Assessing the Single Supervisory Mechanism: passing the point of no return for Europe's banking union. Egmont Paper No. 58, June 2013

From the Executive Summary. Europe’s financial and sovereign debt crises have become increasingly interconnected. In order to break the negative feedback loop between the two, the EU has decided to create a common supervisory framework for the banking sector: the Single Supervisory Mechanism (SSM). The SSM will involve a supervisory system including both the national supervisors and the European Central Bank (ECB). By endowing the ECB with supervisory authority over a major part of the European banking sector, the SSM’s creation will result in a shake-up of the way in which the European financial sector is being supervised. Under the right circumstances, this could be a major step forward in addressing Europe’s interconnected crises.

Banking Union in sight five years on. CEPS Commentary, 13 September 2013

On the fifth anniversary of the start of the financial crisis, Karel Lannoo looks at the regulatory steps that have been taken to date, and argues that the EU should apply the same logic of reinforced integration at the federal level that informed the Single Supervisory Mechanism to the bank resolution systems and deposit guarantee schemes.

Fiscal policy, banks and the financial crisis. National Bank of Belgium Working Paper No. 234, October 2012

This paper studies the effectiveness of Euro Area (EA) fiscal policy, during the recent financial crisis, using an estimated New Keynesian model with a bank. A key dimension of policy in the crisis was massive government support for banks—that dimension has so far received little attention in the macroeconomics literature. We use the estimated model to analyze the effects of bank asset losses, of government support for banks, and other fiscal stimulus measures, in the EA. Our results suggest that support for banks had a stabilizing effect on EA output, consumption and investment. Increased government purchases helped to stabilize output, but crowded out consumption. Higher transfers to households had a positive impact on private consumption, but a negligible effect on output and investment. Banking shocks and increased government spending explain half of the rise in the public debt/GDP ratio since the onset of the crisis.

Memo to Merkel: Post-election Germany and Europe. Bruegel Policy Brief 2013/05, 24 September 2013

Recent economic data points to the seeds of an economic recovery in the European Union. However, significant risks remain and bold policies are still needed. There are three central risks. Competitiveness adjustment is incomplete, casting doubt on the sustainability of public debt. Banking remains unstable and fragmented along national lines, resulting in unfavorable financial conditions, which further erode growth, job creation and competitiveness. Rising unemployment, especially among the young, is inequitable, unjust and politically risky. Germany has a central role to play in addressing these risks. The new German government should work on three priorities: Domestic economic policy should be more supportive of growth and adjustment, with higher public investment, a greater role for high-value added services, and more supportive immigration policy. Germany should support a meaningful banking union with a centralised resolution mechanism requiring a transfer of sovereignty to Europe for all countries including Germany. The establishment of a private investment initiative combined with a European Youth Education Fund and labour market reforms should be promoted. Building on these priorities, a significant deepening of the euro area is needed, with a genuine transfer of sovereignty, stronger institutions and democratically legitimate decision-making structures in areas of common policy.

The European Central Bank in the age of banking union. Bruegel Policy Contribution 2013/13, 1 October 2013

During the crisis the European Central Bank’s roles have been greatly extended beyond its price stability mandate. In addition to the primary objective of price stability and the secondary objective of supporting EU economic policies, we identify ten new tasks related to monetary policy and financial stability. We argue that there are three main constraints on monetary policy: fiscal dominance, financial repercussions and regional divergences. By assessing the ECB’s tasks in light of these constraints, we highlight a number of synergies between these tasks and the ECB’s primary mandate of price stability. But we highlight major conflicts of interest related to the ECB’s participation in financial assistance programmes. We also underline that the ECB’s government bond purchasing programmes have introduced the concept of ‘monetary policy under conditionality’, which involves major dilemmas. A solution would be a major change towards a US-style system, in which state public debts are small, there are no federal bail-outs for states, the central bank does not purchase state debt and banks do not hold state debt. Such a change is unrealistic in the foreseeable future.

Financial services and the Transatlantic Trade and Investment Partnership. CEPS Policy Brief No. 302, 20 November 2013

Given the size of the financial markets on both sides of the Atlantic and the symmetry in the follow-up of the G-20 standards, Karel Lannoo argues in this Policy Brief that the Transatlantic Trade and Investment Partnership (TTIP) provides a good opportunity to put in place a more institutionalised framework. He finds that both blocs have reacted in similar ways to the financial crisis in strengthening their regulatory and supervisory frameworks and incorporating the G-20 recommendations into federal law. He also notes that consumer protection has been reinforced, certainly in the US, with the creation of the Consumer Financial Protection Bureau. And on the EU side, the Single Supervisory Mechanism (SSM) will radically change banking supervision. In his view, inclusion of financial services could also be an opportunity to strengthen prudential rules and consumer protection provisions on both sides. Rather than leading to a reduction of consumer protection, as had been feared in the post-crisis environment, it could lead to an examination, exchange and recognition of best practices in regulation and enforcement. Finally, he concludes that inclusion of financial services would make it part of the permanent regulatory dialogue that will be established as a result of a successful TTIP.

European banking disunion. CEPS Commentary, 14 November 2013

In this CEPS Commentary Daniel Gros argues that the purpose of the euro was to create fully integrated financial markets; but, since the start of the financial crisis in 2008, markets have increasingly separated along national lines. So the future of the eurozone depends crucially on whether that trend continues or is reversed and Europe’s financial markets in the end become fully integrated. But either outcome would be preferable to something in between – neither fish nor fowl. Unfortunately, that is where the eurozone appears to be headed.

Transaction Banking: Respecting its role in the real economy. ECRI Policy Brief No. 6, 6 December 2013

This paper sketches the main features and issues related to recent market developments in global transaction banking (GTB), particularly in trade finance, cash management and correspondent banking. It describes the basic functioning of the GTB, its interaction with global financial markets and related implications of global regulatory developments such as Basel III. The interest in GTB has recently increased, since its low-risk profile, tendency to follow growth rates worldwide and relative independence from other financial instruments became an interesting diversification opportunity both for banks’ business models and for investors. Transaction banking has been a resilient business during the crisis, despite the reduction in world trade figures. In the post crisis period, GTB must cope with new challenges related to increased local and global regulation and the risk of inconsistency in regulatory approaches, which could negatively impact the global network and increased competition by new market entrants. Increased sophistication of corporate clients, as well as the pressure to develop and adopt technological innovations more quickly than other areas of banking continues to impact the business. The future of the industry closely depends on its ability to adjust to complex regulatory developments while at the same time being able to operate a global and efficient network.

Descent from banking union to political chaos. CEPS Commentary, 24 January 2014

To counteract the powerful anti-Europe sentiments swirling throughout the EU today and to motivate EU citizens to vote in a constructive spirit in the upcoming European elections, Karel Lannoo argues in this commentary that the functioning of the EU institutions needs to be openly discussed and proposals need to be aired for improving the decision-making process to render it more transparent and democratic. This process would encompass, in his view, the proper role and functioning of the European Commission, the European Parliament and the member states in the EU Council and the interrelationships between these institutions.

The Single Supervisory Mechanism: A Sound First Step in Europe’s Banking Union? Egmont European Affairs Paper, March 2013

The financial and economic crisis has hit Europe in its core. While the crisis may not have originated in the European Union, it has laid bare structural weaknesses in the EU’s policy framework. Both public finances and the banking sector have been heavily affected. For a long time, the EU failed to take into account sufficiently the perverse link that existed between the two. Negative evolutions in one field of the crisis often dragged along the other in its downward spiral. In June 2012, in the early hours of a yet another EU Summit, the leaders of the eurozone finally decided to address the link between the banking and sovereign debt crises. Faced with soaring public borrowing costs in Spain and Italy, they decided to allow for the direct European recapitalisation of banks when the Member State itself would no longer be in a position to do so. In exchange, supervision of the banking sector would be lifted to the European level by means of a Single Supervisory Mechanism. The Single Supervisory Mechanism, or SSM in the EU jargon, is a first step in the broader revision of policies towards banks in Europe. The eventual goal is the creation of a Banking Union, which is to carry out effective surveillance and – if needed – crisis management of the banking sector. The SSM is to rely on national supervisors and the ECB, with the ECB having final authority on the matter. The involvement of the latter made it clear that the SSM would be centred on the eurozone – while it is to remain open to other Member States willing to join. Due to the ongoing problems and the link between the creation of the SSM and the recapitalisation of banks, the SSM became one of the key legislative priorities of the EU. In December 2012, Member States reached an agreement on the design of the SSM. After discussions with the European Parliament (which were still ongoing at the time of writing), the process towards making the SSM operational can be initiated. The goal is to have the SSM fully up and running in the first half of 2014. The decisions that were taken in June 2012 are likely to have had a bigger impact than the eurozone’s Heads of State and Government could have realised at the time for two important reasons. On the one hand, creating the SSM necessitates a full Banking Union and therefore shared risk. On the other hand, the decisions improved the ECB’s perception of the willingness of governments to take far-reaching measures. This undoubtedly played a significant role in the creation of the Outright Monetary Transactions programme by the ECB, which has led to a substantial easing of the crisis in the short-term. 1 These short-term gains should now be matched with a stable long-term framework for bank supervision and crisis management. The agreement on the SSM should be the first step in the direction of this goal. This paper provides an analysis of the SSM and its role in the creation of a Banking Union. The paper starts with a reminder of why the EU decided to put in place the SSM (§1) and the state of play of the ongoing negotiations on the SSM (§2). Subsequently, the supervisory responsibilities of the SSM are detailed, including its scope and the division of labour between the national supervisors and the ECB (§3). The internal functioning of the SSM (§4) and its relation to the other supervisors are discussed afterwards (§5). As mentioned earlier, the SSM is part of a wider move towards a Banking Union. Therefore, this paper sheds light on the other building blocks of this ambitious project (§6). The transition towards the Banking Union is important and will prove to be a bumpy ride. Before formulating a number of conclusions, this Working Paper therefore provides an overview of the planned road ahead (§7).

Macroeconomic and Financial Crisis Management in the Southern and Eastern Mediterranean: Diagnosis and Prospects. CEPS Paperbacks. December 2013

The global financial crisis, which started in the summer of 2007 and deepened in the aftermath of the Lehman failure in September 2008, has led to a virtual collapse in economic activity and increased financial volatility worldwide. For the developing countries, the main channel of transmission has been a drop in external transactions, such as trade, financial and capital flows, and remittances. The emerging economies in the southern and eastern Mediterranean have also faced declining economic activity, although there seems to be considerable variation in the relative magnitude and timing. Most of these economies have shown a delayed but more lasting response to the crisis, driven mostly by their close trade and investment ties with the EU and the Gulf Cooperation Council (GCC) countries. This book explores the fiscal, monetary and financial effects of the crisis in the region and provides an in-depth analysis of the fiscal, monetary and banking policies in the post-crisis era, the viability of their exit strategies and the future of reforms in the region. These analyses not only provide a comprehensive comparison between the countries but also provide a solid basis for assessing future economic and financial developments and reforms in the region.

Time to Set Banking Regulation Right. CEPS Paperbacks. March 2012

Excessive leverage and risk-taking by large international banks were the main causes of the 2008-09 financial crisis and the ensuing sharp drop in economic activity and employment. World leaders and central bankers promised that it would not happen again and, to this end, undertook to overhaul banking regulation, first and foremost by rectifying Basel prudential rules. This study argues that the new Basel III Accord and the ensuing EU Capital Requirements Directive IV fail to correct the two main shortcomings of international prudential rules: 1) reliance on banks’ risk management models for the calculation of capital requirements and 2) the lack of accountability by supervisors. Accordingly, the authors propose the calculation of capital requirements without risk adjustment and creation of a system of mandated action by supervisors modelled on the US framework of Prompt Corrective Action (PCA). They also recommend that banks should be required to issue large amounts of debentures that are convertible into equity in order to strengthen market discipline on management and shareholders.

Framing Banking Union in the Euro Area: Some empirical evidence. CEPS Working Document No. 389, 3 February 2014

Evidence shows that financial integration in the euro area is retrenching at a quicker pace than outside the union. Home bias persists: Governments compete on funding costs by supporting ‘their’ banks with massive state aids, which distorts the playing field and feeds the risk-aversion loop. This situation intensifies friction in credit markets, thus hampering the transmission of monetary policies and, potentially, economic growth. This paper discusses the theoretical foundations of a banking union in a common currency area and the legal and economic aspects of EU responses. As a result, two remedies are proposed to deal with moral hazard in a common currency area: a common (unlimited) financial backstop to a privately funded recapitalisation/resolution fund and a blanket prohibition on state aids.

Europe's Ungainly Banking Revolution. CEPS Commentaries, 24 March 2014

In assessing the compromise agreement reached on March 20th on how to deal with banks in difficulty in the eurozone, Daniel Gros finds that the Single Resolution Fund represents an awkward step in the right direction in that it leaves as many problems unresolved as it addresses. But the end result is likely to be quite strong, because it establishes a key innovation: a common fund that effectively mutualises much of the risk resulting from bank failures.

Asset-backed securities: The key to unlocking Europe's credit markets? Bruegel Policy Contribution 2014/07, 24 July 2014

The European market for asset-backed securities (ABS) has all but closed for business since the start of the economic and financial crisis. ABS (see Box 1) were in fact the first financial assets hit at the onset of the crisis in 2008. The subprime mortgage meltdown caused a deterioration in the quality of collateral in the ABS market in the United States, which in turn dried up overall liquidity because ABS AAA notes were popular collateral for inter-bank lending. The lack of demand for these products, together with the Great Recession in 2009, had a considerable negative impact on the European ABS market. The post-crisis regulatory environment has further undermined the market. The practice of slicing and dicing of loans into ABS packages was blamed for starting and spreading the crisis through the global financial system. Regulation in the post-crisis context has thus been relatively unfavourable to these types of instruments, with heightened capital requirements now necessary for the issuance of new ABS products. And yet policymakers have recently underlined the need to revitalise the ABS market as a tool to improve credit market conditions in the euro area and to enhance transmission of monetary policy. In particular, the European Central Bank and the Bank of England have jointly emphasised that: “a market for prudently designed ABS has the potential to improve the efficiency of resource allocation in the economy and to allow for better risk sharing... by transforming relatively illiquid assets into more liquid securities. These can then be sold to investors thereby allowing originators to obtain funding and, potentially, transfer part of the underlying risk, while investors in such securities can diversify their portfolios... . This can lead to lower costs of capital, higher economic growth and a broader distribution of risk” (ECB and Bank of England, 2014a). In addition, consideration has started to be given to the extent to which ABS products could become the target of explicit monetary policy operations, a line of action proposed by Claeys et al (2014). The ECB has officially announced the start of preparatory work related to possible outright purchases of selected ABS1. In this paper we discuss how a revamped market for corporate loans securitised via ABS products, and how use of ABS as a monetary policy instrument, can indeed play a role in revitalising Europe’s credit market. However, before using this instrument a number of issues should be addressed: First, the European ABS market has significantly contracted since the crisis. Hence it needs to be revamped through appropriate regulation if securitisation is to play a role in improving the efficiency of resource allocation in the economy. Second, even assuming that this market can expand again, the European ABS market is heterogeneous: lending criteria are different in different countries and banking institutions and the rating methodologies to assess the quality of the borrowers have to take these differences into account. One further element of differentiation is default law, which is specific to national jurisdictions in the euro area. Therefore, the pool of loans will not only be different in terms of the macro risks related to each country of origination (which is a ‘positive’ idiosyncratic risk, because it enables a portfolio manager to differentiate), but also in terms of the normative side, in case of default. The latter introduces uncertainties and inefficiencies in the ABS market that could create arbitrage opportunities. It is also unclear to what extent a direct purchase of these securities by the ECB might have an impact on the credit market. This will depend on, for example, the type of securities targeted in terms of the underlying assets that would be considered as eligible for inclusion (such as loans to small and medium-sized companies, car loans, leases, residential and commercial mortgages). The timing of a possible move by the ECB is also an issue; immediate action would take place in the context of relatively limited market volumes, while if the ECB waits, it might have access to a larger market, provided steps are taken in the next few months to revamp the market. We start by discussing the first of these issues – the size of the EU ABS market. We estimate how much this market could be worth if some specific measures are implemented. We then discuss the different options available to the ECB should they decide to intervene in the EU ABS market. We include a preliminary list of regulatory steps that could be taken to homogenise asset-backed securities in the euro area. We conclude with our recommended course of action.