Completing the Banking Union: Next Steps and Challenges Ahead

Mark Dempsey31st March 202113min
In her address to the IIEA, Isabelle Vaillant, Director of Prudential Regulation and Supervisory Policy at the European Banking Authority (EBA), discussed progress to date towards completion of the Banking Union and outlined possible measures to strengthen the Banking Union framework.

Date: 31 March 2021

Author: Daire Lawler

Three Key Takeaways:

  1. Isabelle Vaillant compared the previous global financial crisis in 2008 to the current economic crisis, due to the COVID-19 pandemic. She argued that risks today are difficult to measure given the high level of uncertainty and that vigilance is required.
  2. While COVID-19 presents many challenges for the EU’s banking industry, it is buttressed by a more complete prudential and regulatory framework. However, much work remains to be completed to achieve a Banking Union. This presents an opportunity to generate added momentum for reforms that have been delayed.
  3. Some of the reforms that will strengthen the EU’s Banking Union and the crisis management framework include the establishment of a common European Deposit Insurance Scheme (EDIS), a harmonised insolvency regime for banks in the EU, progress on meeting the targets for minimum requirements of eligible liabilities (MREL) and disentangling the sovereign-bank nexus.

Introduction

In 2021, the threat of a liquidity crisis in the banking sector, due to the impact of the COVID-19 pandemic, led to an unprecedented response by the European institutions, which included a €1.85 trillion Pandemic Emergency Purchase Programme (PEPP) from the European Central Bank. A lot of work has been undertaken since the 2008 crisis to develop the EU’s crisis management infrastructure and to ensure the resilience of the EU banking industry in the face of idiosyncratic and pan-European economic shocks. Although many reforms proposed in the wake of 2008 have not been progressed, the completion of the Banking Union, first proposed by the European Commission in 2012, is high on the agenda of EU and Eurozone leaders in 2021.

Against this backdrop, Isabelle Vaillant, Director of Prudential Regulation and Supervisory Policy at the European Banking Authority (EBA), addressed the IIEA on Monday, 22 March 2021 on the completion of the Banking Union and provided an assessment of risks to the banking industry arising from the economic shock which began in 2020.

Crises in the Banking System: Past and Present

In her opening remarks, Madame Vaillant described how, in 2008, the world had entered a period of excessive risk-taking in the context of low inflation, stable growth, structural changes in the economy, a greater understanding of monetary policy and innovations in financial markets – but one in which financial stability risks were not clearly understood. Madame Vaillant made an analogy with the EU today suggesting that in many ways, it is currently in a similar set of circumstances.

Economies are experiencing an injection of innovation, previously unseen, in response to the pandemic, which Madame Vaillant said is a positive development. However, due to the high level of uncertainty that is imbued in the nature of the COVID-19 pandemic, the nature and scope of risks to economies are increasingly difficult to measure. She argued that against this increasing level of uncertainty, it is important to consolidate the structural framework of prudential regulation.

Banks are More Prepared for the Challenges that Lie Ahead

Madame Vaillant provided an outline of what has been achieved to date in the prudential framework. The availability of sufficient capital including within the systemic risk buffer (SyRB), the countercyclical capital buffer (CCyB), and the capital conservation buffer (CCoB) has meant that banks were able to apply the flexibility that was required when the pandemic struck. In 2020, just before the onset of the pandemic, the average Common Equity Tier 1 (CET1) capital was approximately 14%, compared to just 9% in 2009.[1]

Madame Vaillant stressed the need to continue to have appropriate levels of capital buffers, even if the regulatory structure has the potential to be simplified. Liquidity buffers, which are significantly above their required levels, will ensure that banks do not enter a liquidity crisis when the full impact of the economic shock is witnessed in the years ahead.

The Bank Recovery and Resolution Directive (BRRD), which entered into force in 2015, developed a standard framework for banks that fail or are likely to fail. In the event of a bank failure, competent authorities on the national level develop plans for the failure and a strategy to execute the resolution plan. The EBA strives to ensure that these plans are realistic.

Gaps in the Banking Union Framework

While the supports that have been provided to assist banks in dealing with the pandemic have been extensive, they will not remain in place forever. When supports are eventually withdrawn, this will most likely coincide with a higher level of non-performing loans (NPLs), particularly related to corporate loans. Madame Vaillant argued that it is now time to accelerate the reforms to the prudential and regulatory framework that were proposed in the aftermath of the previous crisis.

To complete the Banking Union, Madame Vaillant argued that it is necessary to establish a common European Deposit Insurance Scheme (EDIS) and that the absence of this third pillar of the Banking Union leaves a clear gap in the regulatory framework. She remarked that it is very much a political issue but that the EBA had done a lot of work on the technical side of the EDIS, including on risk reduction and on preparing clear, transparent metrics.

Madame Vaillant also highlighted that there is no harmonised insolvency regime for banks at EU level. Currently, variations in domestic insolvency requirements across different Member States cause imbalance and liquidations of similar banks in different jurisdictions with dissimilar outcomes. In addition, many Member States’ insolvency procedures have a general application to corporate entities but cannot specifically be applied to banks.  This, she argued creates a misalignment with the provisions of the BRRD.

Another area for potential progress, which is closer to the remit of the EBA, is in encouraging banks to reach their targets on minimum requirements for eligible liabilities (MREL). These are targets that allow banks to generate a loss-absorbing capacity in the event of a resolution.[2] In particular, Madame Vaillant stressed the need for small and medium-sized banks to generate adequate MREL.

Madame Vaillant addressed the issue of the sovereign-bank ‘doom loop’ which became prominent in the 2008 financial crisis. She stated that over the last two years, holdings of sovereign debt on bank balance sheets have increased, and this coincides with so-called ‘home bias’. While there has been some progress towards greater pooling of risk, Madame Vaillant stressed the need to ensure greater diversification both in the denomination of sovereign debt held by banks, and in the variety of liquid assets held by banks to disentangle the sovereign-bank nexus. An example of this could be greater exchange of debt or a greater issuance of common European debt, for instance.

Conclusion

Isabelle Vaillant’s address to the IIEA explored many of the key themes that were also echoed in a previous keynote address by Klaus Regling, Managing Director of the ESM, to the IIEA on Wednesday, 3 February 2021.[3] Mr Regling’s intervention coincided with reform of the ESM Treaty, which implemented the common backstop to the Single Resolution Fund (SRF), another rung on the ladder towards the completion of the Banking Union.

As outlined in the letter sent by President of the Eurogroup, Paschal Donohoe, to the President of the Euro Summit, Charles Michel, the High-Level Working Group on EDIS is currently developing a proposal to complete all outstanding gaps in the Banking Union framework. The Euro Summit is due to review progress on this matter in June 2021.[4] Member States such as Germany have stated that they will not commit to a full common deposit insurance scheme at EU level until other issues, including the sovereign-bank nexus, are resolved.[5]

Ultimately, the COVID-19 crisis has provided new momentum to address lacunas in the prudential and regulatory framework. Madame Vaillant emphasised that it still remains to be seen whether the political will to break the Banking Union deadlock will remain in 2021.

[1] https://www.bankingsupervision.europa.eu/banking/statistics/html/index.en.html

[2] https://srb.europa.eu/en/content/mrel

[3] https://www.iiea.com/featured-analysis/reforming-the-european-stability-mechanism-esm/

[4] https://www.consilium.europa.eu/media/48897/210319-peg-letter-to-pec-cm.pdf

[5] https://www.ft.com/content/82624c98-ff14-11e9-a530-16c6c29e70ca