Bank of Lithuania
2013-09-23
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Conference on the Integrated European Banking Union
The next steps
19 September, 2013
Ironmongers‘ Hall, City of London

 

Ladies and gentlemen, dear organizers,

Many thanks for providing the opportunity to share the views on this important issue.  Regretfully the Governor could not attend this event but he sends his best regards to participants from the ECB General Council which he had to attend earlier today. I am honored to step in on his behalf.

That said, what follows represents my personal opinion and may or may not correspond to that of the Lithuanian Central Bank or the Lithuanian EU Presidency.

Sense of urgency

We would not have this conference and we would not talk about Banking Union if it were not for the euro crisis.  And by euro crisis I mean the days when financial markets started losing trust in the future of the eurozone.  In those days financial markets took comfort in fiscal backstops provided to some eurozone countries and swift (by EU standards) regulatory initiative to create a single supervisory and resolution framework for the eurozone banking sector. These are the days that we would like to forget, but we should not.

Some think that the peak of the crisis is past us and thus we can afford to move along the regulatory agenda at a slower pace.  I would like to challenge such a view. Starting fall 2014 Single Supervisory Mechanism (SSM) will become operational.  As a consequence, the biggest systemically important banks will fall under direct European Central Bank (ECB) supervision.  At some point before that date ECB must conduct Asset Quality Review to ensure that it is not held responsible for the supervisory blunders of the past.  Thus we must not take too much comfort in the current relatively calm situation, as the sense of urgency is right there, lurking in the shadows of bank balance sheets.  We must get an agreement on all key elements of the Banking Union before that date.  At a minimum the second leg of the Banking Union, Single Resolution Mechanism (SRM), needs to be agreed as soon as possible.

Objectives of the BU

The ultimate objective of the banking union is to break the link between the sovereign and its banking sector.  More specifically we want to ensure that supervisory forbearance is not an issue going forward and that the resolution of financial institutions is not subject to dynamic inconsistency.  Non-binding memorandums of understanding do not provide the legal certainty required.  SSM will ensure that under joint supervision, the national champion institutions are not treated in a fashion that allows them to undertake unnecessary risks.  Equally so, SRM will make sure that preannounced rules of bank resolution are actually followed through.  Most importantly it means that the principle of burden sharing is credibly committed to.  Minimum requirements for own funds and eligible liabilities and robust resolution funding arrangements are important elements of credible commitment.

We would like to make sure that we do have a single market in financial services and that resolutions of financial institutions in individual member states do not lead to financial market fragmentation and that a level playing field is preserved within the union.  We want further financial integration to ensure effective monetary policy transmission to the real economy across all monetary union.

That is what the Banking Union is about.

It is equally important to clarify what the BU is not about.  First of all, it is not about trying to enforce uniformity of financial systems across member states. 

United in diversity - is the motto of the EU. So quite explicitly we never intended to achieve uniformity across member states as we value diversity.  I would dare to say diversity in financial services is as valuable as in any other dimension.  Uniformity in business models for banks can be a potent amplifier of systemic risk.  Thus we have to preserve diversity of risk strategies but in such a way that limits regulatory arbitrage and risk taking at the expense of the others.

We are not trying to achieve a fiscal transfer union, where free riders enjoy the fruits of hard working and prudent. That’s why we are spending endless hours debating the incentive structure of the Banking Union arrangement.

We are not trying to achieve unification of insolvency regimes across member states.  But we should.  European Commission consultation on the European approach to business failure and insolvency is closing in several weeks.  Differential treatment of personal bankruptcy as well as corporate insolvencies does not add to the sense of a level playing field as well as the reduction of imbalances across member states.

Supranational insurance

Back in 2004 Robert Shiller argued that we need to push financial development further to ensure that people can hedge much broader set of real risk factors using financial instruments. Taking the argument to extreme there is no reason why there should not be a market for cross country economic growth or financial crisis insurance, where a country experiencing an unexpected economic contraction would get a payout based on the insurance policy it has subscribed to.  Banking union has the potential to become such risk sharing mechanism in allowing sovereign countries to pool their banking sector risks together under the single resolution mechanism and a joint fiscal backstop.  As in any insurance scheme, incentives must be set right to ensure no free-riding takes place and excessive risk taking is punished.  Like in any insurance contract, legal small print is of utmost importance as it is crucial to understand, what constitutes an ‘insurable event’.

Macroprudential regulation

Latest research underpinning macroprudential regulation shows that independent agents acting in their own interests fail to see that their collective actions are increasing the likelihood of situations in which they all face strictly binding borrowing constraints. In this adverse scenario collateral values spiral downwards and borrowing constraints deteriorate further.  The conclusion is that if left to market forces economy becomes characterized by an over-borrowing equilibrium with too little financial slack and thus too frequent financial crises.  Imposition of macroprudential measures (i.e. LTV limits) has the potential to reduce the likelihood of finding ourselves in such downward spiral. 

One can extend such an argument to a monetary union. Indebtedness levels across member states are arguably too high from the monetary union perspective as member states fail to internalize the negative externalities of their debt levels (state, household or financial sector).  If we accept this argument, then some level of centralization of macroprudential policy at the EU level is justified and desirable.  It would reduce the likelihood of cross country imbalances and thus would add to the financial stability of the union.  As of today we do not have such an element in the draft BU legislation being discussed.

Difficult task of the EU Presidency

The task of the Lithuanian EU Presidency is to find a solution to what seems to be an impossible balancing equation of national interests, long term and short term objectives, as well as different political cycles of the EU member states.  Could the coordination problem be more complicated than that?  A non-euro zone country leads a ground breaking Banking Union project of the eurozone.  That is the beauty of the EU – putting union interests above national ones.

Several years ago, when asked, a friend and a colleague at the FRB New York said that the predominant opinion from across the pond was that euro crisis while annoying is not too worrying, since it is just a problem of coordination, and not a question of there not being a feasible solution. ”You, Europeans, just need to get your act together, as the magnitude of the issue is not that great”. At least it looked that way back then. Not so much anymore.

Coordination (or to be more precise the lack of it) is the essence of euro crisis. Several years ago market participants started having serious doubts if member states are not diverging while following their national interests. In their opinion the European family was headed for a divorce.  Regulators managed to assure the markets that they will do ‘whatever it takes’ to save the family.  The notion of the family is an important one.

Correlated equilibrium

Battle of the sexes is a two player coordination game where two agents (wife and a husband) with slightly different preferences (football and opera) are trying to coordinate on a Saturday venue to go to without talking to each other.  Attending the venue without a spouse is of no value, but attending the venue of preference is desirable.  The game has two so called pure strategy Nash equilibria where the couple either goes to opera or enjoys a game of football.  But both of these equilibria are unfair.

There is also a possibility of a mixed strategy equilibria where both family members go to a particular venue with a certain probability. But this fair equilibrium is inefficient.  Due to frequent misscoordination the husband would be better off just sticking to the opera, while his wife would rather go to a football match every Saturday. If fairness and efficiency is equally important, looks like the family is set for divorce.  

Not necessarily. That is if they follow Robert Aumann’s1 advice.  If they manage to condition their strategies based on some commonly observed event (as simple as if it rains or not) pure coordination will be achieved and fairness ensured.

Banking Union is such a coordination device. Member states have different preferences towards resolution of failed financial institutions. But being alone either on one end of the spectrum or the other is not desirable. Uncoordinated resolutions of financial institutions are inefficient and lead to fragmentation of the single market against the core objective of the European economic integration.  

Financial market demands to know with certainty if the euro family should be expected at the football game or the opera. Unfortunately providing that level of certainty is not feasible as it is bound to be unfair for some in the family.  What Banking Union can offer instead is a coordination device that makes sure that depending on the situation EU member states will follow coordinated actions which will ensure efficiency and fairness.  We will achieve this via single supervisory mechanism, single rule book and single bank resolution and restructuring principles that leave enough clearly articulated conditional flexibility for member states.

Be it rain or sunshine, but if it pours we better all be at the opera.

 

1 Nobel Prize in Economics 2005, for having enhanced our understanding of conflict and cooperation through game-theory analysis.