Untying the European Knot

The European banking union can resolve the conflict between national regulation and the supranational nature of banks that helped bring about the current financial crisis.

In the absence of a banking union the financial crisis that broke out at the end of 2008 turned into a crisis for the euro. The Irish decision— taken without consultation—to guarantee all bank deposits drove the other member countries to adopt similar measures to stop the outflow of deposits, thus eliminating the option of restructuring bank debts. The subsequent German decision to let individual governments guarantee their own bank debts has sent the EU down the path of credit crisis. So it was guarantees that have turned the bank debts of individual customers into the public debt of states.

The hike in indebtedness brought about the threat of the disintegration of the euro, since states unable to repay their debt in euros might be forced against their will to convert to a new inflationary currency. After two years of beating around the bush, whilst the European Central Bank was trying to buy time by adopting various irregular measures, the European Council summoned up the courage to set up a banking union that would cut the link between bank and state indebtedness, thereby banishing the risk of the break-up of the euro while at the same time overcoming the conflict between the supranational bank market and national regulation.

The idea of a banking union was also meant to provide an alternative to further, more far-reaching forms of federalizing the EU, by providing the minimum degree of fiscal and political union capable of resolving the crisis. The transfer of the decision-making authority with regard to restructuring of major banks to the EU level represents an element of a political union, as it involves a shift of decision-making from domestic politicians and regulators to supra-national technocrats. As a result, the banking union also becomes a fiscal and political union, albeit exclusively in the case of a banking crisis, while in periods of financial stability it will not limit the member countries‘ fiscal and political sovereignty beyond the current status quo.

The Three Pillars of the Union

The current proposals for a banking union resemble the architecture of an ancient temple whose foundations and roof have already been built while the connecting pillars are only beginning to take shape. The foundations are provided by the unified rules on bank regulation, administered by the European Banking Authority (EBA) in line with the EU banking legislation, including the nearly adopted reform known as CRD4, while the European Systemic Risks Board (ESRB)—which supervises macro-financial stability jointly with the EBA—provides the roof. The missing pillars are: 1. an integrated system of bank supervision; 2. a harmonized deposit protection scheme; and 3. a single system for bank recovery and restructuring.

The European Central Bank (ECB) is set to become the banking union’s main regulatory body. It will directly supervise major banks vital to the entire system, with assets exceeding 30 billion euro or the three largest banks in each member state, jointly amounting to some 80 per cent of all bank assets in the eurozone. National regulators will cooperate closely with the ECB in processing local information and providing local oversight, while retaining the authority to supervise smaller banks. The single supervisory mechanism (SSM), whose details are currently being negotiated by the European Council and Parliament, is due to come in force in January 2014.

No amount of regulation and no supervisory and prophylactic system can, however, prevent every conceivable cause of a banking crisis. That is why the banking union cannot manage without the two additional pillars.

Bank deposits within the European Union are currently protected at a national level. Each member state is obliged to ensure the protection of depositors‘ savings up to at least 100,000 euros. The sources of funding for deposit protection vary from country to country—also in terms of credibility—since smaller economies where major supra-national banks are located can be affected by the same kind of problems in terms of paying out deposits that we know from Iceland. The European Commission has proposed that the funding for deposit protection be harmonized in a way that would ensure that each national system sets aside a reserve in advance. Should national protection not be sufficient to pay out deposits, the proposal introduces a system of loans from deposit protection funds in other member countries, which also means joint guarantees. The state funding guarantee would be used only in case that limited loans prove insufficient. However, the decision would not be taken in an ad hoc and impromptu manner but rather in line with rules established in advance. These rules, currently drafted by the European Commission, will be finalized by the end of 2013.

The system for bank recovery and the restructuring of ailing banks is the least developed and potentially the most controversial pillar. In 2010 the Commission proposed the creation of a restructuring fund that would collect compulsory contributions from banks as a reserve for financing a potential restructuring. At the same time it proposed drawing up harmonizing rules for crisis bank management that would enable an ailing bank to go bankrupt without threatening the stability of the entire system. The idea is to create a system of buffers to ensure that banks are not bailed out at the expense of the citizenry. Bailouts would be funded by shareholders and creditors in the first instance, to be followed by funds accumulated in the restructuring fund and, finally, by loans from similar funds in other countries, in the same way as with deposit protection. The final line of defence would be the European Stabilization Mechanism, originally created to stabilize economies. Its role, however, is hotly disputed.

The International Monetary Fund (IMF) has been involved in discussions of the banking union to a hitherto unprecedented degree—partly because 60 per cent of its loans are currently concentrated in Europe. The IMF came up with the first proposal for a banking union as early as in 2010, before anyone in the EU would openly admit that it was even needed. Since then the IMF has been stressing the need for a European Restructuring Agency and Fund, jointly guaranteed by EU member states and providing for a fiscal and political union stronger than anything envisaged by the Commission.

It is still too early to calculate the economic impact of the banking union. Rather than changing the rules of the game, the first banking union pillar will only change the referee, with the ECB replacing national supervision. Simplifying the supervision of an entire group of banks will save a number of supra-national groupings some costs. The establishment of the second and third pillars, on the other hand, is certain to result in increased expenditure and thus also in increasing the cost of banking services. The contributions to the protection and restructuring funds will be reflected in loans offered by the banks, thus increasing interest rates. By how much, when, and for how long, will however be determined by the actual form of both pillars as well as the individual states‘ economic development at that time.

A Cautious Reception in Central Europe

At the moment, Central European countries are prepared to support anything that will help stabilize the eurozone, on which all their economies depend. Nevertheless, this does not mean that they are willing to take part in any kind of action. Supra-national groups based in the eurozone own the majority of large banks in the Czech and Slovak Republics as well as in Hungary and Poland, while the domestic authorities that play the role of host regulators, are wary of losing their influence. Since a banking union would greatly diminish their role, their cautious attitude is hardly surprising.

Slovakia, as a eurozone member, will join the banking union. Official reception has been guarded, with an emphasis on the need to maintain a balance between domestic and foreign regulators due to the concern that resources might be channeled from domestic banks to parent companies. Critics have focused on the fact that the first pillar has been constructed before the other two have been tested, which makes proper evaluation of their full impact impossible.

The Polish and Hungarian banks are more dependent on the influx of foreign capital since— unlike those in the Czech and Slovak Republics— the total amount of their loans exceeds the total domestic deposits. The fact that a significant portion of their loans is in foreign currencies is another weakness, since it makes the creditors as well as the banks more vulnerable to losses if the local currency is devalued. At the same time, the much higher proportion of unrepaid loans, particularly in Hungary, combined with the lower profitability of banks, reduces their capacity to write off bad loans. Membership in the banking union is a way of coping with the escalating risk of sudden developments that might make it necessary to resolve the situation in cooperation with the parent banks and eurozone regulators.

Hungary has shown quiet openness to a banking union. The government has plenty of other conflicts with the EU without needing to add another. Poland, on the other hand, has shown the greatest willingness to embrace the proposed reforms, particularly now that the latest proposal offers decent conditions for EU countries outside the eurozone to participate in ECB and EBA decision -making.

In deciding whether or not to join the banking union the Czech Republic enjoys the greatest freedom, as it does not belong to the eurozone and has one of the most solid banking sectors in Europe. And since the Board of the Czech National Bank, which also plays the role of a banking regulator, includes a number of fanatical eurosceptics appointed by Václav Klaus, it is of little wonder that the harshest criticism has come from Prague. However, many people in Budapest, Bratislava and Warsaw share this feeling, relying on the Czech voice in European negotiations as much as on Great Britain, Sweden and Denmark, who are just as keen to protect the interests of countries outside the eurozone.

The Czech Republic has stressed the shared concern about losing control over banks and transfers of funds abroad through loans under the second and third pillar on the one hand, and the fact that the integrated supervision focuses chiefly on the stability of entire groups rather than their national parts. This will inevitably lead to the sharing of capital and liquidity among bank subsidiaries in Central Europe and their parent companies in the eurozone, which will in turn result in a more effective distribution in an integrated market but, at the same time, also increase eventual losses for more stable subsidiaries.

The third oft-mentioned threat arises from the established rules of the integrated market. Foreign parent banks can transform their subsidiaries with a local license into parent company branches that offer services in one country while being licensed in another EU country. However, branches are almost exclusively regulated by the domestic regulator in the parent company’s home country and their obligations towards their host regulators are limited to the duty to report, which deprives the latter of their control over licensing conditions, capital and, to a lesser degree, liquidity control.

The Czech government has threatened to veto the banking union if this option is not restricted. All it has achieved, however, is a general commitment that the banking union ought not to allow the legal statute of subsidiaries to be changed into branches. The banking union proposal provides a further safeguard for countries outside the eurozone—the option of opting out, either after three years without giving reason; or following an ECB ruling on the grounds of a country not meeting their obligation; or at the country’s own request in case of a fundamental disagreement. To prevent a misuse of this option the proposal envisages that a country that has opted out will not be allowed to return earlier than after three years.

New Risks

Non-participation in the banking union entails further risks. It would enable the Czech, Polish and Hungarian regulators to rigorously monitor the relations with parent companies and block any transfers of capital, liquidity or risk. Should the regulators exercise excessively strict control the parent companies might be driven to sell their Central European holdings. This has already happened in several cases, such as the Austrian owner who has sold his Central European subsidiaries to a Russian bank. Excessive regulatory protection of subsidiaries thus entails the risk of the influx of new owners who may not be as obliging with regard to domestic regulators as the current strategic investors from the eurozone.

The banking union will eliminate regulatory fragmentation among its members, while gradually entrenching the differences between members and non-members. Non-participation in the banking union, however great the effort to respect the interests of non-members, increases the risk of losing influence over decision-making with regard to the rules and workings of the banking regulation. Furthermore, elements of fiscal and political union in the emerging pillars are likely to be developed further in response to the pressure for the new rules to be clarified. This will further deepen the differences between members and non-members, making a return to the main integrated group more difficult with time. While this will not be a problem in the short run, in the long run non-member states may relive the humiliating experience of Great Britain after it had initially refused to participate in European integration and was admitted as late as in 1973 following repeated requests.

Participation in the banking union might shift some of the risk within the European banking groups from the eurozone to Central Europe. This could be regarded as the price for continuing to influence bank regulation within the banking union. The shifting of the risk will, however, be limited and controlled since the European Central Bank won’t allow any plundering. On the contrary, it will have a better overview of stability in the entire financial group, which will make it more able to prevent crises that might lead to supra-national groups disintegrating into national subgroups. Thus the banking union will also play the role of a safety valve against an uncertain future when the historic anomaly may no longer apply, whereby some of the Central European bank sectors are currently more stable than others.

The risks of participating in the banking union can be further limited by negotiating some safeguards. Eurozone governments are more likely to favor such safeguards if there is a real chance of the Central European countries joining the banking union at the outset. Active participation in the decision-making on integrated supervision and the remaining pillars thus offers the best possible strategy for negotiation.

Zdeněk Kudrna

works at the Salzburg Centre of European Union Studies, University of Salzburg. His work recently appeared in Journal of Common Market Studies, Journal of European Public Policy, Journal of Banking Regulation, and in a volume on the EU‘s decision traps by Oxford University Press. He is a member of the Regulatory Impact Assessment Board of the Czech government and regular commentator on European affairs in the Czech and Slovak media.

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