Under the headline ‘Risk Sharing in the EU: How to ensure Common Grounds on Adequate Instruments, Institutional Frameworks and Appropriate Procedures’ first impulses were held. Moving on, policy makers discussed what kind of institutional designs create the right incentives and market discipline to make risk-sharing acceptable, the discrepancies between real and perceived redistributive impact of arrangements, how much risk-sharing is embedded in the existing framework and how to find fair responses to burden sharing and crisis management procedures. The debate clearly revealed the different positons and views from the repesented member states and institutions.
Financial Stability Conference 2019
28 October 2019
Panel IV – Impulses and Discussion
Risk Sharing in the EU: How to ensure Common Grounds on Adequate Instruments, Institutional Frameworks and Appropriate Procedures
with Giuseppe De Martino, Senior Advisor, Banking and Financial System – Legal Affairs, Italian Ministry of Finance; Dr. Levin Holle, Director General Financial Markets Policy, German Federal Ministry of Finance; Nicoletta Mascher, Head of Banking, European Stability Mechanism; Sébastien Raspiller, Assistant Secretary for Financial Services, Directorat General of the Treasury, French Ministry for the Economy and Finance; Emiliano Tornese, Deputy Head, Resolution and Crisis Management Unit, European Commission; moderated by Nicolas Véron, Senior Fellow, Bruegel and Peterson Institute for International Economics
Panel IV – Impulses and Discussion
Nicolas Véron opened the panel by appreciating the Financial Stability Conference as a matter of public service, as it brings together important actors in the setting of Berlin, which is highly relevant for European politics. Starting in a first round of impulse statements, Emiliano Tornese highlighted that the final objective of the Banking Union (BU) was to establish a single market for banking to benefit from synergies and prospects for financial stability. In this regard, several EU banking packages have been adopted to create a coherent framework with instruments including capital buffers in terms of the minimum requirement for own funds and eligible liabilities (MREL), increased liquidity ratios and an extended scope of the total loss-absorbing capacity (TLAC). These efforts led to an increase in overall safety but also to fragmentation, over-banking and low profitability in the banking system.
In a way, despite all these rules we have failed to achieve the internal market for banking. Moreover, the BU architecture consists of the Single Supervisory Mechanism (SSM) and Single Resolution Mechanism (SRM) as the first two pillars, on top of which the important component of the European deposit insurance scheme (EDIS) has to be implemented and coupled with a backstop. Liquidity in resolution remains a major challenge in this framework, which would require a specific facility, while the BU architecture can partially tackle this issue by creating more trust and allowing free capital and liquidity flows within banking groups, which enhances private instead of public risk sharing.
Nicolas Véron remarked that there were two policy narratives of the BU, one being the imperative to break the sovereign-bank nexus and the other being the creation of the Single Market enshrined in the 1957 Treaty of Rome. Emiliano Tornese considered these two fairly different narratives to be complementary and strictly related. Regulation and the institutional infrastructure have to create the right incentives for cross-border activities and an internal market, which in turn facilitates the provision of credit to the real economy and efficient resource allocation. Finally, to break the sovereign-bank nexus it requires the infrastructure of a complete BU with a common system for deposit protection and a common backstop for the Single Resolution Fund (SRF) providing liquidity in resolution at the European level.
To break the sovereign-bank nexus it requires a complete Banking Union with a common system for deposit protection and a common backstop for the SRF.
Giuseppe De Martino referenced a recent ECB paper, for which a stress scenario assuming a fully-fledged and funded EDIS was simulated to understand whether it would withstand multiple banking crises. As a result, even under a conservative loss scenario, the specified EDIS was sufficient to cover payouts to depositors. Merely a non-systematic but crisis-specific redistributive impact occurred and without any cross-subsidization, no Member State benefited disproportionately from the EDIS mechanism. The real goal of any risk sharing mechanism is to increase the system’s overall resilience and capability to absorb local shocks. Nicolas Véron critically reflected that this result of non-permanent transfers and merely crisis-specific redistributions counters the popular narrative of EDIS as a transfer mechanism.
The goal of any risk sharing mechanism is to increase the system’s overall resilience and capability to absorb local shocks.
Sébastien Raspiller noted that breaking the sovereign-bank vicious circle and creating a genuine single market are two essential and mutually reinforcing elements to complete the BU and the overall goal of resilience of the Economic and Monetary Union. While it is difficult to break the doom loop, diversification via cross-border mergers helps to avoid spill-over risks and to provide shock absorption capacity thereby contributing to a genuine single market, in which eventually some form of a residual doom loop might even be negligible. Well-designed risk sharing with proper incentives to avoid moral hazard presents another useful measure to enhance resilience, though it is neither the ultimate solution nor a goal by itself.
Diversification via cross-border mergers helps to avoid spill-over risks and to provide shock absorption capacity thereby contributing to a single market.
But before talking about EDIS, the SRM and effective resolution have to be ensured to function properly. And while the SSM has done a good job, more intrusive supervision on less significant institutions is needed for EDIS to rebuild trust. On the other hand, the BU has proven beneficial to make the banking system safer at the national level with risk reduction measures of increased supervision and capital buffers. Other issues of governance, market fragmentation, low profitability and limited financial diversification, for which additional buffers are not always effective, should be addressed at a transversal instead of supervisory level.
Levin Holle went on to explain why the much needed progress on the BU is comparably slow. Basel III and increased capital levels for banks present a yet unfinished legislative piece of work. Low interest rates and technological change put massive pressure on the profitability of European banks. Transitioning to a European resolution regime under the BRRD remains difficult due to different political preferences and its technical complexity. The completion of the BU to increase resilience in the Monetary Union requires pending solutions to mutualize risks and funds. Finally, the issue of money laundering impedes the rebuilding trust and has to be addressed. Nonetheless, a comprehensive agenda, better understanding of the SRM and its required improvements, increased risk reduction with higher capital buffers as well as the start of a new Commission are promising factors for further progress on the BU.
Nicoletta Mascher emphasized the importance of risk sharing as defined by the absorption capacity of a country to insulate its disposable income from idiosyncratic regional shocks given that a recent IMF paper found 80 percent of idiosyncratic regional shocks in the Euro area to go unsmoothed impacting income and consumption in a given country. Private risk sharing by means of risk diversification via financial market integration could substantially contribute to making economies less vulnerable to local shocks and hence achieve the BU‘s objective of a safe and sound banking system with profitability for all intermediaries. The more private risk sharing, the less public intervention is needed to absorb the impact of shocks. Therefore, it needs more financial integration with a complete BU and CMU. As a result, investors could freely move resources, banks have access to financing even when local markets are under distress, consumers benefit from less expensive services and more importantly, market players could better compete on a global scale. In terms of public risk sharing, the short-term agenda for EDIS is to rebuild trust and confidence by overcoming fears of contagion or systemic transfers, which requires an open discussion involving the industry in the design of EDIS.
The more private risk sharing, the less public intervention is needed to absorb the impact of shocks. Therefore, it needs integration with a complete BU and CMU.
Subsequently, Nicolas Véron collected reactions from the panel on the assessment that European supervision works while resolution does not. Giuseppe De Martino conceded that resolution has not yet been applied at European level, given that the Banco Popular case was quite particular, and agreed with Emiliano Tornese that the resolution framework needs to be improved in order to remove constraints preventing authorities from effectively applying resolution.
Levin Holle made the observation that common European supervision was easier to establish because it was merged from existing rules and institutions, whereas new institutions had to be formed for resolution, which naturally takes more time. He further suggested that supervision has a role to play in making the second pillar of resolution work. On behalf of the supervisor, it is questionable whether previous early intervention measures for banks adequately prevented excessive liquidity coverage ratio outflows and subsequent replacements by emergency liquidity assistance (ELA) or government-guaranteed bonds, which overall made it politically more difficult for resolution authorities to bail-in. Admittedly, to define the right point in time for the proper instrument is a challenge for any banking supervisor. Using a different label for early intervention could help to avoid putting public blame on a bank and restrain potential deposit flights. Nicoletta Mascher agreed that loopholes already exist concerning the first pillar of supervision and its linkage to resolution. As a consequence, supervision requires a better design of early or normal interventions, better coverage of risk with a more forward-looking approach and an equivalent regime for non-bank financial institutions.
Using a different label for early intervention measures could help to avoid putting public blame on a bank and restrain potential deposit flights.
Nicolas Véron then referred to a recent paper by the Bank of Italy, which suggests that Member States should create national regimes similar to the one applied to the two Venetian banks. Thus, a regime specifically for banks not entering EU resolution as they failed the public interest assessment of the Single Resolution Board (SRB). Giuseppe De Martino explained that the disorderly piecemeal liquidation for banks presents the worst outcome of any crisis management framework because it detrimentally impacts the real economy. To prevent this, national deposit guarantee schemes (DGSs) could play a more active role in liquidation by conducting alternative and more efficient measures. However, the current framework restrains the national DGSs from doing so as it is based on the least cost assessment and the super-priority for covered deposits. Therefore, alternative DGS measures demand specific regulatory amendments, for instance, to include indirect costs from domestic liquidation in the least cost assessment.
National DGSs could play a more active role in liquidation by conducting alternative and more efficient measures.
Finally, Nicolas Véron asked the panelists whether it was possible to overcome national ring-fencing in the eurozone without EDIS, which he referred to as an effectively European deposit insurance in contrast to the Commission‘s proposition. Nicoletta Mascher suggested that EDIS is crucial to ensure the same level of deposit protection across the BU because the current DGSs still rely on national resources, for which the sovereign-bank nexus cannot be solved. It is not possible to rebuild trust and confidence without EDIS, she underlined.
EDIS is crucial to ensure the same level of deposit protection across the BU. It is not possible to rebuild trust and confidence without EDIS.
Levin Holle replied that while there is a strong political connection between the two elements, in practical economic terms EDIS is hardly helpful to overcome ring-fencing. This is because most cross-border activities take place in large banks that are under the remit of the SRB. In a crisis scenario, those banks will be resolved at the European level with granted access to the SRF. The key concern of bail-in for competent authorities in the host Member State is then to ensure and trust that sufficient capital and liquidity can move freely to where the crisis happens within a banking group. In contrast, deposit insurance and its super-priority for covered deposits are only economically relevant for smaller banks that do not enter European resolution.
Sébastien Raspiller suggested that in a steady-state BU with an integrated single market for banking, EDIS could assure all supervisors of the reliable protection of national DGSs against being used in a systemic event in the eurozone and therefore avoid ring-fencing. However, while the eurozone currently falls short of being fully integrated, EDIS is neither a means to make progress on integration nor the home-host issue. Emiliano Tornese considered EDIS as a necessary element to provide more safeguards to the host Member States, while it is not sufficient by itself to overcome ring-fencing or to ensure free intra-group capital and liquidity flows.
EDIS is a necessary element to provide more safeguards to the host Member States, while it is not sufficient by itself to overcome ring-fencing.
Giuseppe De Martino agreed that EDIS is not sufficient but necessary, because as long as national authorities have a mandate to protect national deposits they are prone to ring-fence. In addition, the system is not credible as long as deposit insurance cannot take alternative measures, for which a general depositor preference based on a tiered approach is needed. This last aspect marked a separate debate in contrast to whether national resolution regimes for banks are sufficiently swift.
According to Levin Holle, alternative measures given to DGSs make sense economically, if according to the least cost assessment the payout would be more expensive for a deposit insurance than respective alternatives. Still, the European system should adhere to a strict least cost principle and super-priority of covered deposits. Nicolas Véron clarified that the pure payout EDIS is different from an EDIS with alternative measures and that the latter is specifically linked to a policy proposal of general depositor preference. Nicoletta Mascher summarized that a common deposit insurance is in any case necessary to have a properly functioning BU.
As the core feature of this panel, Nicolas Véron summarized the extraordinary technical complexity of the discussed issues with remaining problems to be solved at the technical level as well as the fact that EDIS was a necessary though not sufficient part of the package towards completing the BU.
The first question from the audience referred to the missing elements needed to get to EDIS at the end of the process. Nicoletta Mascher replied that a recent ESM discussion paper proposed a roadmap with a sequential approach of 20 steps, which were attentively crafted to account for all interlinkages between the different issues to achieve the final goal of a common deposit insurance by 2028. Among these, crisis management tools, the harmonization of creditor hierarchy as well as the alignment of burden sharing rules with the bail-in criteria were critical elements. Levin Holle identified the regulatory treatment of sovereign debt, targeted harmonization and bank insolvency law as well as anti-money laundering (AML) efforts as the missing elements.
On the issue of whether additional administrative liquidation instruments would be useful at the SRB, Levin Holle agreed that such instruments independent of the public interest test would be helpful to deal with smaller banks. The BRRD integrated the public interest assessment as a threshold, for if a bank meets all criteria of being threatening to financial stability, the SRB is allowed to apply certain instruments and to access the SRF. This implied the legislative intent for smaller banks to be subject to national insolvency procedures instead of resolution initiated by the SRB. However, these regimes were too cumbersome in some Member States, which could be addressed by either modifying those national regimes or via legislation to introduce special EU-wide instruments. Sébastien Raspiller argued that the BRRD is a good piece of legislation and that the political will to apply the available tools exists. Before installing further regimes trying to correct resolution, it is necessary to fix the legislation that is already in place and implemented.
Additional administrative liquidation instruments would be useful at the SRB and, independent of the public interest test, helpful to deal with smaller banks.
With regards to whether capital waivers with guarantees were an appropriate way to overcome the problem of limited capital and liquidity circulation in a cross-border context without having some form of EDIS in place, Giuseppe De Martino replied to that this would not be an option unless these guarantees were fully collateralized as a kind of internal MREL mechanism.
The final question referred to whether anti-money loundering should be effectively addressed at a European level through a new supervisory authority, as this risk is not sufficiently addressed at national level. Levin Holle admitted that up until now, AML has been treated as an EU instead of BU issue in term of legislation. Eventually, AML supervision should be conducted directly from a European institution that is closely connected to the executive part of the justice system, such as general law enforcement. But before jumping ahead, the role and set of rules for such an institution have to be clarified vis-a-vis existing EU supervisory authorities like EBA and SSM, and existing national authorities such as Financial Intelligence Units. Sébastien Raspiller added that AML should be addressed in terms of regulation instead of directives to avoid a regulatory race-to-the-bottom. Moreover, creating a supervisory EU body, either new or inside an existing authority, is first and foremost about having an EU governance that is independent of national supervisors. This can be problematic as the aspects of police and justice will probably remain at the national level in the foreseeable future.
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