Bank of Lithuania
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Article by Gediminas Šimkus, Chairman of the Board of the Bank of Lithuania for the Eurofi Magazine.

The benefits of cross-border banking are indisputable -- it allows for economies of scale and geographic diversification, reduces bank exposure to negative shocks through better risk sharing, and enables a more efficient allocation of resources. So-called ring-fencing practices, such as application of capital and liquidity requirements on banks limiting activities to national boundaries, hinder the deepening of the single banking market. Typically, ring-fencing evolves as a result of countries’ concerns about financial stability. The resulting fragmentation comes at a cost for both the efficiency of the financial system and the banks themselves.

While the issue of ring-fencing should be resolved, developing pan-European banks should not come at the expense of host jurisdictions. Only completing and expanding the Banking Union, and complementing it with a deep and well-integrated Capital Markets Union, would sufficiently reduce the risks that can presently be addressed only by domestic ring-fencing.

First, the European Deposit Insurance Scheme (EDIS) – the third pillar of the Banking Union – should be established and become fully operational. For host countries, a fully-fledged EDIS is crucial. A hybrid model, where EDIS only comes in once national depositor protection tools are depleted, is not an adequate compromise. As banks become larger, we need correspondingly stronger safeguards. Assume that a consolidated transnational bank (for which the prudential requirements are applied on a group level only) fails and the host country has to compensate the depositors of its domestic subsidiary. Local taxpayers’ exposure to the risk of losses can be substantially reduced only with a fully-fledged EDIS in place.

Furthermore, a fully-fledged EDIS is necessary to remove present risks of transforming subsidiaries into branches. Home countries as well as hosts face downside financial stability risks, because the home country might be unable to cover depositor claims of the large banks in other Member States. Such risks are even more pronounced when a large entity makes its headquarters in a small home jurisdiction. As occurred in one case in the EU, if a bank’s asset portfolio becomes three times larger than the GDP of the home nation, the stakes on EDIS rise.

Second, further efforts should be taken to expand the Banking Union beyond the euro-area. This is important for countries where a substantial share of the banking sector is foreign-owned, primarily by non-euro area entities. For example, the parent companies of many of the largest banks in the Baltic States are not supervised by the Single Supervisory Mechanism (SSM).

A Banking Union which spans beyond the euro-area would solve this issue. We should therefore look for ways to encourage the non-euro area countries to joining the Banking Union through the ‘close cooperation’ regime by emphasizing the benefits of the SSM supervisory expertise, information-sharing, and efficiencies arising when the home and the host jurisdictions make collective decisions.

Finally, it must be noted that while the completion of the Banking Union with a fully-fledged EDIS and establishing a pan-European Banking Union are both key in curtailing ring-fencing practices, these alone are not enough. For a truly integrated European banking market, we also need a deep and well-functioning Capital Markets Union. Research shows that while risk is efficiently shared in a banking union when economies are hit with demand shocks, a capital markets union is necessary to help absorb supply-side shocks. Without security market integration complementing banking activities, as well as a higher level of harmonization of national insolvency and taxation regimes among the European Union member states, cross-border banking will remain hindered.

Removing the non-prudential barriers to cross-border banking will take time and determination. Member States need to agree on how to collect taxes on cross-border investments and establish unified definitions of the underlying tax base for banks. Furthermore, insolvency law should be harmonized to make outcomes of insolvency procedures more predictable. For this reason, we have to take a long-term view and aim to reform these specific topics which create obstacles to pan-European activities.

An incomplete Banking Union is the main reason behind the low levels of cross-border consolidation in the European banking sector. Thus, a complete and expanded Banking Union, complemented by a well-functioning Capital Markets Union, should allow us to suspend ring-fencing practices and unlock the full potential of Europe-wide banking.