State of the (banking) union: work in progress

Policy in Practice – Regulation in Financial Services

On November 14th 2013, executives from leading financial institutions and think tanks once again joined policy makers, academics and management consultants from A.T. Kearney at the Brussels campus of the Vlerick Business School for the second edition of the “Policy in Practice – Regulation in Financial Services”. Vlerick Business School’s Center for Financial Services hosted this event at a moment when the European Central Bank (ECB) was taking its first steps to implement the new Single Supervision Mechanism (SSM). The European Banking Union was therefore rightfully chosen as central theme for the conference, held under the Chatham House rules.

Obviously, the political agreement to create a full Banking Union takes time to materialize but the current state of affairs indicated lack of clarity and doubts whether a level playing field would ever be achieved. The current design of the Banking Union possibly introduces significant differences in prudential oversight between banks, depending on their size, home base and activity mix. But the emerging consensus also leads to amendments and changes which are hard to anticipate, against a background of tight deadlines. “It is like playing soccer in the fog: we have the players now, but you do not see the corner flags. Where is the level playing field? And does the referee know all the rules? Or are there several referees, each one with his own rules?” one of the participants remarked. The conference therefore explored the true meaning of the banking union, its implications for business and finally its position versus the shadow economy.


The overall banking environment improved over the last 12 months, when the dominant fear consisted of regualtion becoming counter-productive. Europe still sees a slow, uneven and painful recovery and steadily rising debt. Intense competition by shadow banking systems and payment challengers surfaced for the banking industry. On top of that, the piecemeal surfacing of multiple major scandals (Libor, foreign exchange) continues to project a long shadow on the reputation of the financial sector.



The Banking Union is the fourth step the European Union has taken in response to the 8-year old financial crisis, after the fiscal consolidation, so-called Six Pack, the creation of the sovereign rescue fund, (EFSF/ESM) and the ECB’s, unconventional measures (LTRO, OMT). While in general positive about the evolution to date and the potential for the Banking Union, the discussion focused on critical issues in each of the components of the Banking Union; the overall regulatory architecture, the Single Supervisory Mechanism, the Single Resolution Mechanism and the Deposit Guarantee.

Will the current framework for Banking Union work? There is a risk of accumulating requirements as the regulatory bodies are organized at different levels: the national level, the European one and the international one (Basel III). Emphasis to date has been on capital requirements and progress is observed here. However, lack of subsidiarity may increase regulation and reduce transparency, which is next to risk resilience an objective of the Banking Union. For example, the lines demarcating the responsibilities of EBA and SSM still remain blurred. Close cooperation between the ECB and the national supervisors is required to address these concerns, but here this appears not obvious. A specific issue relates to the possible splitting of banking activities, as suggested in the Liikanen report. It is unlikely that Europe will impose such a split, and national governments have quite some leeway in deciding on this.  Some EU countries therefor embrace universal banking as a model, while others advocate separation through ring fencing or other mechanisms (UK).

The SSM has a tiered structure, with the 130 largest banks being directly supervised by the ECB and the smaller ones by national supervisors, using the ECB framework. The ECB has started preparation for the asset quality review in Q1 of 2014 and stress tests in Q3 of 2014 for banks under direct supervision. There is a clear concern that the different structure will eventually lead to different treatment between banks in different countries, different banks in one country and classics banks versus unregulated players. As the SSM focuses on the Eurozone (other countries may voluntarily opt in), the relationship between the Eurozone and other EU countries, and in particular the City of London versus Continental Europe, may be tested as each of them sets different objectives.


Political agreement is in the making around a Single Resolution Mechanism (SRM). There is political agreement on reserving  € 60 Billion of the agreed € 500 Billion agreed firepower, which would allow the ESM to intervene directly in systemic banks in need of capital. This fund will also be allowed to intervene – under strict conditions and as provider of last resort- in distressed banks. But the ESM’s ability to intervene is contained by its treaty and to the geographical scope of the Eurozone. Existing shareholders, junior debt holders, and local authorities are higher ranked to suffer losses and provide additional support.

Finally the current discussions  indicate that Deposit Guarantee could remain a national implementation, without an EU-wide scheme. As a result, it remains unclear what happens if a national authority is unable to cover the guarantee.


What does for example Banking Union mean for insurance companies? While it appears not directly concerned, Banking Union could positively impact insurance companies’ investment policies by providing new diversification opportunities, e.g. more bank issued debt and more geographical diversification by reduced spread risk. In addition, if a similar asset protection guarantee scheme were to be set up for life insurance, the unit cost of such a combined scheme could be lower than a combined industry scheme. The Banking Union may have some negative impact on the commercial side, however, if banks start moving into long term lending, which is now the preferred hunting ground for life insurance companies.

To conclude, Banking Union is a major step to ensure stability and integrity of the European banking system, but the tiered approach, differences in approach towards banking model and demarcation of EU and Eurozone scope fuel risks to maintain and incomplete and tilting playing field.


The second panel discussed implications of Banking Union for banks, from different angles. Here, banks have made significant progress in the last months dealing with implications of Banking Union, but stability for implementation is not yet achieved.


EU banks start to comply with Basel III and core capital ratios have risen from 7% to 11% over the past years. Yet the banking sector, with total assets over 300% of EU GDP, is still excessively large and leveraged. Its total size is likely to significantly reduce further, while focusing on financing the real economy. Total credit is thereby expected to be reduced gradually, but without a ‘crunch’. The Deposit Guarantee scheme, in whatever form it materializes, will drive the need for more transparency. And while the ‘Too big to fail’ issue is not solved, participants felt the SSM could cause another wave of cross-border consolidation.


Large banks with cross-border operations are already facing the challenge of providing large quantities of consistent information to the ECB to enable asset quality review and stress testing, but requirements have not been released. To deliver in time, they should be available as soon as possible, clear, stable and realistic. The division of roles and responsibilities between the ECB and national supervisors, especially for banks with several home markets, is equally an area for urgent clarification to be done.


Smaller banks feel very much squeezed by regulation, which focuses on large banks and ignores more limited operational capabilities of smaller banks, who subsequently suffer extremely large costs for compliance. On top of that, specific banking taxes on for example deposits are much more significant for small banks relative to earnings. Too much regulation scatters in different directions, undermining small banks’ profitability. As the ‘Too big to fail’ problem has not been solved yet, tax payers would still need to rescue systemic banks in trouble. To help small banks, the ECB timing should be more lenient.


Looking ahead, it is far from obvious whether regulation will create sufficient benefits and growth for the financial system to justify the new costs and uncertainties. Given the dynamic aspects of risk and the accumulation of risk over time, the SSM will need to evolve as well. It is therefore expected that the ECB will require more data in the future to monitor the impact on business models and understand the accumulation of risk. In this respect, the current climate of additional data requirements is likely to pertain for the net years.


What can be done to stabilize the situation? Three themes surfaced from the discussion:

1. Parliament should first debate what type of banking sector it wants and then adopt the required regulation to implement that vision. This is the process that was followed by the US and which led to the Dodd-Franck Act and the Volker rule.

2. The regulation should aim for a diversified banking landscape with a level playing field. This includes shadow banking and financial institutions located in less regulated areas, which should not have unfair advantages in terms of competitive positioning.

3. Private investors should be incentivized to invest directly in long term assets, reducing the need for intermediation by the bank in transforming short term assets in long term assets, thereby reducing its balance sheet.


During the last session, the discussion focused on opportunities offered by regulation and government priorities regarding the shadow economy, In particular the role banks and payment providers can play a major role in reducing the shadow economy. Given current budgetary constraints across Europe, the battle against social and fiscal fraud  the shadow economy (meaning all undeclared or underreported income) is a top priority for most governments. The shadow economy is sizable and widespread, as demonstrated by the  A.T. Kearney report made in cooperation with Visa and Prof. Friedrich Schneider: ‘The Shadow Economy in Europe, 2013’, This report estimated the total size of the shadow economy in Europe at 2,15 trillion EUR, representing 18,5% of the total GDP.


Stimulating electronic payments and reducing the cash circulation is one of the main levers governments have to fight this shadow economy and governments can gain substantially from increased electronic payments. Too often, government still looks at payments from a cost point of view, and not as a strategic means to increase fiscal income. Governments could for instance decide to lower the maximum cash amount (which has happened in countries such as Italy or Belgium) or reduce the maximum bank note size for example to 100 EUR. This would reduce the cost of cash to business. The latter is a subject which is often poorly understood in its full complexity. While the complete abolishment of bank notes seems an ideal solution, it remains an illusion as the question would then be how the ECB can guarantee the availability of money to each citizen.  Some cash will have to remain as well as its universal acceptance.


Other ways to reduce the shadow economy are for example shown by the example of Slovakia. By implementing a lottery where each month 150.000 EUR is distributed among citizens who have submit a restaurant VAT-receipt paid in cash, additional VAT-income of 100 million EUR per annum was generated.

The conclusion was that governments, banks, retailers and businesses have to work together to develop enhanced customer-centric value propositions for electronic payments so that the payment will be an invisible part of the purchasing process. Banks can take a leading role in this development and leveraging this to enhance their reputation.


The implementation of the banking union is well underway, but the discussion revealed a number of important questions discussion which remain unanswered. 

How will the ECB tests be conducted? How are we going to assess the differentiated quality of government debt in the quality reviews and stress tests?  Of course, as the political agreement on an SSM is relatively new, open points can be expected, but it appears vital to provide answer fast to prepare for a god asset quality review and stress test in 2013. Further evolution can be expected as the SSM evolves into a mature stage.

How will the ‘Too big to fail’ issue be tackled?  This remains perhaps the toughest issue around.  Today, for smaller countries such as Belgium or the Netherlands, balance sheets of large banks still dwarf the GDP of their home countries.  This maintains a risk and moral hazard in terms of ultimate government bail- out. If, as was suggested, further international consolidation could merge once more once the SSM is stable and implemented, will this lead to a new increase in size of large banks?

What are banks going to be known for in the future? What will be their role in payments? Do we need banks in the future? These somewhat more existential issues point to a deeper set of reflections regarding the nature of banking, even if properly de-risked and supervised.  IN particular, the increasing emphasis on ensuring fair outcomes for customers, as pioneered in the UK and the growing need for customer awareness are important factors.

And will banks succeed in partnering up with governments and businesses to reduce the shadow economy, thereby starting to regain their lost reputation? In an era of fiscal austerity, this question gains in relevance. Staying in the shadow economy is not necessarily hampering activity growth, its relevance for society is more that it is punishing those who comply and are honest, and therefore obtain a competitive disadvantage.  It may be ironic that an industry seeking to rebuild its reputation after many trust-destroying scandals emerges in co-operation with authorities to establish a level playing field in the economy.

The state of the Banking Union is rightly labeled as work in progress, but to create a financial environment with better risk control and more stability, a long process is to be expected.  However, for regulation to be most effective to achieve this, it must be as simple as possible, and maximally strive for a level playing field. This lofty goal will be hard to attain, but could ensure the adoption of a stable environment for development and growth.

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