in this context, as rules concerning the Single Market in financial services have to be determined at EU level before they can be applied within the Banking Union.67

However, much of the practical impact of the overall rules is determined by supervisory decisions on how to apply them. Hence, there is the risk of regulatory arbitrage, where certain financial activities move to London or into the Banking Union, depending on which place has a less restrictive supervisory regime. This risk certainly existed prior to the Banking Union, since the former 27 national authorities were not able to fully coordinate their regulatory policies. There is a strong belief that, as long as the U.K. remains within the EU, the degree of potential regulatory arbitrage should remain within acceptable tolerances.68

3.5.3 Banking Union and a withdrawal of the U.K. from the EU

Based on the tensions and risks explained above, there are legitimate concerns that the formation of the Banking Union in Europe will, sooner or later, cause the U.K. to leave the EU. After all, there has always been dissent between national interests and political as well as economic views of the U.K. and many of the continental European nations. EU critics in Britain claim that the euro area-centric

66 See: Elliot, D. (2012), p. 47. 67 See: Elliot, D. (2012), p. 48. 68 See: Elliot, D. (2012), p. 47.

30 3 Evolution of the Banking Union in Europe banking policy is about to put London and the rest of the Island at a considerable disadvantage. There are already many conflicts between the U.K. and many of the other EU members about the extent and form of banking regulation concerning hedge funds and compensation levels at banks. If the EU-level institutions become weaker in practical terms because of a need to accommodate the views of the ECB and those within the Banking Union, then it would be harder for the U.K. to protect its interests.69

As Howard Davies put it in June 2012, “I suspect that a banking union of some kind will be implemented, and soon. Otherwise, the Eurozone banking system will collapse. But the consequences of such a step for Europe’s great free trade exper- iment could be serious, and, if not managed correctly, could lead to Britain’s withdrawal.70” However, apart from the Banking Union, there will be many other motives affecting the British people at the Referendum about Britain's membership in the EU, scheduled for 2016.

69 See: Elliot, D. (2012), p. 48f. 70 See: The Guardian (2012), European banking union raises unanswerable questions, http://www.theguardian.com/business/economics-blog/2012/jun/29/eurozone-banking-union- questions, Date of Access: May 2015.

31 4 Single Supervisory Mechanism (SSM)

4 Single Supervisory Mechanism (SSM)

The SSM, which entered into operation in November 2014, is a big step towards greater European harmonisation. It was established as a response to the lessons learnt after the financial crisis and its global economic consequences to enhance the robustness of the euro area banking system. Today the SSM is responsible for the prudential supervision of all credit institutions in the participating Member States of the Banking Union. It ensures that the EU’s policy on the prudential supervision of credit institutions is implemented in a coherent and effective manner and that credit institutions are subject to supervision of the highest quality. The overall objectives of the SSM are to:71  ensure the safety and soundness of the European banking system,  increase financial integration and stability,  ensure consistent supervision.

4.1 Supervising principles

According to the ECB the SSM is not an attempt to “reinvent the wheel”, but instead it aims to build upon the best supervisory practices that are already in place. It works on commonly agreed principles and standards within the ECB and the national supervisory authorities together with the EBA, the European Parliament, the Eurogroup, the European Commission, the European Systemic Risk Board (ESRB) and other international standard-setters. The main principles, guiding the ECB and the National Competent Authorities (NCAs) as well, are:72

71 See: ECB (2014a), p. 4f. 72 See: ECB (2014a), p. 7ff

32 4 Single Supervisory Mechanism (SSM)

Figure 8: General principles of the SSM Source: Own representation

Principle 1 - Use of best practices The supervisory model used now builds on state-of-the-art supervisory practices and processes developed over the time throughout Europe. Thus, it builds upon experiences of the various supervisory authorities of the Member States.

Principle 2 - Integrity and decentralisation The SSM primarily relies on the expertise and resources of NCAs in performing its supervisory tasks. In order to ensure consistent supervisory results it also benefits from centralised processes provided by the ECB.

Principle 3 – Homogeneity within the SSM Supervisory principles and procedures are applied to credit institutions across all participating Member States in a harmonised way to ensure consistency of supervisory actions in order to avoid distortions in treatment and fragmentation.

Principle 4 – Consistency with the Single Market The SSM integrates supervision across a large number of jurisdictions and follows the single rulebook provided by the EBA. The SSM is fully open to all non-euro Member States on a voluntary basis.

33 4 Single Supervisory Mechanism (SSM)

Principle 5 – Independence and accountability The supervisory tasks shall be exercised in an independent manner and are subject to high standards of democratic accountability in the participating Member States.

Principle 6 – Risk-based approach The SSM approach to supervision is based on qualitative and quantitative approaches and involves judgement and forward-looking critical assessment of risk management.

Principle 7 – Proportionality The intensity of the SSM’s supervision varies across credit institutions, with a stronger focus on the largest and more complex systemic groups and on the more relevant subsidiaries within a significant banking group.

Principle 8 – Adequate levels of supervisory activity for all credit institutions The SSM adopts minimum levels of supervisory activity for all credit institutions and ensures that there is an adequate level of engagement with all significant institutions, irrespective of the perceived risk of failure. It categorises credit institutions according to the impact of their failure on financial stability and sets a minimum level of engagement for each category.

Principle 9 – Effective and timely corrective measures The SSM proactively supervises credit institutions in participating Member States to reduce the likelihood of failure and the potential damage, with a particular focus on the reduction of the risk of a disorderly failure of significant institutions. The SSM’s supervisory approach fosters timely supervisory action and a thorough monitoring of a credit institution’s response.

4.2 Legal basis of the SSM

As the ECB is now responsible for the overall functioning of the SSM, it will oversee euro area banks, while sharing responsibilities and closely cooperating with the NCAs. The transfer of supervisory tasks to the ECB is primarily based on

34 4 Single Supervisory Mechanism (SSM)

Article 127 (6) TFEU73 stating that, "The Council, [...] may unanimously, and after consulting the European Parliament and the European Central Bank, confer specific tasks upon the European Central Bank concerning policies relating to the prudential supervision of credit institutions and other financial institutions with the ex- ception of insurance undertakings." NCAs will therefore remain responsible for tasks not explicitly conferred on the ECB.74

Council Regulation No 1024/201375, which is also called SSM Regulation, trans- fers specific tasks concerning policies relating to the prudential supervision of credit institutions to the ECB. It was also decided back then, that the ECB must publish an ECB framework regulation within six months of the entry into force of the SSM regulation. The ECB accomplished its task by adopting Regulation No 468/201476, which establishes the framework for cooperation within the Single Su- pervisory Mechanism between ECB and NCAs.77

It has been laid down, that the ECB and the NCAs must act independently within the SSM. Furthermore, the ECB must carry out its supervisory tasks separately from its monetary policy tasks it is accountable to the European Parliament and to the Council. The setting of technical rules and the convergence of supervisory practices in the EU fall exclusively within the scope of the EBA, which issues the Single Rulebook and the Single Supervisory Handbook (see Sections 3.2.1 and 3.2.2).78

In addition to the legal documents the ECB issued the "Guide to banking supervision" in November 2014 to guide the implementation of the SSM and explain how the SSM works in practice.

73 Treaty on the Functioning of the European Union (TFEU) 74 See: Huber, D. and Pföstl, E. (2013), p. 53. 75 Published on 15 October 2013 in the Office Journal of the European Union. 76 Published on 16 April 2014 in the Office Journal of the European Union. 77 See: Huber, D. and Pföstl, E. (2013), p. 53f. 78 See: Huber, D. and Pföstl, E. (2013), p. 54.

35 4 Single Supervisory Mechanism (SSM)

4.3 The functioning of the SSM

According to Principle 1 the SSM aims to combine the strengths of the ECB and the NCAs. Hence, it builds on the ECB’s macroeconomic and financial stability expertise, while relying on the NCAs’ long-established expertise in the supervision of credit institutions, taking into account their economic, organisational and cultural specificities.79

4.3.1 Distribution of tasks between ECB and NCAs

The SSM as a whole is responsible for the supervision of around 4,700 supervised entities within the participating Member States. To ensure maximum efficiency the supervisory roles and responsibilities of the ECB and the NCAs are allocated on the basis of the significance (see Chapter 4.3.2) of the supervised entities.80 Fig- ure 9 shows the overall supervisory architecture of the new SSM.

Figure 9: Tasks within the SSM Source: ECB (2014a), p. 13.

79 See: ECB (2014a), p. 9. 80 See: ECB (2014a), p. 10f.

36 4 Single Supervisory Mechanism (SSM)

The ECB directly supervises only those institutions that are classified as significant - these are currently 120 banks81 accounting for almost 85% of total banking assets in the euro area. The day-to-day supervision is conducted by Joint Superviso- ry Teams (JSTs), consisting of staff from both NCAs and the ECB. The NCAs, however, continue to supervise less significant institutions, approximately 3,500 entities. Furthermore, the ECB can also take over the direct supervision of less significant institutions if it considers it necessary.82

4.3.2 Classification as significant or less significant

To determine whether a credit institution is significant or less significant, the SSM conducts a regular review in each Member State. In this context, each credit institution licensed within a Member States is assessed to determine whether it fulfils the criteria for significance, which are:83  The total value of assets exceeds €30 Billion, or  the total value of assets exceeds 20% of the national GDP and the total value of assets exceeds €5 Billion, or  the national supervisory authority has notified the ECB that the credit institution is significant in terms of the country's national economy and its significance has been confirmed by the ECB.  Moreover, a credit institution can also be classified as significant by the ECB based on its significant cross-border activity.  The receipt of direct financial aid from the European System of Financial Supervisors (ESFS) or the European Stability Mechanism (ESM) also results in classification as significant.  In any case, at least the three largest banks in every euro area Member State will be classified as significant.

The status of credit institutions may change over time through normal business activity or due to exceptional occurrences (e.g. a merger or acquisition). If a credit

81 As each subsidiary of a banking group is considered to be an individual entity subject to supervision, the ECB directly oversees approximately 1,200 entities. 82 See: ECB (2014a), p. 10ff. 83 See: ECB (2014a), p. 9 and FMA Austria (2015), https://www.fma.gv.at/en/special-topics/single- supervisory-mechanism.html, Date of Access: May 2015.

37 4 Single Supervisory Mechanism (SSM) institution, that is considered less significant so far, meets one of the relevant criteria for the first time, it is declared significant. As a consequence the NCA has to hand over responsibility for its direct supervision to the ECB or conversely, if a credit institution does no longer fulfil the criteria for being significant.84

4.3.3 Joint Supervisory Teams

The fact that the ECB takes over control of the supervision of significant banks does not mean that the NCAs are discharged from all supervisory responsibilities concerning their large domestic banks. As mentioned above, the day-to-day supervision of significant institutions is now conducted by Joint Supervisory Teams, which consist of staff from both the ECB and the NCAs of the countries in which the credit institutions are established (Figure 10). A JST is established for each significant institution and its size, composition and organisation is tailored individu- ally to the nature, complexity, scale, business model and risk profile of the supervised credit institution.85

Figure 10: Functioning of the JST Source: ECB (2014a), p. 13.

84 See: ECB (2014a), p. 9. 85 See: ECB (2014a), p. 16f.

38 4 Single Supervisory Mechanism (SSM)

Every JST is managed by a JST coordinator86, who coordinates the work of the JST and who is as well the contact person for the significant institution. The employees of the NCAs, who are assigned to the JSTs, remain responsible for the preparation and execution of a multitude of supervisory tasks, while bringing national supervisory practices and national legal specificities to the JST's attention. In the case of a JST consisting of a large number of staff, a core JST including the JST coordinator at the ECB and (national) sub- coordinators in the NCAs, organis- es the allocation of tasks among all the other JST members.87

4.3.4 Excursus 2: The Role of the Austrian FMA in the SSM

The FMA is the national competent authority (NCA) for Austria. Its primary task is therefore to provide the necessary supervisory and administrative contributions from an Austrian perspective to ensure the successful operation of the SSM. Since the SSM has entered into force, the following duties have been assigned to the FMA:88  The FMA is still the direct supervisor of less significant institutions in Austria and reports regularly to the ECB.  FMA employees are actively involved in the supervision of significant Aus- trian Institutions in their capacity as members of JSTs.  In addition to the SSM, the following tasks remain the sole responsibility of the FMA: o Prevention of money laundering and terrorist financing, the prevention of unauthorised banking operations, as well as consumer protection issues. o Supervision of all credit institutions which are not CRR-credit institutions. o Enforcement of special legal acts relating to banking supervision (e.g. the Austrian Building Society Act (BSpG), the Austrian

86 Usually the JST Coordinator shall be ECB staff in order to provide the necessary degree of ob- jectivity. 87 See: ECB (2014a), p. 16f and FMA Austria (2015), https://www.fma.gv.at/en/special- topics/single-supervisory-mechanism.html, Date of Access: May 2015. 88 See: FMA Austria (2015), https://www.fma.gv.at/en/special-topics/single-supervisory- mechanism.html, Date of Access: May 2015.

39 4 Single Supervisory Mechanism (SSM)

Mortgage Banks Act (HypBG) and the Austrian Mortgage Bond Act (PfandbriefG))  Responsibilities relating to macroprudential supervision remain the compe- tence of national authorities, although it is now possible for the ECB to impose stricter regulations.

Figure 11 shows the supervisory architecture in Austria under the new SSM as an example. There are currently 8 (*989) credit institutions classified as significant institutions in Austria, which are now directly supervised by a JST of the ECB. Con- sequently, the FMA remains the competent authority for the supervision of more than 550 less significant institutions in Austria, but it must now report to the ECB about its supervisory activities on a regular basis.90

Figure 11: Supervisory architecture in Austria Source: Own representation

89 Bank Austria is a subsidiary of the Italian UniCredit Group since 2005. 90 See: FMA Austria (2015), https://www.fma.gv.at/en/special-topics/single-supervisory- mechanism.html, Date of Access: May 2015.

40 4 Single Supervisory Mechanism (SSM)

4.4 Progress in the operational implementation

According to the fourth quarterly report to the European Parliament, the EU Coun- cil and the European Commission on progress in implementing SSM Regulation the ECB considers itself as ready to fully perform the supervisory tasks conferred on it by the SSM Regulation:91  The comprehensive assessment has been finalised on schedule and the first results were published on 26 October 2014 in the form of standardised templates for bank-level outcomes (see Section 4.5).  The SSM governance, covering the determination of the significance of supervised institutions and all other related decisions, is fully operational.  In 2014 about 900 new employees out of more than 20.000 applications have been recruited by the ECB in order to fill positions, budgeted for in the five SSM business areas as well as the related shared services.  The Joint Supervisory Teams are operational and already started the day- to-day supervision of significant banks. From 1 November 2014 on, more than 330 staff have been working at the ECB to supervise significant banks.  Despite the core tasks of the SSM the ECB's work has also advanced well in many other supporting areas, such as IT infrastructure, internal and external communication, logistical organisation, as well as legal and statistical services.

The challenges facing the SSM in the near future are wide-ranging. First of all, they include the monitoring and critical review of the first comprehensive assessment (i.e. stress test) in order to evaluate, whether the European banking system is on the right way to restore financial stability especially in case of another crisis. Another critical task is the operational embedding of the JSTs, as there are still many challenges such as the integration of a large number of new staff, the inter- action between the ECB and the NCAs, as well as the establishment of the new infrastructures within the ECB and the NCAs.92

91 See: ECB (2014b), p. 3ff. 92 See: ECB (2014b), p. 27f.

41 4 Single Supervisory Mechanism (SSM)

4.5 Results of the first comprehensive assessment in November 2014

In autumn 2014 the ECB conducted a comprehensive assessment in order to pre- pare itself and the banks involved for the new supervisory architecture under the SSM. The assessment was particularly broad in scope, covering 130 credit institutions with total assets worth €22.0 trillion (≈ 82% of total banking assets in the SSM). The stated objectives of this exercise were to:93  Repair – identifying and implementing necessary remedial actions that are required to safeguard solvency in the near term.  Transparency – enhancing the quality of information available on the condi- tion of banks to facilitate a more accurate assessment of their solvency.  Confidence building – assuring stakeholders, that banks will be stable and trustworthy after the identified remedial actions are implemented.

4.5.1 Rationale

The overall aim of the comprehensive assessment was to consistently and objec- tively evaluate both the health of banks' balance sheets and their solvency prior to the handover of responsibility from the NCAs to the ECB.94 The comprehensive analysis was implemented in two major steps, which are:95 1. The Asset Quality Review (AQR) is a point-in-time assessment of the accu- racy of the carrying value of banks’ assets as of 31 December 2013 and provided a starting point for the following stress test. The exercise was based on the Capital Requirements Regulation and Directive (CRR/CRD IV), on the definition of regulatory capital96 as of 1 January 2014. 2. The stress test provides a forward-looking review of the resilience of banks’ solvency considering two hypothetical scenarios. Under the baseline scenario, banks were required to maintain a minimum Common Equity Tier 1 ratio of 8%; under the adverse scenario, they were required to maintain a minimum CET1 ratio of 5.5%.

93 See: ECB (2014c), p. 2. 94 See: ECB (2014c), p. 13. 95 See: ECB (2014c), p. 2f. 96 This means, that under the AQR, banks are required to have a minimum Common Equity (i.e. capital invested by shareholders/owners and retained earnings) Tier 1 (CET1) ratio of 8%.

42 4 Single Supervisory Mechanism (SSM)

4.5.2 Excursus 3: Stress test - baseline and adverse scenario

The baseline scenario is built upon macroeconomic projections for a 2-year horizon starting in Winter 2014 until 2016. These forecasts97 cover the major macroeconomic aggregates (GDP growth, employment, inflation and house prices) for the EU Member States, the candidate countries and the European Union as a whole, as well as the euro area and the international environment. The baseline scenario foresees an overall continuation of the economic recovery in most Member States and in the EU as a whole. The outlook therefore presumes a moderate step-up in economic growth, a modest rise in employment and a marginal rise in Inflation.98

The adverse macroeconomic scenario also covers the horizon 2014-16. The aim of this exercise, however, is to produce paths for the macroeconomic variables in terms of deviations from a given baseline. In concrete terms, the adverse scenario reflects the systemic risks that are currently assessed by the ESRB General Board including: an increase in global bond yields amplified by an abrupt reversal in risk assessment, a further deterioration of credit quality in countries with still vulnerable banking sectors, dragging policy reforms jeopardising confidence in the sustaina- bility of public finances and the lack of necessary bank balance sheet repair to maintain affordable market funding.99

4.5.3 Results

The AQR resulted in aggregate adjustments of €47.5 billion to asset carrying values of the participating banks. These adjustments originated primarily from accrual accounted assets, particularly adjustments to specific provisions on non-retail ex- posures and non-performing exposure stocks. Figure 12 shows the AQR adjustments divided per country. It also shows the large differential in national supervisory jurisdictions prevailing prior to the SSM. These jurisdictions are now replaced by common standards for all participating states of the SSM.100

97 Forecasts are based on annual public finance data as published in Eurostat and a set of external assumptions reflecting market expectations. 98 See: European Commission (2014b), p. 1ff. 99 See: European Systemic Risk Board (2014), p. 1f. 100 See: ECB (2014c), p. 2f.

43 4 Single Supervisory Mechanism (SSM)

Figure 12: Gross AQR adjustment by country Source: ECB (2014c), p. 70.

The stress test revealed, that under the adverse scenario, defined by the ESRB (see Excursus 3), the banks' aggregate available capital is predicted to diminish by €215.5 billion101 while the risk weighted assets (RWA) might increase by about €860 billion by 2016. As a consequence, this capital impact leads to a decrease of the CET1 ratio for the median participating bank by 4.0 percentage points102 (Fig- ure 13) from 12.4% to 8.3% in 2016. The numbers in Figure 13 are therefore to be regarded with a negative sign as they represent reductions from the CET1 ratio in baseline scenario.103

101 This accounts for approximately 22% of the total capital held by participating banks. 102 Although not fully comparable, the median projected CET1 ratio reduction in the Comprehensive Capital Analysis and Review (CCAR) carried out in the United States in 2014 was 2.9% and 2.1% in the EBA stress test carried out in 2011. 103 See: ECB (2014c), p. 5f.

44 4 Single Supervisory Mechanism (SSM)

Figure 13: Median projected adverse scenario reduction in CET1 by country Source: ECB (2014c), p. 6.

Overall the scenario tested under the 2014 EU‐ wide stress classified 25 participating banks to fall below the capital threshold in the adverse scenario, leading to a maximum capital shortfall of €24.6 billion. In other words, almost every fifth of the banks being tested failed to reach the capital requirements under the worst- case scenario. However, it must also be noted, that after taking account of the capital raised in 2014 by the affected banks, the capital shortfall boils down to €9.5 billion. Figure 14 shows the number of banks that failed the stress test and the expected shortfall in the adverse scenario broken down by country.104

Figure 14: Stress test - failing banks and shortfall by country Source: EBA (2014), p. 22.

104 See: ECB (2014c), p. 6 and The Wall Street Journal Online (2014), http://blogs.wsj.com/moneybeat/2014/10/26/here-are-the-european-banks-that-failed-the- stress-test/ Date of Access: May 2015.

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4.5.4 Excursus 4: European stress test for Austrian banks

According to the Austrian Central Bank the results of the comprehensive assessment show to a great extent the expected outcome for Austria’s major banks. Fi- nally, five of the six reviewed credit institutions performed well in the assessment and have sufficient capital buffers even under the adverse stress scenario. Only the ÖVAG105, which is known to be currently in a fundamental restructuring process, failed the stress test, as its 2016 CET1 ratio will be significantly lower (2.1%) than the required 5.5% benchmark. Figure 15 gives an overview of results under the adverse scenario106 for the Austrian banks.107

Figure 15: Stress test - results for Austrian banks Source: Oenb.at (2015), "http://www.oenb.at/en/Media/20141026.html".

Ewald Nowotny, Governor of the Austrian Central Bank, commented calmly on the results by stating that "The results correspond to our expectations. The figures for ÖVAG come as no surprise, either. All in all, Austrian banks are found to have become more resilient to crises in recent years.108” Considering the ÖVAG, it is important to know that the bank currently (status 2014) meets all regulatory requirements. However, the stress test revealed, that the ÖVAG has a substantial capital shortfall under both the baseline and the adverse scenario in 2016 unless significant changes are made. The ÖVAG has therefore been working on a restructuring plan to close this potential capital gap and it keeps working on it in close cooperation with its owners and the competent supervisors.109

105 ÖVAG is the formal abbreviation for Österreichische Volksbanken AG. 106 For more detailed results see Annex 3 or the aggregate report on comprehensive assessment published by the ECB. 107 See: Gutlederer, C. and Grubelnik, K. (2014), p. 1f. 108 See: Gutlederer, C. and Grubelnik, K. (2014), p. 1f. 109 See: Gutlederer, C. and Grubelnik, K. (2014), p. 3.

46 5 Single Resolution Mechanism (SRM)

5 Single Resolution Mechanism (SRM)

Since the breakout of the financial crisis in the U.S. and the following financial meltdown in Europe, especially in the euro zone countries, repeated bailouts of banks have increased public debt and imposed a heavy burden on taxpayers. In numbers, the multiple bailout packages in form of recapitalisation and asset relief measures between October 2008 and December 2012 amount to €591.9 billion or 4.6% of EU 2012 GDP. If sovereign guarantees are included, this figure would nearly triple in size to €1.6 trillion or 13% of EU GDP for the period 2008-2010 only. Global financial integration and the creation of a single market in financial services for the EU have enabled the banking sector to expand strongly. Thus, large banking groups started to gradually outgrow national GDP in some Member States resulting in institutions, which were "too-big-to-fail" but at the same time "too-big- to-save" under existing national arrangements. On the other hand, experience also shows that the failure of relatively small banks may already cause cross-border systemic damage.110

In order to prevent such extensive bail-outs in the future, and also to facilitate the resolution of complex, cross-border connected banks without misusing tax resources, international policymakers joined forces to define a set of key attributes for an effective resolution regime. As a result, the Financial Stability Board (FSB) made up a document111 providing the core elements that are necessary for an effective resolution regime. At the Cannes Summit in November 2011 the G20 heads adopted this document as a new international standard for resolution regimes. In the EU, two legislative projects were launched to put this initiative into practice:112 I. Bank Recovery and Resolution Directive (BRRD): This Directive applies to all EU Member States and aims at a harmonisation of the recovery and resolution practices but leaves the implementation at the national level. (see Section 5.3)

110 See: European Commission (2014a), p. 6 and European Commission (2012), p. 9. 111 FSB (2014), Key Attributes of Effective Resolution Regimes for Financial Institutions, latest Ver- sion: 15 October 2014. 112 See: Deutsche Bundesbank (2014), p. 31.

47 5 Single Resolution Mechanism (SRM)

II. Single Resolution Mechanism: The SRM builds on the tools created by the BRRD and complements the establishment of the SSM. The SRM thus applies only to those Member States, which participate in the SSM, respectively the Banking Union. The core institutions of the SRM are the Single Resolution Board (SRB) at European level as well as a Single Resolution Fund (SRF). (see Section 5.4)

For that reason, the European Commission recognised in 2012, that the common supervision within the Banking Union (i.e. the SSM) helps to improve the robustness of the European banking system. If a crisis nonetheless occurs it is necessary to ensure that institutions can be resolved in an orderly manner and that depositors are assured their savings are safe.113

5.1 European resolution prior to the SRM

Before the adoption of the SRM each of the 27 Member States had its own approach to deal with troubled banks. For instance, during the financial crisis many countries strongly relied on ad hoc solutions for individual problem cases leading to an unsystematic and uncoordinated resolution process within the European financial market.114 This is why the Commission proposed a legal act115 in June 2012 to harmonise the national resolution approaches by establishing a union- wide framework for the recovery and resolution of credit institutions (for BRRD see Section 5.3).

Overall, there have been a couple of trends across Europe in how bank resolution was handled in practice. First, there was a strong bias to not allow any bank to be liquidated, no matter how small or troubled it was. In European tradition a bank failure has been viewed as a morally bad thing, rather than the inevitable consequence in a capitalistic market economy, as it has always been viewed in America. Thus, banks have sometimes been forced into mergers or fundamental restructuring processes, but they have seldom failed in a manner analogous to the U.S.

113 See: European Commission (2012), p. 9. 114 See: Elliot, D. (2012), p. 31. 115 European Commission's Proposal for a Directive (BRRD) of the European Parliament and of the Council, 2012/0150 (COD), June 6, 2012.

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Furthermore, in almost all cases of bank insolvency the government has guaranteed all liabilities, so that neither depositors nor lenders to the involved bank lost any money. With the proposal for the SRM there emerged a strong push to change this approach going forward, in order to ensure that both bank creditors and shareholders become aware that banking activities are inherently risky.116

5.2 Linkage between banking and sovereign crisis

The strong interdependence between banking and sovereign crisis has emerged as an outstanding problem of the Eurozone debt crisis since 2009. There are two primary reasons why euro area banks and sovereigns seemed to be so closely tied together. On the one hand, in the absence of a supranational banking resolution framework, Member States kept individual responsibility for the rescue of their national banks. Given the size of the cross-border banking systems in the euro area, this implies that the fiscal consequences of rescuing such a bank are enor- mous. On the other hand, domestic banks usually hold a significant share of the debt issued by their domestic government on their balance sheets, making them vulnerable to changes in sovereign solvency. This two-way bank-sovereign interdependence constitutes one of the specific features of the euro area that makes it especially fragile.117

5.2.1 Statistical evidence

Merler and Pisani-Ferry support their statement made above by illustrating the correlation of the evolution of sovereign and bank credit default swaps (CDSs) between sovereign and bank solvency.

116 See: Elliot, D. (2012), p. 31. 117 See: Merler, S. and Pisani-Ferry, J. (2012), p. 2.

49 5 Single Resolution Mechanism (SRM)

Figure 16: Statistical evidence (U.S. and Spain) Source: Merler, S. and Pisani-Ferry, J. (2012), p. 3.

Figure 16 shows the tremendous difference in correlation of the European countries, e.g. Spain (Italy and Greece analogous), compared to the United States. While the correlation between banks' and sovereign CDS' in Spain is extremely high in 2008 and even increases until 2012, the correlation in the U.S. remains very low. This implies for the European countries, that whenever perceived solvency risks for either the state or the banking system have increased, there has been a noticeable effect on the other one. In the U.S., however, concerns over the situation of banks did not affect materially the perceived solvency of the federal government, which means that the safe-haven role of the U.S. treasuries remained unaffected by changing conditions in the banking system.118

5.2.2 An illustration - the Spanish Caja Debacle

The Spanish banking crisis has been to a large extent a crisis of the caja sector119. By 2012, the Banco de España estimated, that the three most problematic Span- ish cajas (Bankia, CatalunyaCaixa and Novagalicia) have accumulated capital def- icits to be covered by the Spanish bank rescue funds (FROB) of €54 billion, amounting over 5% of Spanish GDP. The Wyman report of 2012120 revealed that from 2008 to 2012 the problematic cajas were busy reclassifying, refinancing and

118 See: Merler, S. and Pisani-Ferry, J. (2012), p. 3. 119 i.e. the traditional banking business covering the control of savings and loans. 120 As Spain sought help at the European rescue fund in 2012, an external private firm (Oliver Wy- man) was consulted to create a stress test report for the Spanish banking system.

50 5 Single Resolution Mechanism (SRM) extending loans to cover up their losses. The Banco de España, however, remained inactive for all these years, but why?121

Luis Garicano, Professor at the London School of Economics, identifies four likely reasons for this failure of the Spanish supervision: 122 I. Human error: Supervisors are reluctant to uncover their own previous mistakes to ruin their future career. Supervisors of the Banco de España had little interest in discovering that Spain’s main regulator had in fact missed the largest financial crisis in the history of the country. II. Dynamic provisions: This forward-looking risk management tool comprises the adjustment of banks provisions for future defaults on loans for the effects of the economic cycle. Unfortunately, the cajas misused this tool for years to hide their stressed equity base from the supervisors. III. Resolution framework: The lack of action by the Banco de España was caused to a large extent by the lack of an appropriate resolution framework at the time. If the Banco de España had uncovered the extensive imbalance in the caja sector, it would have not been able to deal with the capital shortfalls as there was no appropriate resolution regime available. IV. Political influence: The Spanish case of ex-politicians appointed to the board of directors of the cajas is certainly not unique on a worldwide comparison. The Spanish supervisors, however, were not able to prevail against the strong political influence throughout the cajas.

The previous sections lead to the conclusion, that in an integrated European banking network resolution procedures at national level are doomed to failure. While the original Eurozone structure did not foresee it, the ECB gradually became the lender of last resort during the Global Financial Crisis, but was poorly equipped to act as such. First, as a European institution it had only limited information about local banks in the Member States and no authority to intervene anyway. Second, as demonstrated by the Caja Debacle, national authorities with the responsibility to intervene, restructure, and recapitalise banks procrastinated as long as possible, putting additional pressure on the ECB to intervene, but only when it is too late. At

121 See: Beck, T. (2012), p. 79. 122 See: Beck, T. (2012), p. 81ff.

51 5 Single Resolution Mechanism (SRM) this point the formation of the Banking Union began, by equipping the ECB not only with supervisory but also with resolution authority for all banks in the participating Member States.123

5.3 Bank Recovery and Resolution Directive (BRRD)

The BRRD124 represents a major step towards restoring the theoretical principles of a market economy, which determine that if a credit institution fails, its shareholders and creditors should be first in line to absorb the arising risks and losses before a resolution fund financed by the banking industry or taxpayers steps in. The BRRD strives to achieve this goal through a new bail-in tool, which primarily requires shareholders and creditors to absorb losses. The idea behind the new European resolution regime for banks is to provide a set of resolution tools that facilitate the resolution of banks without misusing taxpayers’ money. The BRRD therefore provides a set of cornerstones (Figure 17) for future resolution management in Europe:125  Banks and authorities shall make adequate preparation for crisis.  National authorities shall be equipped with the necessary tools to intervene in a troubled institution at a sufficiently early stage to address developing problems;  National authorities shall use harmonised resolution tools and powers to take rapid and effective action when bank failure cannot be avoided;  Authorities shall cooperate effectively when dealing with the failure of a cross-border bank.  Banks shall contribute to resolution financing arrangements to support the costs of restructuring.

123 See: Beck, T. (2012), p. 12. 124 See: Directive 2014/59/EU of 15 May 2014, establishing a framework for the recovery and resolution of credit institutions and investment firms. 125 See: European Commission (2014c), p. 4.

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Figure 17: Basic principles of the BRRD Source: Own representation

5.3.1 Legal background and scope

The BRRD is a Directive by European law, which means that is neither legally binding nor directly applicable in the Member States. Instead, it is to be transposed into national law by the Member States to reach maximum effectiveness under the predominant national conditions. Accordingly, on 6 June 2012 the European Commission presented a proposal for the Directive establishing a framework for the recovery and resolution of credit institutions (BRRD) and a year later on 10 July 2013 the European Commission presented a proposal for a Regulation126 establishing a uniform regime for resolving banks. The two documents are independent in legal terms, but the SRM Regulation builds on the provisions of the BRRD.127

The major difference between the documents is that the BRRD applies across all 28 Member States of the EU and harmonises the fundamental resolution law by providing a common set of resolution tools. The SRM Regulation, by contrast, establishes a European resolution board with the powers that can be exercised by

126 European Commission's Proposal for a Regulation (SRM Regulation) of the European Parlia- ment and of the Council, 2013/0253 (COD), July 10, 2013. 127 See: Deutsche Bundesbank (2014), p. 33f.

53 5 Single Resolution Mechanism (SRM) national resolution authorities under the BRRD framework. Even though the SRM Regulation is theoretically also applicable across all 28 Member States, the SRM can only cover the countries participating in the SSM. So strictly speaking, only the SRM, and not the BRRD, is part of the Banking Union project.128

5.3.2 Recovering proceedings and early intervention

Recovery proceedings are characterised by the fact that the institution itself conducts them independently. In other words the management can decide to sell certain assets or entire business lines to other institutions or it can attempt to reorganise, downsize or terminate certain business activities. Common to all recovery measures is that they are solely private-law arrangements that do not involve any sovereign or official powers. Recovery measures are therefore solely private-law arrangements that do not permit any intervention by sovereign powers in the rights of investors against their will.129

However, the BRRD provides early intervention powers (Articles 27-30) to the supervisory authorities so that they can, whenever it is necessary require an institution to take recovery action. The BRRD even enables supervising authorities to dismiss the management of an institution as well as to call a meeting of shareholders to adopt urgent reforms. To save additional time during the recovery process Article 5 BRRD requires all institutions to draw up and maintain recovery plans identifying the most appropriate resolution tools to be used under different future scenarios. The recovery plan shall ensure that any credit institution, regard- less of its size and complexity, can be resolved with the available tools in a way that does not threaten financial stability and does not involve costs to taxpayers.130

5.3.3 Resolution process

The overall objective of resolution is to minimise the cost of a bank failure that has to be borne by the State, i.e. its taxpayers. The BRRD therefore equips resolution authorities with an effective set of tools to handle even large banks that are in major distress. These include the power to sell or merge the business with another

128 See: Deutsche Bundesbank (2014), p. 33f. 129 See: Deutsche Bundesbank (2014), p. 35. 130 See: Deutsche Bundesbank (2014), p. 35 and European Commission (2014c), p. 5.

54 5 Single Resolution Mechanism (SRM) bank, to set up a temporary bridge bank to operate critical functions, to separate good assets from bad ones and to convert to shares or write down the debt of failing banks (for Bail-in see Section 5.3.4). These tools will ensure that all critical functions are preserved without the need to bail out the bank, and that shareholders and creditors of the bank under resolution bear an appropriate part of the losses. They should also minimise the loss of value of the bank assets associated with bankruptcy by a quick restructuring or an orderly wind-down.131

5.3.4 Bail-in

The main aim of the bail-in mechanism is to stabilise a failing bank so that its es- sential services can continue, without the need for public funds. The tool enables authorities to recapitalise a failing bank through the write-down of liabilities and their conversion to equity so that the bank can continue as a going concern. This would avoid disruption to the financial system (e.g. bank run) that would likely be caused by immediately stopping the bank's critical services, and give the authorities time to reorganise the bank or wind it down in an orderly manner. But this also means, that under the BRRD the shareholders and the management have to bear responsibility for the resolution process.132

Figure 18: Liability cascade in the bail-in procedure Source: Own representation based on Deutsche Bundesbank (2014c), p. 40.

131 See: European Commission (2014c), p. 5. 132 See: European Commission (2014c), p. 7f.

55 5 Single Resolution Mechanism (SRM)

The first step when applying the bail-in tool is to assess the total amount of funds necessary to absorb the cumulated losses. The first instruments to be written down shall be regulatory equity funds covering Tier 1, Additional Tier 1 and Tier 2 capital (see Figure 18). Should this not suffice to raise the target amount, subordinated liabilities can be written down. Last but not least, all other creditors can be called to task. Eligible deposits are held by natural persons or by small and medium-sized enterprises (SMEs) that would normally benefit from deposit protection but exceed the deposit guarantee threshold of €100,000 per institution and depositor. Covered deposits have the highest ranking in the resolution process. However, if the funds generated in the resolution process are insufficient, the deposit guarantee scheme (see Chapter 6) safeguards deposits up to €100,000.133

5.3.5 Cooperation and coordination

A major concern of the BRRD is to improve cooperation between national authorities in Europe so that the failure of even large cross-border banking groups can be handled without major disruption of financial stability in Europe. The BRRD therefore provides the formation of so-called resolution colleges, composed of resolution experts of the involved supervisory authorities. The EBA will be the central hub for the coordination between the resolution colleges and it will also handle mediation in case of disagreements between authorities.134

5.3.6 Resolution financing at European level

An orderly bank resolution requires both time and money. For example, if the resolution authority requires a bridging to split up a distressed bank into a good and a bad bank, it will need capital and short-term loans to be able to operate. This is why under the BRRD every Member State is required to set up a national resolution fund financed by contributions from domestic banks in proportion to their liabilities and risk profile. The contributions are to be made annually in order to reach a target funding level of at least 1% of covered deposits by the end of 2024. As a consequence, each national fund will finance the resolution of the entities established in its own territory. For cross-border groups, a combined financing

133 See: Deutsche Bundesbank (2014), p. 39ff. 134 See: European Commission (2014c), p. 5ff.

56 5 Single Resolution Mechanism (SRM) plan negotiated between the involved national resolution authorities may be used.135

Herein lies one important difference to the SRM, which applies for the Banking Union Member states. As explained in Chapter 5.4.2 banks of all participating Member States have to contribute to one common resolution fund covering risks of the entire Banking Union. The logical consequence of such a Single Resolution mechanism is the mutualisation of risks and costs across the participating Member States, which is still a heated political debate in Europe.

5.4 SRM within the Banking Union

Although the BRRD harmonises European resolution law, covering restructuring and resolution planning, it leaves institutional responsibility at the national level. The SRM Regulation takes a further step as it creates a uniform institutional framework on how to apply the harmonised tools under the BRRD. However, the SRM Regulation has a narrower geographical scope than the BRRD, as it applies solely to banks of EU countries participating in the SSM, i.e. the euro-area countries and opt-in countries. The SSM and SRM are both cornerstones in the Bank- ing Union project that will complement one another. It is not possible to have a Single European Supervisory Mechanism (SSM) but to leave the resolution of banks to national authorities as tensions between the supervisor (ECB) and national resolution authorities could emerge. The SRM Regulation was published on 30 July 2014 and it will take full effect on 1 January 2016, with some provisions applying from an earlier date.136

Nevertheless, the SRM project faces two major difficulties: From a legal point of view, the fact that the existing EU treaties were not drawn up with a banking union in mind is problematic. As a result, the treaties do not provide the necessary legal foundations for creating an independent European resolution authority with extensive decision-making powers. The current approach to the SRM project is adapted to these existing constraints of primary EU law, which means that the European

135 See: European Commission (2014c), p. 9. 136 See: European Commission (2014d), p. 7.

57 5 Single Resolution Mechanism (SRM) resolution authority can only be given limited decision-making powers. In addition, there is an economic obstacle to full mutualisation of bank resolution. The SSM largely raises banking supervision to the European level. Other areas, though, such as fiscal, economic or taxation policy will remain under national responsibility. At this stage a gradual mutualisation of liability until 2024 seems to be an appropriate solution.137

5.4.1 Single Resolution Board (SRB)

The Single Resolution Board is a key element of the SRM. In a nutshell, the SRB is the European resolution authority for the Banking Union, which is responsible for the orderly resolution of failing banks with minimal costs for taxpayers and to the real economy. The Board was established on 1 January 2015 in Brussels as an agency with legal personality and independent finances. The SRB comprises six permanent members: the chair, the vice-chair and four board members. Figure 17 shows the first composition of the SRB, which will be fully operative by March 2015.138

Figure 19: Composition of the Single Resolution Board Source: Own representation

137 See: Deutsche Bundesbank (2014), p. 45f. 138 See: Single Resolution Board (2015), http://srb.europa.eu, Date of Access: May 2015.

58 5 Single Resolution Mechanism (SRM)

In its executive sessions, the Board takes decisions for resolving individual banks which involve the use of the Single Resolution Fund (see Section 5.4.2) below a €5 billion threshold. For this session, the SRB consists of the six permanent Board members and the relevant national resolution authorities where the troubled bank is established. A plenary session has to be called when the resolution case exceeds the €5 billion threshold. In this session, the SRB comprises the six Board members and representatives of all participating Member States. The ECB and the European Commission have observer status in the SRB.139

According to the guidelines set by the BRRD, the SRB as the European level resolution authority has the following major tasks: 140  Preparation and adoption of resolution plans. o Set up of necessary resolution tools. o Financial planning of resolution costs.  Analysis and assessment of resolvability of an institution.  Coordination between national resolution authorities in case of failure of a cross-border banking group.

Like under the SSM, there is a division of tasks and responsibilities between Euro- pean level and national authorities. The SRB is responsible for those institutions that are directly supervised by the ECB (i.e. significant institutions), for cross- border groups, and for banks that need funds from the Single Resolution Fund. The national resolution authorities (e.g. for Austria the FMA) are responsible for all other institutions.141

5.4.2 Single Resolution Fund (SRF)

The Single Resolution Fund is next to the SRB the second pillar of the SRM. The SRF forms the financial backup to enable the SRB to orderly restructure or

139 See: European Commission (2014d), p. 6. 140 See: Austrian Central Bank (2015), http://www.oenb.at/en/Financial-Stability/banking- union/single-resolution-mechanism/single-resolution-mechanism.html, Date of Access: May 2015. 141 See: European Commission (2014d), p. 6 and Austrian Central Bank (2015), http://www.oenb.at/en/Financial-Stability/banking-union/single-resolution-mechanism/single- resolution-mechanism.html, Date of Access: May 2015.

59 5 Single Resolution Mechanism (SRM) wind-down a distressed bank. According to the BRRD, the Fund shall be financed by contributions from the banking industry depending on an institution's size and risk profile. The establishment of the Fund ensures that the taxpayers' burden in the resolution of failing institutions is minimised. The Fund will be built up over an eight-year period starting on January 1, 2016. In 2024, it is scheduled to reach EUR 55 billion, 1% of the amount of covered deposits of all credit institutions in the Banking Union.142

As mentioned above, EU law did not foresee the build-up of a Banking Union. As a consequence there is no legal foundation for a mutualisation of risks and costs within the EU leading to the fact that the Resolution Fund will rest on very shaky foundations. In fact, the contributions to the SRF are regulated by a so-called "In- tergovernmental Agreement" (IGA) between the members of the Banking Union. According to the IGA, contributions to the Fund are on a first stage to be deposited in national fund, which will be merged in a transitional period to form a common pool as soon as the SRF takes legal effect (1 January 2016).143

142 See: Austrian Central Bank (2015), http://www.oenb.at/en/Financial-Stability/banking- union/single-resolution-mechanism/single-resolution-mechanism.html, Date of Access: May 2015. 143 See: Deutsche Bundesbank (2014), p. 51.

60 6 Deposit Guarantee Schemes (DGSs)

6 Deposit Guarantee Schemes (DGSs)

For the third pillar of the Banking Union, large efforts had been made to change to the existing European rules for protection of bank account holders and retail investors. This aim shall be achieved through a Directive (see section below) which ensures the union-wide protection of deposits, per depositor per bank, up to an amount of €100,000. Ambitious visions of creating a permanent European Deposit Insurance Corporation144 to centrally protect deposits in all Member States soon turned out to be impractical, due to the high degree of mutualisation of resources and costs. As a consequence the European Council adopted another Directive in 2014 to harmonise the protection of deposits in the EU, to maintain depositor confidence and to strengthen the safety net provided by the governments.145

6.1 Deposit protection in the EU

The Eurozone crisis strikingly illustrated how banks are susceptible to the risk of bank runs, when bank account holders believe that their savings are not safe any more. It is therefore crucial for the government to provide a reliable safety net for individual savers in order to avoid the disastrous consequences of a mass hyste- ria.

6.1.1 Preface - panic in Cyprus 2013

In spring 2013, after being hit hard by the financial crisis, the subsequent Greek government-debt crisis and the downgrading of the Cypriot government's bond credit rating to junk status, Cyprus' second-largest bank called Laiki Bank Group had to close down. What the Cypriot authorities in cooperation with the Troika did not expect, was a mass panic due to the fact that all deposits, exceeding €100,000 (many of them from Russia) were supposed to pay for the bail-out. In order to avoid a disastrous bank run Cypriot banks were closed for almost a week to stabilise the island's financial system. The freezing of the Cypriot banking system fol- lowed an international rescue deal that involved the restructuring of the country's

144 See: Merler, S. and Pisani-Ferry, J. (2012), p. 9, and Gros, D. and Schoenmaker, D. (2014), p. 8f. 145 See: European Commission (2014e), p. 1f.

61 6 Deposit Guarantee Schemes (DGSs) two largest lenders, with heavy losses for wealthy savers. Cypriot and European policymakers later acknowledged, that the country had come one step away from economic collapse.146

6.1.2 Directive 94/19/EC - Minimum harmonisation in the EU

Since 1994, the Directive 94/19/EC ensures that all Member States have a safety net for bank account holders in place. Accordingly, if a bank is to be closed down, the national Deposit Guarantee Schemes is supposed to reimburse account holders of the bank up to a certain coverage level. The keynote behind this law is the protection of individual savers and SME's that are usually not able to reliably evaluate the solvency of a bank. For this reason, deposits of financial institutions and public authorities will not be covered, as they are professional market actors that do not need protection.147

6.1.3 Directive 2009/14/EC - Unified coverage level

However, the Directive of 1994 could only bring about minimum harmonisation in national DGS. Instead it led to significant intergovernmental differences of DGS concerning the level of coverage, the scope of covered depositors and the pay-out delay. In addition, the financing of schemes was left entirely to Member States, which turned out to be disruptive for the functioning of the Single Market when the financial crisis hit Europe in 2008. Thus, the Council decided in 2009 that the level of deposit protection has to be quickly increased in the EU from previous €50,000, to a uniform level of €100,000 under the new Directive 2009/14/EC.148

Under the new Directive, deposits are covered per depositor per bank, which means that the limit of €100,000 applies to all aggregated accounts of one account holder at the same bank. The DGS protect only those deposits held by individuals and small, medium-sized or large businesses, as they are usually not able to un- dertake a profound analysis of the creditworthiness of a bank. However, deposits of financial institutions shall not be covered because they do not need protection

146 See: The Guardian online (2013), http://www.theguardian.com/world/2013/mar/26/cyprus- banks-closed-prevent-run-deposits, Date of Access: March 2015. 147 See: European Commission (2010), p. 1f. 148 See: European Commission (2010), p. 1f.

62 6 Deposit Guarantee Schemes (DGSs) as being professional market actors. Prior to the Directive account holders had to be reimbursed within three months after a bank failure. Through the new legislation this delay had been reduced union-wide to between four and six weeks, which is, however, still quite a long time.149

In the course of the establishment of the Banking Union it soon became clear that more had to be done in order to harmonise or even unify DGSs among the Union. As neither the European treaties nor the political will of the Member States allowed for single DGS with maximum mutualisation of resources and risks, the European Commission had to pursue highest possible harmonisation of the national DGS. This critical review of Directive 2009/14/EC started in 2010 and lead to a new Di- rective (see Section 6.3) that entered into force in 2014.

6.2 Calls for a Single Deposit Guarantee Scheme

As proposed by several European economists150, a single European deposit insurance and resolution authority (EDIRA) could remedy the institutional weaknesses of the union-wide safety net for bank customers. According to Gros and Schoenmaker (2014) a single authority could manage European resolution and deposit insurance more efficiently than at national level, while at the same time providing a more solid foundation for the whole financial system. In accordance with the risk-based approach provided by the BRRD the EDIRA should be financed by a fund fed through regular risk-weighted deposit insurance premiums charged from the European banks. This fund would thus ensure that private sector funds are available for resolution and deposit protection at the same time in crisis management without burdening taxpayers again. As this fund would bear dual responsibility its target volume should be proportionally higher, 1.5% or €90 billion according to the authors.151

149 See: European Commission (2010), p. 2f. 150 See: Merler and Pisani-Ferry (2012 as well as Gros and Schoenmaker (2014). 151 See: Gros, D. and Schoenmaker, D. (2014), p. 9ff.

63 6 Deposit Guarantee Schemes (DGSs)

Surprisingly, the European Commission already reflected on a single pan- European DGS in 2010. Despite all political issues a single DGS would have two compelling advantages:152 I. The impact assessment on behalf of the Commission estimated that €40 million administrative costs per year could be saved through a centralised system of deposit insurance. II. Pan-European deposit insurance could easily deal with bank failures, even on a large scale. The impact of a single bank failure on a scheme borne by the whole Union is much lower than on a scheme only covering the banking sector of one Member State.

However, there are complicated legal issues, which would need to be examined. After all, the European primary law does not provide a foundation for mutualisation of resources to such a large extent. The idea of a European DGS remains therefore a potential longer-term project that is currently not under discussion. The pan- European DGS could be a potential option in the future once the current elements of the Banking Union namely the SSM and the SRM are in place.153

Instead, under the new supervisory structure, the EBA shall oversee and facilitate the functioning of DGS within the Member States. Following its tasks the EBA will help settle any disagreements in a cross-border case when two schemes have to coordinate their actions and it will ensure the consistent determination of contributions based on the risk of each bank. 154

6.3 Directive 2014/49/EU - maximum harmonisation of national schemes

With the mandatory level of deposit guarantees at €100,000, the Directive provided some sort of a common denominator for all Member States. However, the 27 (resp. 28) Member States of the EU still had their own approach to deposit guarantees leading to the fact, that some countries, e.g. Germany had additional

152 See: European Commission (2010), p. 3. 153 See: European Commission (2014e), p. 6. 154 See: European Commission (2014e), p. 6.

64 6 Deposit Guarantee Schemes (DGSs) guarantee funds, six in total, to provide maximum security. And while most EU countries charged premiums each year in order to have money available to pay depositors if necessary (ex ante funding), some other countries like the U.K., Italy and the Netherlands continued to wait until losses occurred to be compensated (ex post funding).155 As illustrated in the Cyprus case of 2013 (see Section 6.1.1), under such heterogeneous structures the confidence in a national DGS strongly correlates with the confidence in the economic security of the providing country.

In the course of its comprehensive review of the DGS Directive the European Commission aimed at harmonising and simplifying the Directive in order to improve protection of deposits and maintain depositor confidence in order strengthen the European safety net for bank customers. In order to stabilise the confidence of depositors and ensure financial stability the current funding requirements shall therefore ensure that DGS are able to fulfil their obligations towards depositors at any time.156

6.4 Funding of DGS

As mentioned above the transitions between ex ante and ex post funding were fluid in Member States leading to major imbalances when the crisis hit the Euro- pean continent. Even though it would economically not be feasible to provide DGS covering an amount equivalent to all deposits, a new improvement ensures that banks will have to pay on a regular basis into the schemes. The target level for those ex ante funds was set at 0.8% of their covered deposits (i.e. about € 55 billion) to be reached by 2024. 157

In addition to ex ante contributions, the Directive empowers national authorities if necessary to charge their banks additional (ex post) contributions. If this is still insufficient, national DGS may borrow from each other up to a certain limit, or as a last resort use loans from public or private third parties. Ultimately, the financing requirements of Directive 2014/49/EU shall ensure that DGS have enough funds in

155 See: Elliot, D. (2012), p. 41. 156 See: European Commission (2014e), p. 1. 157 See: Barnier, M. (2014), Statement, Brussels, 15 April 2014.

65 6 Deposit Guarantee Schemes (DGSs) place to deal with small and medium-size bank failures. Large banks will be subject to resolution according to the BRRD, respectively SRM for the Banking Un- ion.158

6.4.1 Target funding levels and composition

It has to be noted that the above target funding level of 0.8% is a minimum level required by EU law. Thus, Member States can certainly set higher target levels for their DGS to improve their safety net. Currently, in one third of Member States DGS funds are above 1% of covered deposits, and in a few of them, they are even beyond 2% or 3%. In principle, the available financial terms of funds should include cash, deposits, low- risk assets, which can be liquidated within a short period of time, and last but not least payment commitments. Commitments, however, have to be fully collateralised shall not exceed 30% of the total amount of available financial means of the DGS fund. The available funds of DGS shall not lie idle but they must be invested in a low-risk and diversified manner, that can liquidated within a short period of time as the pay-out delay must not exceed 7 days as from the year 2024.159

6.4.2 Risk-based approach of DGS funds

The Directive furthermore provides that the contributions to DGS shall be based on the amount of covered deposits and the degree of risk incurred by the respec- tive member. As riskier banks imply a higher likelihood of failure and, in turn, the need to trigger DGS they have to pay more contributions to DGS. However, to ensure consistent application of this Directive in Member States, the EBA will issue guidelines to specify methods for calculating the contributions to DGS. In particular, it will include a calculation formula, specific indicators, risk classes for members, thresholds for risk weights assigned to specific risk classes, and other necessary elements.160

158 See: European Commission (2014e), p. 3. 159 See: European Commission (2014e), p. 4. 160 See: European Commission (2014e), p. 4.

66 7 Conclusion

7 Conclusion

The European Banking Union as it is being built right now is clearly a game changer for the European banking system. The Single Supervisory Mechanism is about to transform a largely fragmented national supervisory structure into a comprehensive European one. By doing so it is supposed to bring back safety and soundness to the banking system and establish a common approach to banking supervision, based on harmonised regulations and banking policies, under the umbrella of the ECB. The question remains, however, whether the ECB might become too powerful compared to other EU Institutions like the EBA as the ECB takes over the place of all the national supervisors of the participating Member States. For the Member States outside the Banking Union it is of particular concern that the ECB might overrule the board of the EBA in many cases, leaving outstanding issues for the future relationship between the Banking Union and the rest of the EU.

The fact that the Banking Union represents also a political compromise on a Euro- pean level raises the question if the Banking Union will be capable of living up to its full potential. Not only Great Britain, but almost all non-euro Member States have expressed criticism towards different aspects of the Banking Union and have decided to opt-out for the time being. The main points of criticism range from technical shortcomings to unanswered question regarding the institutional distribution of supervisory competences. Complaints can however be reduced to a common denominator: a lack of political will to mutualise risks and costs. In my opinion this is where one of the key weaknesses of the Banking Union lies. Furthermore, the current design of the Single Resolution Fund and the new bail-in mechanism alone will not suffice to grant an orderly wind-down of a systemic-important European bank without dependency on governmental funding. This is why I believe that improvement of the European banking system's resilience against a systemic crisis can only be achieved to a certain extent. Another unresolved issue in this context is the distribution of common funds within the Single Resolution Fund for the resolution of single national banks. After all it is the participating Member States’

67 7 Conclusion ambition not to utilise funds raised from national banks in order to safe misman- aged banks in other Member States.

Looking at the set-up of the Banking Union, one can ask whether the glass is now half-full or half-empty. Shifting responsibility for supervision from national supervisors to a truly European institution will certainly improve confidence in the banking system and restore financial stability. Furthermore there will now be clear rules about what has to be done if a couple of medium-sized (or even a large) banks get into trouble and have to be wound down. After a transition period, the costs of such rescues will be borne by a European fund rather than by Member State governments. The new Directive on Deposit Guarantee Schemes now provides union- wide harmonised protection of deposits of bank account holders and retail investors up to a certain limit. However, the original idea of a union-wide Single Deposit Guarantee Fund soon had to be postponed for an indefinite period of time due to a lack of political disposition in almost all Member States.

However, the new framework probably is not designed to deal with systemic crises as occurred in the recent past. The funds available are simply not sufficient and there is no clear fiscal backstop defined yet. In addition to that, it will be interesting to observe how the new duties of being supervisor at higher level of 18 or more Member States will interact with the ECB's primary tasks in monetary policy. Con- flicts of interest and coordination problems are surely issues to be addressed in the future.

I believe that future developments in the relationship between the Banking Union and the rest of the European Union will remain particularly interesting. How will the U.K. react to stronger economic collaboration on continental Europe in the upcom- ing EU referendum for British independence in 2016? Will medium- and long-term opt-out countries join the Banking Union with time and raise it up to its full potential? Finally, what can the Banking Union contribute to a politically overarching vision for a united Europe when the current financial crisis is overcome completely? In the years to come the answers to the greater part of these questions will probably be discovered.

Annex 1

Since the outbreak of the Global Financial Crisis in 2008/09 the number of non- performing loans (NPL) - especially in the peripheral countries (Greece, Ireland, Italy, Portugal and Spain) - greatly increased (see Annex I).161

Annex I: Non-performing loans (NPLs) to total loans (%) Source: Breuss, F (2013), p. 6.

The cross-border banking (assets and liabilities) is characterized on the one hand by a "neighbourhood effect"162 but at the same time there is a strong "bias" towards Britain, which in turn builds the bridge to the overseas countries like the United states. (see Annex Ia).163

Annex Ia: Cross-Border Interbank Networks Source: Tonzer, L (2013), p. 20.

161 See: Breuss, F (2013), p. 6 162 i.e., German banks are trading more with customers and banks in neighbouring countries such as in France and vice versa); 163 See: Breuss (2013), p. 7

Annex 2

Detailed timeline of the evolution of the European Banking Union

Timeline 2008 - 2008 Global financial crisis begins to hit European banks and markets. 2009 February – De Larosière report calls for reform of European banking regulatory system. 2009 March – New Directive requires Member States to increase coverage of their Deposit Guarantee Scheme to a uniform level of € 100 000 by the end of 2010. 2009 December – Lisbon Treaty reforms EU institutions and gives greater voice to the European Parliament. 2010 April – Greek government requests an initial loan from European partners. 2010 May – EU leaders announce €70 billion plan to protect the euro. 2010 May – EU ministers agree €500 billion fund to save the euro from disaster. 2010 November – Irish government seeks assistance from the EU and IMF. 2011 January – The European Banking Authority, European Insurance and Oc- cupational Pensions Authority, and European Securities and Markets Au- thority begin operations. 2011 April – Portugal requests a rescue package. 2011 September – Europe's debt crisis prompts central banks to provide dollar liquidity. 2011 October – Banks agree 50 percent reduction on Greece's debt: private investors take 'haircut' on Greek bonds in €100 billion package of measures that also strengthens European rescue fund. 2011 December – Confidential paper from Council President Herman Van Rompuy proposes empowering the commission. 2011 December – EU agrees “Fiscal Compact”, coordinating economic policies and debt ceiling. 2012 March – Eurozone ministers agree €500 billion in new bailout funds. 2012 May – G8 leaders end summit with pledge to keep Greece in euro zone. 2012 May – Germany rules out common Eurobonds.

2012 June – Spain seeks a European rescue package for its banks. 2012 June – G7 finance ministers back greater fiscal and financial union in Eu- rozone. 2012 June – Cyprus seeks Eurozone bailout. 2012 June – Euro Summit calls for quick movement to European Banking Union to break the "vicious circle between banks and sovereigns". 2012 July – EU financial-services chief Michel Barnier calls for pan-European banking supervision "with real teeth", accompanied by joint bank- resolution system and pooled deposit guarantees. 2012 July – Spanish, Italian bond yields reach euro-era record highs. IMF calls on ECB to stand behind deposit insurance in order to forestall bank runs. 2012 July – ECB will do 'whatever it takes' to preserve the currency declares Mario Draghi. 2012 September – European Commission releases proposal for European banking supervision. 2012 September – Draghi secures agreement for 'outright monetary transac- tions' scheme. 2012 October – European Stability Mechanism becomes legally effective. 2012 October – European Summit agree on a broad outline of European Bank- ing Union. 2012 November – Catalan referendum on independence. 2012 December – EU President Herman van Rompuy calls for SSM as well as common national standards on bank resolution and deposit insurance, in "stage one" to be completed by end of 2013. 2012 December – EU finance ministers reach common position on SSM. 2013 January – European leaders reach full political agreement on supervision. 2013 January – ECB to begin taking on overall supervisory role for Eurozone banks. 2013 March – ECB calls about 140 large, systemic banks to be under direct oversight. 2013 March – Euro area announces Cyprus bailout. 2013 May – Draghi emphasises that SSM and SRM are crucial elements for

moving towards reintegration of banking system in Europe. 2013 May – Merkel and Hollande endorse the banking union effort 2013 July – European Commission releases proposal for euro-area SRM including 55 billion-euro common fund. 2013 August – EU's Barnier says there is no alternative to a single system for handling failing banks. "There is no plan B." 2013 September – Hypo Alpe Adria receives EU approval for up to 8 billion euros in state aid. 2013 October – Sweden says it won't join Banking Union for "foreseeable future". 2013 October – EU reaches deal with U.K. to remove objections to SSM. 2013 November – SSM Regulation comes into force 2013 December – Ireland becomes first euro-area nation to leave aid program. 2013 December – The Council agrees on the Single Resolution Mechanism. 2014 January – Spain exits aid program. 2014 January – ECB hosts Day One for supervisors 2014 March – Draghi tells reporters Banking Union can't work without SRM. 2014 March – EU reaches deal on SRM with 8-year transition to common fund, to be filled over time by bank charges. 2014 May – Portugal exits aid program. 2014 June – Austria breaks new ground in EU bank bail-ins by overriding state guarantees on HAA International AG's subordinated bonds. 2014 June – ECB releases list of 120 banks it will directly supervise. 2014 July – EU governments fully sign off on SRM 2014 October – Release of results of Comprehensive Assessment of 130 euro- area banks, including asset-quality review and stress test run. 2014 November – ECB officially takes over euro-area bank supervision. 2015 January – Bank Recovery and Resolution Directive comes into force. 2015 January – SRM for nations that participate in the Banking Union begins. Banks start to deposit money into funds covering future resolution costs. 2016 January – Single Resolution Fund takes legal effect. 2016 January – Deadline to transfer to Single Resolution Fund of contributions

previously held in national funds. Direct payment of bank contributions to SRF from now on. 2024 January – Deadline for Single Resolution Fund to have resources equivalent to 1 percent of covered deposits.

Annex II: Own representation based on BloombergBusiness Source: BloombergBusiness (2015), http://www.bloomberg.com/news/articles/2014-08-28/eu- banking-union-reference-guide-to-key-dates-coming-milestones and Elliot, D. (2012), p. 50f.

Annex 3

Stress test results detailed Austria

Source: ECB (2014c), Appendix.

(I) List of participating banks in the comprehensive assessment Group Stress test AQR SSM

derivative re- derivative

- Name

RWA group (€ bil- group RWA lion) Test Stress EBA Join Dynamic Static vs. Sheet Balance Non valuations Pricing Derivative review Models Processes Core Review credit Significant institution BAWAG P.S.K. 10-25   Static     Erste Group Bank >75   Static     RLB Oberösterreich 25-75   Static     Raiffeisenlandesbank Niederösterreich- 10-25   Static     Wien Raiffeisen Zentralbank >75   Static     Österreichische Volksbanken-AG 25-75   Dynamic    

(II) CET1 ratios for participating banks (%)

Name

Bank reported reported Bank 2013 adj. 2013 AQR 2014 Post CA Baseline 2015 Post CA Baseline 2016 Post CA Baseline 2014 Post CA Adverse 2015 Post CA Adverse 2016 Post CA Adverse BAWAG P.S.K. 14.5% 13.7% 12.8% 11.9% 12.8% 10.6% 8.5% Erste Group Bank 11.2% 10.0% 10.1% 10.6% 11.2% 9.1% 8.4% 7.6% RLB Oberösterreich 11.4% 10.3% 10.6% 11.0% 11.3% 9.1% 8.8% 7.9% Raiffeisenlandesbank Niederö- 17.5% 16.8% 17.0% 17.1% 17.2% 15.2% 13.5% 11.8% sterreich-Wien Raiffeisen Zentralbank 10.4% 9.7% 9.8% 9.6% 9.5% 9.2% 8.4% 7.8% Österreichische Volksbanken- 11.5% 10.3% 9.5% 8.8% 7.2% 8.0% 5.9% 2.1% AG

(III) Buffer (+) / shortfalls (-) for participating banks (€ million)

Name

Bank reported reported Bank 2013 adj. 2013 AQR 2014 Post CA Baseline 2015 Post CA Baseline 2016 Post CA Baseline 2014 Post CA Adverse 2015 Post CA Adverse 2016 Post CA Adverse BAWAG P.S.K. 1,097 1,064 961 807 651 1,258 904 552 Erste Group Bank 3,200 2,036 2,173 2,722 3,286 3,835 3,109 2,278 RLB Oberösterreich 902 612 684 808 894 976 905 668 Raiffeisenlandesbank Niederöster- 1,239 1,157 1,177 1,192 1,198 1,302 1,069 841 reich-Wien Raiffeisen Zentralbank 2,160 1,570 1,632 1,465 1,367 3,413 2,741 2,106 Österreichische Volksbanken-AG 955 638 411 206 -191 691 97 -865

(IV) AQR adjustment by bank and asset class (€ million)

Name

Retail SME real Residential estate retail Other Corporates Other expo- value Fair review sure ad- AQR Total justment BAWAG P.S.K. 0 4 0 38 0 0 42 Erste Group Bank 3 155 75 1,138 0 42 1,413 RLB Oberösterreich 24 0 4 284 0 51 363 Raiffeisenlandesbank Niederöster- 0 0 0 100 0 2 102 reich-Wien Raiffeisen Zentralbank 84 240 30 371 0 29 753 Österreichische Volksbanken-AG 27 56 0 213 0 21 317

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