www.pwc.es www.ie.edu The Banking Union, under way and here to stay A report by the PwC and IE Business School Centre for the Financial Sector. This report has been coordinated by Luis Maldonado, managing director of the PwC and IE Business School Centre for the Financial Sector February 2014 Contents Introduction 4 Executive summary 10 The Single Supervisory Mechanism, the key to the entire process 14 The entrance exam. Crossing the gorge. 22 The SSM from the inside 24 The Single Resolution Mechanism, a crucial component 26 Operations. This is how the SRM will work 32 A Safety Net with Loopholes 34 Emergency liquidity assistance, the taboo last resort 38 The ESM, a cannon of limited use 40 A Single Rulebook to prevent fragmentation 42 Learning from mistakes 47 Conclusions and recommendations 48 References 51 3 Introduction The European Union’s progress towards Since then, spectacular progress has integration has always been marked by been achieved in a little more than a firm steps and inconsistent political year and a half. Today there is impulses, guided to a large extent by considerable consensus on the developments in the international components that should constitute the economic environment. The banking union: a Single Supervisory implementation of the Economic and Mechanism (SSM) for the entire euro Monetary Union (EMU) and the creation area; a Single Resolution Mechanism of the euro constitute a key – and (SRM), with a single European authority fortunately irreversible – advancement, able to take over a bank’s management, as the European Central Bank reiterated restructure it and even wind up its at the height of the sovereign debt crisis operations if necessary, and a Single in 2012. But the recent financial and Resolution Fund; a Safety Net for bank fiscal crisis has revealed serious deposits that does not distort weaknesses in the European financial competition but prevents fragmentation, system’s architecture. Financial and a Single Rulebook to serve as the fragmentation has been proved to play a legal basis or framework for the entire crucial role in the vicious cycle that process. connects banking systems with sovereign debt. At times of economic difficulty, Not all of these components have their mutual effect is compounded, reached the same degree of potentially leading to acutely critical development, though. The supervisory situations, as was the case in mid 2012. system, which is due to enter into effect in November 2014, is almost completed, European leaders had already warned at and the institutions involved are the turn of the century that adoption of working round the clock on the the euro did not mean the end of the the necessary preparations. The resolution EMU process. Yet no further progress mechanism, which will start operating would be made in the area of monetary in 2015, is backed by an initial until the following crisis, as the then agreement that was confirmed in early president of the European Commission 2014. rightly predicted in 2001, when the single currency came into being: “I am The Safety Net is the slowest in the certain that the euro will require the group, with no expectation of any introduction of new economic policy progress being made in the short term instruments. Today it is politically towards establishing a common deposit impossible to propose such instruments. guarantee fund. Significant progress has But some day there will be a crisis and been achieved, nonetheless, in then they will be created.” Arguably, the harmonising the existing individual turning point came with the European deposit guarantee funds. The Single Council of 29 June 2012, which gave Rulebook is largely laid out, although political approval to the establishment certain important aspects also remain to of a Banking Union and instructed the be resolved. European Commission to submit a concrete proposal (Chart 1). 4 The Banking Union, under way and here to stay Chart 1. Banking Union key milestones. 19–21 March 2013 January 2014 SSM: Final drafting of the European SSM: Single Supervisory Council resolutions as agreed in The Council, Parliament Mechanism December 2012. and the Commission start SRM: Single Resolution negotiating the final Mechanism 22 May 2013 approval of the SRM. SSM: The European Parliament backs EDGF: European Deposit the legislation package but issues a Guarantee Fund number of recommendations. 1 March 2014 21 June 2013 Deadline for approval of the intergovernmental agreement setting SSM: Political agreement within the out the operation of the Single European Council on the Proposal for a Resolution Fund. Regulation of the Council, which assigns 26 July 2012 specific functions to the ECB. 20 March 2014 SSM/SRM/EDGF: The European Council, in collaboration with the Commission, the 15–22 October 2013 SRM: Agreement between the Council Eurogroup and the European Central Bank, SSM: The agreements are formally of Ministers and the European makes a call for Banking Union (“Towards a adopted and published in the Parliament. genuine Economic and Monetary Union”). Official Gazette on 29 October. 23 October 2013 SSM: The ECB begins an overall assessment with a view to assuming a supervisory role. The Risk Assessment Exercise commences on the 128 credit institutions included. 2012 2013 2014 27 June 2013 11 December 2013 March–July 2014 European Council Agreement between the SSM: Asset quality review to identify agreement on the Council, Parliament and capital and provisions needs. Directive the Commission to 12 December 2012 establishing a approve the Bank SSM: The Council agrees framework for the Recovery and Resolution its position on the SSM recovery and Directive. legislative framework. resolution of credit May–October 2014 institutions and 27 November 2012 investment firms. SSM: Stress tests performed on individual banks. SSM: Opinion of the European Central Bank. 12 September 2012 17 December 2013 November 2014 10 July 2013 SSM: The European Commission publishes SRM: Ecofin agreement on SSM: The ECB to assume the the legislation package on the single SRM: The Commission the elements of the Single functions assigned to it by the supervisory system for banking. proposes a Single Resolution Board and Regulation. Resolution Mechanism for Fund. Prior to that, it will release the the Banking Union. Agreement between the results and recommendations European Parliament and to the different banks. the Member States on the new Deposit Guarantee Directive. Source: Prepared in-house. Introduction 5 Before we go into an in-depth analysis of from having access to the markets. All this each of these components and their has had a negative effect on European implications for financial institutions, we economies’ potential for growth and job will give a brief account of the reasons creation, including Spain. that justify the establishment of a Banking Union. Home bias – the tendency for a country’s savings to finance investment preferably The crisis has revealed that the in that same country – is one of the most architecture of the European financial markedly direct consequences of financial system, built on national supervisors and fragmentation. Affecting interbank national resolution mechanisms, is unable lending and public debt alike, home bias is to guarantee financial stability in an area exacerbated during a crisis and therefore that uses a single currency. The accelerates its effects. connection between sovereign risk and banking risk has demonstrated its clearly All the above have also contributed to the procyclical nature, causing situations in malfunctioning of the European monetary which damage to the financial system has policy transmission mechanism during far exceeded a country’s fiscal capacity the crisis. Since late 2010, interest rates on (the case of Ireland), or where imbalance lending to families and businesses have in public finances and its attending dropped in some large European increase in sovereign spread have economies, but risen in peripheral contributed to a rise in borrowing costs countries (Greece, Portugal, Ireland, Italy and even prevented the soundest banks and Spain). Chart 2. Mutual contagion between sovereign risk and banking risk. Spain Ireland 0,6 Net sovereign- 0,4 to-banking contagion 0,2 1E 16 -0,2 Net banking- to-sovereign -0,4 contagion Greece Portugal Ireland Lehman bail-out bail-out Bankia bail-out -0,6 jun-08sep-08dec-08mar-09jun-09sep-09dec-09mar-10jun-10sep-10dec-10mar-11jun-11sep-11dec-11mar-12jun-12 jun-08sep-08dec-08mar-09jun-09sep-09dec-09mar-10jun-10sep-10dec-10mar-11jun-11sep-11dec-11mar-12jun-12 Note on methodology: This indicator represents the difference between the net variation percentage for an equal-weighted index of leading banks’ CDS prices (which is not due to the CDSs’ historical record but to contemporary shocks on sovereign credit risks) and the opposite net variation, i.e. the variation that reflects the impact of shocks affecting financial risk levels on sovereign risk. The indicator is positive when the shocks’ impact on sovereign credit risk levels in relation to financial risk is higher than the opposite effect. The value of this indicator on any given day is estimated based on the information available for the preceding sixty days. The series is also modulated using a sixty-day moving average. Source: O. Arce & S. Mayordomo, 2012, “Credit risk contagion between sectors”, work document. 6 The Banking Union, under way and here to stay A further issue worth noting is loan-to-deposits ratios of their banks’ fragmentation generated by the reaction branches and subsidiaries in other to the crisis, which has added its effects countries. Regulations have been to the existing financial fragmentation. introduced restricting foreign banks’ In the absence of a single resolution freedom of action in a given market. authority, the authorities of the Member New constraints have been put in place States have reacted on the basis of on subsidiary-to-parent cash flows.