House of Lords - European Banking Union: Key issues and challenges

European Banking Union: Key issues and challenges - European Union Committee Contents

Chapter 4: Further Steps Towards Banking Union

98. The Single Supervisory Mechanism proposals outlined in Chapters 2 and 3 do not stand in isolation, but were envisaged as the first building block in a comprehensive banking union. In this chapter, we examine the further steps towards banking union that may follow in due course, namely a common resolution scheme and a common deposit insurance mechanism. In addition, we reflect on the findings of the Liikanen Report on reforming the structure of the EU banking sector, published in October 2012. Before doing so, it is necessary to consider the foundations upon which any banking union would be constructed, namely the so-called single rulebook in financial services.

The Recovery and Resolution Directive and banking union

99. The three principal elements of the single rulebook are the Commission's proposed amendment of the Deposit Guarantee Schemes Directive (published in 2010), the capital requirements legislative package, known as CRD IV (published in 2011), and the Recovery and Resolution Directive (published in June 2012).[137] This Committee has previously engaged in detailed scrutiny of the first two of these packages,[138] and the Commission has stated that it is seeking to reach agreement on all three proposals by the end of 2012.

100. The third element, the proposed Recovery and Resolution Directive (RRD), seeks to establish a framework for dealing with credit institutions and investment firms in the event of a material deterioration in their financial position. 'Recovery' is concerned with early intervention to restore an institution or financial group's financial strength and viability. 'Resolution' is concerned with ensuring that the failure of an institution or financial group can occur without severe systemic disruption and without exposing taxpayers to loss. Orderly resolution would be necessary in the event that recovery measures are not feasible or prove ineffective. The main provisions of the RRD are set out in Box 5 below. The proposal is a 'minimum harmonisation' directive, meaning that Member States are permitted to go further if they wish.

BOX 5

The main provisions of the Recovery and Resolution Directive[139]

· It would constitute the first step towards a harmonised EU regime for resolution.

· It would apply in relation to all credit institutions and most investment firms, including financial groups.

· It would require recovery and resolution plans ('living wills').

· It would provide for supervisory early intervention powers where the financial situation of an institution was deteriorating.

· It would specify minimum harmonised resolution tools.

· Resolution tools would include the power to sell businesses to third parties, to transfer a business to a State-owned bridge institution or to transfer bad assets to a publicly-owned asset management vehicle for eventual sale or orderly wind-down.

· Resolution tools would also include bail-in powers, which enable resolution authorities to write down debt or convert it into equity. Bail-in powers would apply to a wide range of unsecured liabilities. Institutions would be required to hold a minimum amount of 'bail-inable' liabilities by 1 January 2018.

· Member States would be required to establish national pre-funded resolution funds.

· It would provide for the use of national deposit guarantee schemes for resolution funding purposes.

101. The Committee currently retains this proposal under the parliamentary scrutiny reserve. We received a substantial amount of evidence on the RRD, which we will take into account in our continued scrutiny of the Directive.

102. The publication of the RRD was followed almost immediately by the June 2012 European Council, which set out the first steps towards banking union, including the possible introduction of a common resolution mechanism. Mr Pisani-Ferry told us that the Commission was aware that the RRD was not fully consistent with the logic of the SSM and at some point it would be asked to come back with further proposals.[140] Mr Lannoo and Mr Persson believed that the RRD had already been overtaken by events.[141]

103. Ambassador Boomgaarden described the RRD as "an essential part of the harmonisation effort."[142] Yet Mr Whyte stressed the limitations of a harmonised approach,[143] arguing that it was "still embedded in the old system of the pre-banking union world, in which these sorts of things happen at national level rather than at federal or eurozone level."[144]

104. Attention is therefore shifting from the harmonised model that the RRD encapsulates, to the potential for a common resolution scheme as a key element of banking union. This again brings the concept of variable geometry into focus. Whereas the Recovery and Resolution Directive, as a harmonising measure, would apply across the EU as a whole, a common resolution mechanism would presumably apply only to those Member States who chose to participate in banking union.

105. The Recovery and Resolution Directive is a necessary step towards strengthening the single rulebook. However, the harmonisation model that it encapsulates is no longer sufficient to ensure the effective operation of the euro area banking sector. While there is a need for further steps towards effective banking union within the euro area in the form of a single resolution mechanism, it is vital that these steps do not risk a deepening split within the single market.

Further steps towards banking union?

106. Besides the Single Supervisory Mechanism, the Towards a Genuine Economic and Monetary Union report also referred to two other legs of a banking union: a potential single resolution scheme and a single deposit insurance scheme under the control of a common resolution authority. Even as the SSM proposals emerged, the prospect of the other elements being implemented quickly was receding. German pressure led to references to the proposal for a common deposit insurance scheme being removed from subsequent reports. President Van Rompuy conceded that whilst the common deposit insurance scheme and common resolution scheme were key elements of banking union, there was no consensus on their introduction.[145]

107. Mr Whyte told us that "if that is what you understand by a banking union then Germany does not believe in one. It believes, and has just about conceded, that you can transfer responsibility for supervising systemic banks, particularly in the eurozone. However, it does not believe in a common deposit protection scheme or a common resolution authority, or in having a common fiscal backstop to the eurozone. The question then is: is Germany going to get its way or, as has been the case to some extent for the past two years, is it going to have to give way on some of these issues over an extended timescale?"[146]

108. The conclusions of the October 2012 Summit reflected these tensions. The Conclusions merely noted the Commission's intention to propose a single resolution mechanism for Member States participating in the SSM once the existing proposals for a Recovery and Resolution Directive and for a Deposit Guarantee Schemes (DGS) Directive had been adopted. There was no reference at all to the proposal for a European deposit insurance scheme.[147] As such, the original banking union model has already been significantly diluted.

109. The financing arrangements involved in a single resolution and single deposit mechanism help explain why such further steps are controversial. The Recovery and Resolution Directive requires the establishment of national resolution funds, which will require ex ante levies on banks and investment firms. The existing Deposit Guarantee Schemes Directive proposes a similar funding arrangement of ex ante levies from the industry, and one option of merging the two funds to create a joint "DGS-resolution fund".[148] The assumption is that, if either a single resolution or deposit insurance scheme were introduced, it would be funded at the European level, with levies on the banks and investment firms from within the participating Member States. But given that crises affecting banks are commonly macroeconomic in nature, any deposit insurance or resolution fund would be likely to run out of funds and ultimately government support would be needed to ensure credibility.[149]

110. Several witnesses argued that some form of debt mutualisation was therefore inevitable.[150] Barclays felt it difficult to conceive of an effective banking union that did not have a mechanism for mutualising the cost of bank failures.[151] Mr Persson told us that, whilst a joint backstop for Europe's banks was a logical element of banking union, given that this would make one Member State's taxpayers liable for those in another, he understood why it was controversial.[152] The UK Government's view was that mutualised deposit insurance and a single resolution authority were such integral elements of a comprehensive banking union that mutualisation of fiscal risk was inevitable.[153]

A) A SINGLE RESOLUTION MECHANISM

111. Taking the two proposals in turn, the Commission's September 2012 paper, A Roadmap towards Banking Union, argued that a single resolution mechanism "would be more efficient than a network of national resolution authorities, in particular in the case of cross-border failures, given the need for speed and credibility in addressing banking crises. It would be a natural complement to the establishment of a single supervisory mechanism. It would also entail significant economies of scale, and avoid the negative externalities that may derive from purely national decisions."[154]

112. Mr Enria called for "stronger steps in the euro area towards a common resolution mechanism—maybe also a common resolution authority."[155] Mr Whyte agreed, stating that "if you are talking about the stability of the eurozone", keeping resolution at the national level "is not really good enough."[156] Mr Pisani-Ferry pointed to the inconsistencies that would result from having a single supervisor but with recovery and resolution remaining at the national level. He argued that, if there were to be a supervisory failure at the European level, national states would not be willing to pay for those mistakes.[157]

113. Others were more cautious. Mr Harding argued that a single resolution mechanism was "not an inevitable or an absolutely necessary thing."[158] Mr Constâncio saw a common resolution framework as the next step, but only for the largest cross-border banks.[159]

114. We recognise the political and technical difficulties in moving towards a single resolution mechanism. However, it is a necessary step if the destructive link between banks and sovereign states is to be decisively broken.

B) A COMMON DEPOSIT INSURANCE SCHEME

115. A common deposit insurance scheme is a mechanism specifically intended to tackle the problem of capital flight. Professor Lastra explained that "with perfect capital mobility, in order to prevent a flight of deposits from troubled countries to countries perceived to be 'safe', one needs to convince ordinary citizens that a euro in a bank account in one eurozone Member State is worth the same and is as secure as a euro in a bank account in another eurozone Member State".[160] President Van Rompuy stated this was a logical step once banking union was in place, but it was "a case of first things first".[161]

116. Ambassador Boomgaarden made clear Germany's opposition to a single deposit insurance scheme with "centralised credit lines between national intervention funds".[162] He stressed that further integration was necessary before a centralised scheme could be considered.[163] More recently, in comments delivered to a German mutual banking event in Frankfurt, the ECB President Mario Draghi indicated that plans for a common deposit scheme may not be revived.[164]

117. Mr Wieser felt that a harmonised approach was sufficient, and described himself as "in a minority of one" in Brussels in questioning the importance of deposit guarantee schemes.[165] On the other hand, Mr Lannoo argued that a single deposit guarantee scheme would be crucial in a crisis, given the need for speedy decisions in terms of cost sharing.[166]

118. Mr Constâncio told us that common deposit insurance could wait for now, and that the immediate priority should be to proceed with the SSM.[167] HM Treasury acknowledged that the proposal for common deposit insurance had been taken out of the Commission road map under German pressure. However they questioned whether this was a sustainable position.[168]

119. We understand the controversial nature of the proposal for the introduction of a common deposit insurance scheme, given that it would represent a significant step towards debt mutualisation. Nevertheless, for banking union to succeed and for the euro area to thrive, some form of common insurance scheme for the euro area would make sense. The case for such a scheme should continue to be made in the coming months.

The Liikanen report

120. In February 2012 Commissioner Barnier established a High-level Expert Group on banking structural reforms, chaired by the Governor of the Central Bank of Finland, Erkki Liikanen. The mandate of the Group was to "assess whether additional reforms directly targeted at the structure of individual banks would further reduce the probability and impact of failure, ensure the continuation of vital economic functions upon failure and better protect vulnerable retail clients."[169]

121. The Liikanen report was published in October 2012.[170] Its central conclusions are set out in Box 6. In relation to structural reform, the Group concluded that it was necessary to require legal separation of certain risky financial activities from deposit-taking banks within a banking group. In particular, they recommended that proprietary trading and other significant trading activities should be assigned to a separate legal entity if the activities to be separated amounted to a significant share of a bank's business. This would ensure that retail deposits would no longer directly support risky trading activities.

BOX 6

Key recommendations of the Liikanen report[171]

· Proprietary trading and other significant trading activities should be assigned to a separate legal entity if the activities to be separated amount to a significant share of a bank's business.

· Banks need to draw up and maintain effective and realistic recovery and resolution plans as proposed by the Recovery and Resolution Directive. The resolution authority should request wider separation than considered mandatory above if deemed necessary.

· Banks should build up a sufficiently large layer of bail-inable debt and such debt should be held outside the banking system.

· There should be application of more robust risk weights in the determination of minimum capital standards and more consistent treatment of risk in internal models.

· There should be an augmentation of existing corporate governance reforms by specific measures to i) strengthen boards and management; ii) promote the risk management function; iii) rein in compensation for bank management and staff; iv) improve risk disclosure and v) strengthen sanctioning powers.

122. Attempts to separate retail banking from more risky activities are by no means a new phenomenon. The USA Glass-Steagall Act (1933), enacted in response to the failure of nearly 5000 banks during the Great Depression, prohibited commercial banks from engaging in the investment business. The Gramm-Leach-Bilely Act of 1999 repealed many of the most essential elements of the Glass-Steagall Act.

123. Interest in structural separation has intensified in the midst of the financial crisis. In the United States, the Volcker Rule, which forms part of the Dodd-Frank Act of 2010, advocates a ban on proprietary trading by commercial banks. In the UK, the September 2011 final report of the Independent Commission on Banking (ICB), chaired by Sir John Vickers, recommended retail ring-fencing of UK banks.[172]

124. The responses of our witnesses to the Liikanen report's recommendations were mixed. Mr Constâncio felt it was an "intelligent compromise between the so-called Vickers proposal and the Volcker rule."[173] Commissioner Barnier agreed.[174] There were, however, some concerns over how the recommendations would be implemented.[175]

125. HSBC argued that, whilst ring-fencing was attractive from a political perspective, there were examples of banks that had failed that would be entirely or substantially inside a retail ring-fence. They felt it unlikely to reduce the probability of bank failure, although it could change the identity of those who bore the cost.[176] Nationwide Building Society thought that ring-fencing would reduce the risk to taxpayers from future crises.[177]

126. Commissioner Barnier and the Financial Secretary to the Treasury were both confident that the Liikanen conclusions were compatible with the Vickers recommendations,[178] although Professor Lastra had greater concerns.[179] Commissioner Barnier told us that the Commission intended to consult on Liikanen's findings and bring forward legislative proposals before the summer of 2013.[180] We will scrutinise any legislative proposals as they emerge. In the meantime we look forward to the findings of the Parliamentary Commission on Banking Standards, which is considering several of these issues.

127. While the case for some form of structural separation within the banking sector may be attractive, the devil is in the detail. There remains considerable uncertainty as to how the ringfence proposed in the Liikanen report will function, and questions remain about its compatibility with the recommendations of the UK Independent Commission on Banking (the Vickers report). The Commission is considering the Liikanen report and we will scrutinise its legislative proposals as and when they emerge. In the meantime we look forward to receiving the findings of the Parliamentary Commission on Banking Standards on its consideration of these issues.

137 Q 212 (Mr Rathi). Back

138 Deposit Guarantee Schemes Directive (EM 12386/10): See House of Lords European Union Committee: Economic and Financial Affairs and International Trade (Sub-Committee A), Correspondence with Ministers, May-November 2010, pp. 16-18:
http://www.parliament.uk/documents/lords-committees/eu-sub-com-a/CWM/CwMSubAMay10-Nov10.pdf; December 2010-May 2011, pp. 12-14:
http://www.parliament.uk/documents/lords-committees/eu-sub-com-a/CWM/CwMSubADec10-May11.pdf; June-November 2011, pp. 11-13:
http://www.parliament.uk/documents/lords-committees/eu-sub-com-a/CWM/CwMSubAJun11-Nov11.pdf,; and December 2011-May 2012, p. 17:
http://www.parliament.uk/documents/lords-committees/eu-sub-com-a/CWM/CwMSubADec11MAY12FINAL.pdf. CRD IV (EM 13284/11 and 13285/11): See Correspondence with Ministers, June-November 2011, op. cit., pp. 44-53; December 2011-May 2012, op. cit., pp. 48-52; and House of Lords European Union Committee: Economic and Financial Affairs (Sub-Committee A), Correspondence with Ministers, May-October 2012, pp. 46-47: http://www.parliament.uk/documents/lords-committees/eu-sub-com-a/CWM/CWMsubA9may31Oct2012.pdf.

Back

139 COM (2012) 280. See EM 11066/12. Back

140 Q 52. Back

141 QQ 68, 205. Back

142 Q 189. Back

143 Q 195. Back

144 Q 205. Back

145 See Appendix 4. Back

146 Q 195. Back

147 October 2012 European Council Conclusions, op. cit. Back