24. Breaking the doom loop: towards banking union

In the spring of 2012, Spain too was suffering from downgrades as it struggled to get its banking system under control. The banking crisis would soon force the Spanish government, under its Prime Minister Mariano Rajoy, to seek euro area aid. Yet Spain was far from alone in its concern about the financial sector. Countries across the euro area feared some of the biggest banks could collapse, bringing down sovereigns and the common currency with them.

This phase of the euro crisis reshaped the political map of Europe, eventually helping spearhead a drive to address the sovereign-bank nexus, which was seen as one of the biggest threats to financial stability^[1]. Creating tools to break that so-called ‘doom loop’ seemed a logical method of defence. There would also be a move to end the fragmentation of financial markets within the currency union by creating a common EU supervisor and a bank resolution regime.

IMF chief Lagarde was among first financial leaders to call for a European banking union. The euro area already had a central bank, but the continent-wide industry lacked coordinated supervision to prevent banks from taking on too much risk, and it did not have comprehensive deposit insurance that could help prevent a bank run.

Unlike in the US, where the Federal Deposit Insurance Corporation had been set up in 1933 in response to the Great Depression, there was little precedent on the EU level for how to handle a failing private lender. Generally speaking, few avenues other than state support shielded consumers and investors from the consequences of a bank failure.

When the euro was launched, banking supervision was the sole preserve of individual member states. As it became clear that a problem in one country could imperil everyone, however, policymakers began to believe that any bank big enough to pose a systemic threat to the euro area should be supervised at that level.

In a 17 April 2012 speech, Lagarde noted that the fragmentation of financial markets had been created by a patchwork of financial regulation and oversight that left the common currency struggling to preserve financial stability. She pointed to the growing worry of a vicious cycle between banks and sovereign nations, where the misfortunes of one could topple the prospects of the other. Europe had seen this work both ways: the banking sector’s problems damaged Ireland’s overall economy, whereas Greece’s banks, heavily invested in their sovereign’s domestic debt, were harmed by the Greek public debt crisis and its impact on the broader economy. ‘To break the feedback loop between sovereigns and banks, we need more risk sharing across borders in the banking system. In the near term, a pan-euro area facility that has the capacity to take direct stakes in banks would help,’ Lagarde said. ‘Looking further ahead, monetary union needs to be supported by stronger financial integration which our analysis suggests be in the form of unified supervision, a single bank resolution authority with a common backstop, and a single deposit insurance fund’^[2].

Changes in Europe’s political constellation would put together a coalition to tackle banking problems. In May 2012, voters in France replaced President Sarkozy, who had shaped the crisis response alongside Germany’s Chancellor Merkel, with the socialist François Hollande.

Ahead of a Group of 20 summit in June 2012, there were increased calls for the euro area to do more to help countries such as Italy weather the crisis and steer clear of potentially crippling contagion. When leaders met on 18 and 19 June in Los Cabos, Mexico, the euro area was urged to shore up its financial foundations.

‘We fully support the actions of the Euro Area in moving forward with the completion of the Economic and Monetary Union,’ their statement said. ‘Towards that end, we support the intention to consider concrete steps towards a more integrated financial architecture, encompassing banking supervision, resolution and recapitalization, and deposit insurance’^[3].

In the run-up to the 29 June 2012 European summit, tension mounted over whether or not the EFSF – or the ESM, then a few months from its inauguration – should be called into action to buy bonds of countries where market access appeared to be tenuous. While the purchasing tools existed, there was no consensus on whether to activate them.

A former European commissioner, Mario Monti, had become Italy’s prime minister in mid-November 2011, bringing with him a pro-European mindset and a government committed to reforms. The economics professor was trusted as a safe pair of hands by other European leaders – and crucially by financial markets.

In Monti’s view, Europe had to stand for something positive lest market turbulence destroy confidence in the entire euro project. His support would be pivotal for the emerging concept of banking union within the monetary alliance.

Italy’s Monti, joined by France’s Hollande and Spain’s Rajoy, rallied support for more help.

Euro area leaders eventually zeroed in on financial infrastructure as the area where they could make the most impact. They directed their finance ministers to develop a strategy to help troubled banks directly without burdening the balance sheet of any already struggling country^[4].

In a 29 June summit statement^[5], the leaders laid the foundation for what would become the euro area banking union, envisaging a move to common supervision and resolution powers alongside harmonisation of national deposit insurance laws. The banking union would be mandatory for members of the common currency and open to any other EU countries wishing to join. Euro area leaders also pledged to use the ESM to help banks directly as necessary to protect financial stability.

This June 2012 commitment to banking union was a major breakthrough for Europe. The commitment to joint financial sector safeguards allowed the currency union to move forward.

Banking union has three main elements: supervision, resolution, and deposit insurance^[6]. The first element aims to keep banks from getting into trouble by making sure a European regulator monitors day-to-day affairs. The second is designed to make sure that EU-wide there is a safe way to restructure or shut down a failing bank, avoiding a chaotic collapse that could spawn contagion. And the third element focuses on protecting the broader economy by reassuring savers that the banking system is safe and that they can access their insured cash – up to €100,000 – even if a bank falls on hard times^[7]. This can prevent national bank runs.

Using a section of the EU Treaty that allows the ECB to take on new powers, the leaders called on the European Commission to draft a proposal for a single supervisory body. This was a major success for those favouring greater integration throughout the euro area, as it made it possible to create a joint banking supervisor.

The political breakthrough led the euro area to create a new regulator, housed at the ECB: the Single Supervisory Mechanism, which became operational in November 2014^[8]. It has direct oversight of about 120 systemic banks across the bloc^[9] – the three biggest banks in every country, plus others that operate across borders or meet certain thresholds and are also considered systemic.

The euro area also adopted a Single Resolution Mechanism for banks under ECB oversight^[10]. Euro area member states backed this up by asking banks to begin paying into an accompanying Single Resolution Fund and build it up to its target of 1% of the deposits of the banks in the participating countries, initially estimated at €55 billion^[11]. This fund is ramping up over eight years from 2016 to 2023, with the full capacity to be reached in 2024.

There was some initial talk of housing the resolution agency and its fund at the ESM, but euro area leaders decided against making the soon-to-debut ESM fully responsible for salvaging banking sectors weighed down by legacy issues. Meanwhile, the ESM had been tasked with developing a tool for recapitalising banks directly.

The EU made tremendous strides on the supervisory and resolution fronts between 2012 and 2014, while the ESM was developing its direct bank recapitalisation capability.

For more on the direct recapitalisation instrument, see Chapter 34.

Although that instrument was never deployed, Andres Sutt, then ESM head of banking, called it an important part of the arsenal. ‘It’s better to have the option in your toolkit than not have it at all,’ Sutt said. ‘If things get really bad, then you have something at hand to use.’

Another European priority during this period was to draw up a legal framework for dealing with troubled banks, setting out a clear hierarchy for assigning losses to different classes of investors. The landmark bank recovery and resolution directive was set up to govern the treatment of failing banks. It requires banks to create recovery and resolution plans ahead of time and began taking effect at the end of 2014^[12]. These rules, which apply to the entire EU, not just the euro area, changed the parameters for the ESM bank recapitalisation instrument even as it was being developed.

The core principle of the directive is that bank creditors such as shareholders and bondholders must bear losses before any public support can be drawn upon. This reflected a standardising and toughening of previous EU approaches on public aid to banks, which limited state aid under EU competition law but didn’t dictate losses in such a specific way.

In Ireland and Spain, for example, the question of whether or not and how to force senior bank creditors to take losses became an integral part of the debate around their rescue programmes. At one point early on, Ireland had wanted to ‘bail in’ – or impose losses upon – senior bank bondholders as well as junior investors, only to be dissuaded by its fellow euro area member states. At that time, there was a view that pushing bank bonds into default could further escalate the crisis.

By the time it became apparent that Spanish banks would need recapitalising, consensus was building around the idea that junior creditors, at least, should always absorb losses before taxpayer funds were put at risk. But the idea was still controversial, particularly because in some countries bank bonds were marketed to consumers as equivalent to cash savings accounts, even though they posed greater risks.

The bank recovery and resolution directive aimed to make clear to investors up front what risks they were taking. It became an essential part of the long-term effort to strengthen the euro and its financial architecture. In a move to limit the tapping of taxpayer funds, the directive also required the banking industry to fund the cost of resolution wherever possible. To accomplish this, every EU Member State was required to set up a bank resolution fund financed by industry fees. Some countries already had a system in place, while others had a deposit insurance scheme to coordinate with. Even after the euro area created a common resolution system for the currency area’s biggest banks, countries also continued to need national systems for banks not covered by regular ECB supervision.

Since 2016, the euro area has had common systems for two elements in banking union, supervision and resolution^[13], and it is establishing rules on national frameworks for the third, deposit insurance^[14]. Proposals for a common deposit insurance system, which would complete the banking union fully, may take time before they are ripe for agreement, given important legacy problems with banks in several member states and sizeable non-performing loan problems in some countries.