Welcome to the Banking Union

The current state and the future of the European banking sector set the agenda of the AGI workshop entitled “Welcome to the Banking Union: Sound Financial Regulation to Fuel Economic Growth?” on November 17, 2014. Panelists included experts on the financial sector Nicolas Véron from the Peterson Institute for International Economics, Gunnar Stangl from Commerzbank AG, Andrea Montanino from the Atlantic Council, and Peter Rashish from Transnational Strategy Group. Together with active participants, the panel discussed the state of the banking union, political and economic dynamics in the euro zone, and the role of the monetary policies of the European Central Bank (ECB).

Panel One:

Apart from assessing the current state of the banking union, the first panel discussed options and policy recommendations for its future development. With the European banking weaknesses exacerbated by the financial crisis, the sovereign debt crisis forced European leaders to tackle some institutional shortcomings of the EU, including the need to create a truly European banking sector. However, the absence of a well thought-out plan forced leaders to make ad hoc decisions. Often they were not based on consensus. Indeed, they did not include all member states or banks. As a consequence, the current European banking union can rather be described as a “half banking union,” still very much in transition. In fact, so far only the first pillar of the banking union is in place.

As of November 2014, the Single Supervisory Mechanism (SSM) of the ECB came into effect to monitor the financial stability of banks. The Single Resolution Mechanism (SRM) and its Board will start its work in 2015. In order to finance the restructuring of failing credit institutions, the Single Resolution Fund (SRF) will start in 2016. The panel suggested SSM policy actions such as harmonization, removal of geographic ring-fencing, and reduction of sovereign-debt home bias. Further parts of the EU legislative agenda should be coherent accounting and auditing, bank insolvency, and a greater separation of the ECB and SSM. Once these steps are undertaken, this will strengthen the role of SSM and the ECB as key players of the European financial sector.

The latter part of the panel discussed how the SSM is another step toward fixing the European Monetary Union (EMU). Even though the EMU functioned well, it was incomplete. Due to the large independence of the ECB, the EMU was able to effectively remove sovereign debt, as member states in the currency union can no longer unilaterally change their spending and debt limits. As a result, the ECB should be seen as the liquidity provider of last resort for banks. However, with the introduction of the SRF, the monetary union will finally gain a lender of last resort. Yet, the fact that the SRF is pre-funded implies that resources are finite and limit its capacity to provide a floor if the entirety of the banking sector experiences a systemic crisis. Ultimately, all speakers agreed that the SSM will function as an additional, powerful regulator and grant the ECB more responsibility, while further decreasing the states’ influence on banks.

The recent G20 Summit in Brisbane showed that the global focus is shifting from bank fixing to a growth-focused perspective, which needs to be backed by stable and profitable banks. In contrast to the U.S. system, however, the EU banking system is not very profitable. But what is it that keeps people from investing? Leverage is employed more carefully than before the financial crisis and investment tends to remain constant, but not increasing. In comparison to the U.S., it becomes visible how significant the role of deposits is in Europe. The discussion also highlighted that the banking union is a constructive step to growth, but alone does not solve the problems of the euro zone. Current policy discussion must include both banking and capital markets.

Panel Two:

The second panel addressed the specific issue of European Central Bank’s role in the political and economic dynamics of the euro zone. The speakers focused on the relationship between growth and public debt and spending. Governments may not be in a position financially to promote growth, but the ECB can help only on the inflation front—it cannot revive the credit and lending atmosphere.

The major problems are the constraints on supply and demand for credit. The reason for the supply constraint from the side of the banking sector is the high level of non-performing loans, chiefly in countries like Italy, France, Spain, and Portugal. Until this is solved, banks do not have enough leeway to turn around their lending policies. But the greater issue is on the demand side, as companies in these countries see their interest expenses overtaking their actual earnings and are thus too indebted to ask for more loans. On the state side, public debt in the EU has increased by almost €4 trillion—equivalent to the size of Germany’s GDP. Member states need to think about developing a climate in which companies can invest more—EU firms have roughly nine times less private equity investment than U.S. firms—and thus reduce their debt.

One solution may lie in the application of the EU’s budgetary rules, which currently is commonly criticized for being too lax or too harsh. To solve the issue in the medium to long term, rather than debating over limits on what countries are allowed to spend, the EU should focus on how countries can achieve reform. This may require it to allow deviations from the budgeting limits put in place. The EU also needs to account for countries “too big to deliver” on reforms, because their decision-making mechanisms are too obstructed to push through structural reform, like France or Italy. At the same time, these reforming countries must allow their reform progress to be subject to inspection, in order to maintain the trust and confidence of austerity advocates like Germany.

The second focal point of the discussion was on infrastructure investment. The state of European infrastructure is precarious, starting with Germany lacking the will to invest. Like France, Germany faces great domestic political constraints on spending, along with budgetary responsibility as a sort of national concept. What little it has pledged toward infrastructure is symptomatic of Germany’s crisis policies: just the minimum in the right direction, very late, and only after refusing at first. However, it is once again crucial that even if Germany should enact an effective infrastructure program, it would need reassurance that its neighbors are structurally able to benefit from it and keep Europe’s economy competitive globally. With regard to the global perspective, the pending TTIP agreement should not be weighed down with expectations of renewing growth in Europe. Seeing TTIP not as a geo-economic measure but as a growth measure could end up hampering both the treaty and growth efforts in Europe.

Please contact Ms. Kimberly Frank at kfrank@aicgs.org with any questions.

Relevant articles:
“Central Banks Diverging Path Equals a Weakening Euro” by Alex Privitera, 9/26/14
“ECB Turning into a ‘Bad Bank’? Nonsense” by Holger Schmieding, 10/6/14
“Funding the Recovery: The Future Role of Traditional Banking and Capital Markets: Comparing the United States and Europe” Policy Report by Alex Privitera, 6/9/14