The creation of the EMU and the introduction of the euro were milestones of European integration. They stand out as one of the EU’s most far-reaching achievements. Indeed, the euro is one of Europe’s defining symbols. The EMU opened opportunities for citizens to diversify their portfolios and brought about benefits as it led to a sharp acceleration in the pace of financial integration. However, under the original design of EMU, responsibility for financial supervision and crisis management remained predominantly at national level. This asymmetry between integrated financial markets on the one hand, and a financial stability architecture segmented on national lines on the other, resulted in inadequate coordination among the relevant authorities.

As the crisis revealed, the absence of euro area-wide supervisory and resolution institutions gave rise to the so-called “doom loop”, i.e. the vicious circle between the banking system and the public purse in the vulnerable countries. Problem banks, especially those considered too-big-to-fail, turned to national governments for financial support, in the process raising the cost for taxpayers and sending public finances on an unsustainable path. In turn, markets viewed weak governments as riskier and demanded higher premiums on national bonds, which consequently led to higher interest rates on bank lending. This resulted in a re-fragmentation of financial markets as businesses and households in different euro area member states faced different financing conditions. Consequently, economic growth faltered, feeding back into lower fiscal revenue and wider budget gaps. And so the downward spiral snowballed, wiping out many benefits of European financial integration while the risk of contagion affecting the euro area as a whole increased.

The European Commission has taken a leading role in the EU’s response to the crisis and to break this vicious loop by adopting important legislative proposals for an integrated financial framework that over time would evolve into a full banking union. The June 2012 euro area summit marked a turning point in the approach to the crisis as European leaders announced their readiness to transfer key banking policy instruments to the EU level. In response, the Commission outlined its vision of an EU banking union in its Communication of 12 September 2012. The banking union must be built on a single rule book for the prudential supervision of banks and should include a single supervisor; a single resolution mechanism based on a common recovery and resolution framework, and an effective framework for deposit guarantee schemes. Together with the already-operational European Stability Mechanism (ESM), these elements would ensure a functioning banking union – one of the four building blocks for a genuine EMU as laid out in the four Presidents’ report. 

Progress so far

The Commission has tabled legislative proposals on all the four pillars of the banking union. The adoption of the relevant regulation has moved apace through the various stages of the EU’s decision-making process with varying degrees of progress:

The single rule book relates to a common set of prudential rules all EU banks must respect and is by far the area where most progress has been achieved. The capital requirements package consists of two pieces of legislation: a directive (CRD IV) governing the access to deposit-taking activities and a regulation (CRR) establishing strict prudential requirements. Unlike its predecessor, the package adopts a multi-dimensional approach to regulation and supervision that covers the whole balance sheet of banks i.e. better and more capital, sufficient liquidity and reduction in excessive leverage (ratio of assets/loans to capital). First proposed by the Commission in July 2011, the package is in force and will become applicable as of 1 January 2014.

On 12 September 2012, the Commission adopted two proposals for the establishment of a single supervisory mechanism (SSM) for banks led by the European Central Bank (ECB). The SSM – composed of the ECB and national competent authorities – applies to all the euro-area member states and is open to the participation of other member states that wish to embark on a path of deeper integration for supervision. Key supervisory tasks and powers are conferred to the ECB over all the credit institutions established within the euro area. The SSM will be responsible for the supervision of all 6,000 banks of the euro area. Specifically, the ECB will directly supervise banks having assets of more than €30 billion or constituting at least 20 per cent of their home country’s GDP or which have requested or received direct financial assistance from the EU’s backstop facilities. The ECB will monitor the supervision by national supervisors of less significant banks. Following intensive negotiations in the first months of this year, the co-legislators reached agreement on the package on 19 March. The SSM is expected to be fully operational by late 2014.

While the SSM will ensure stronger bank supervision, episodes in which banks experience material financial deterioration cannot be completely ruled out. This calls for supervision and resolution to be exercised at the same level of authority and backed by adequate funding arrangements. Otherwise tensions between the SSM and national resolution authorities may emerge over how to deal with troubled banks. To this end, on 10 July the Commission tabled legislation for the setting up of a single resolution mechanism (SRM) – the most recent proposal towards a banking union. The SRM will feature a strong central decision-making body and a single resolution fund. The latter will be funded ex-ante from bank contributions and will provide short to medium-term financial assistance to ensure viability of the restructured bank. The SRM will basically apply in a coherent way the substantive rules of the draft directive on bank recovery and resolution (BRRD) adopted by the Commission in June 2012 and agreed by finance ministers last June. The BRRD is aimed at ensuring an orderly wind-down of troubled banks so as to preserve the EU’s financial stability. It would also reduce the cost to taxpayers by making private investors – along a pecking order starting with shareholders and unsecured creditors but excluding certain type of creditors – bail-in ailing banks.

Deposit guarantee schemes (DGS) reimburse a limited amount of deposits to depositors whose bank has failed. This protects a part of depositors’ wealth from bank failures and mitigates panic withdrawals from banks thereby preventing severe economic consequences. On 12 July 2010, the Commission adopted a legislative proposal for a thorough revision of the directive on DGS, which mainly deals with the harmonisation and simplification of protected deposits, a faster payout and improved financing of schemes. The finance ministers agreed on a general approach in June 2011 but negotiations on this proposal are still going on and the directive has not yet been adopted by the co-legislators (Council and Parliament). Once agreed, the DGS will ensure that every member state has a properly-funded deposit insurance scheme.

Lastly, a functioning banking union needs a credible financial backstop at the level where supervision and resolution are carried out to ensure access to additional funds in crises of a systemic nature. Last June, euro area finance ministers agreed that once the SSM, SRM and DGS enter into force and subject to strict conditions, the ESM could allocate a maximum €60 billion to recapitalise banks directly. This will further contribute to sever the vicious circle between banks and sovereign debt.

Mr Ebejer is the economic analyst at the European Commission Representation in Malta