2015.12.03_Daniela Gabor_Banking Union. a Response to Europe's Fragile Financial Integration Dreams - 2014

8/18/2019 2015.12.03_Daniela Gabor_Banking Union. a Response to Europe's Fragile Financial Integration Dreams - 2014

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Daniela Gabor

UWE Bristol

Banking Union seems to be the best solution to secure European financial stability and,

at the same time, to have a possible governance regime given divergent national

interests. Satisfactory compromises appear to have been reached regarding this issue,

however, banking union proposals have not tackled the fundamental challenges posedby the architecture of European finance, shaped by large, complex and systematically

interconnected banks.

Economic Policy Brief No. 3, 2014


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‘...while financial integration is ultimately a market-driven process,

policy plays a key role in creating the conditions for its progress’.

Mario Draghi, February 20141

Since 2010, European policy makers have been struggling with a dilemma: what

governance regime would work best to secure European financial stability vs. what

governance regime is possible given divergent national interests? By March 2014, the

desirable and the possible converged into (some argue, Germany’s vision of) the bankingunion: a single supervisory mechanism (SSM) for large, cross-border European financial

institutions and a single resolution mechanism (SRM) financed by banks.

In an optimistic reading, satisfactory compromises appear to have been reached. First,

crucial elements of supervision and resolution have been moved at European level,promising to resolve the challenges of coordinating the governance of large cross-

border banks. Such coordination between home and host regulators, we know from

Eastern Europe’s experience, is difficult. When at the height of the banking crisis in2011, Austria announced tighter lending standards on the subsidiaries of Austrian banks

in Eastern Europe, regulators there interpreted this as a poorly-masked attempt to

strengthen the balance sheet of the Austrian parents by clawing back funding from

subsidiaries. Faced with vocal protests, the Austrian central bank backtracked.

Similarly, since 2010, Hungary has come under sharp criticism from parent regulators

when it forced its banks – mostly foreign-owned (Austrian, Italian, Belgian) - torenegotiate the terms of mortgages in exotic currencies (Japanese yens, Swiss francs)

and to fund mortgage relief plans. Unilateral actions, it is hoped, would no longer be

necessary once the ECB takes over. This will help reverse the financial fragmentation

brought by the crisis.

Second, its architects argue, the banking union will significantly loosen the dangerous

embrace between banks and governments - the sovereign-bank feedback loop- that

nearly destroyed the eurozone. Under the ECB’s careful supervision, banks will no

longer pursue aggressive expansion strategies that would render them large and

vulnerable enough to destabilize their governments (as in Ireland’s case) and equally

important, governments will no longer rely on their banks to gobble up debt in order toavoid the market discipline imposed by other, less co-dependent investors. The Single

Resolution Fund will ensure that banks, rather than individual member states, bear the

burden of shutting down failing banks. Better decision making structures will allow for

urgent solutions to banking stress.

Critics have focused on the details of the compromise. The resolution fund - projected to

reach EUR 55 bn over the next eight years through levies on banks - is dwarfed by the

size of Europe banking sector assets, in 2013 calculated at around EUR 31 trillion.

1 ‘ Financial integration and banking union’ . Speech at the conference for the 20th anniversary of theestablishment of the European Monetary Institute, Brussels, 12 February 2014. available at

http://www.bis.org/review/r140213a.htm


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Member states still retain veto power over failures, and historical precedent suggests

these will not hesitate to use it, particularly where the failure of large cross-border

banks is at stake. Furthermore, hopes that ECB will resist pressures from both

governments and banks – when, for example, it conducts the stress-test exercise in late2014 – may be misplaced. After all, it is worth remembering that German opposition

delayed Draghi’s ‘whatever it takes’ moment until 2012, a long two years into thesovereign debt crisis. This promise, rather than the announcement of banking union

plans, restored stability in Europe.

Concerns about details, this brief argues, mask a larger issue. The banking union

proposals have not tackled the fundamental challenges posed by the architecture of

European finance, shaped by large, complex and systemically interconnected banks. The

predicament of the European project is that financial integration has been achieved by

encouraging European banks to become ‘too important to fail’ through business modelsreliant on market-based activities, including shadow banking. Indeed, it is no

coincidence that two out of three banks rescued in Europe had become vulnerable

through their substantial trading activity. The dichotomy bank vs. market-based

financial systems no longer holds for Europe. Its financial systems may be bank-based,

but systemic European banks are increasingly market-based .

Policy initiatives since the crisis, including the recent push for re-energizing

securitisation, highlight the enduring faith that European governments and policy-

makers have placed in market-driven financial integration. Yet this commitment,

unshaken by the banking and sovereign debt crisis, has not generated an institutional

architecture that can mitigate its systemic vulnerabilities. While the sovereign-bank loopis central to those vulnerabilities, its resilience stems from the crucial role that

government debt has come to play in the stability of market-based banking and finance

broadly defined. Such structural change blurs the line between safeguarding financial

stability and monetizing government debt. Financial stability requires either a

fundamentally different mandate for the ECB (normalizing Outright Monetary

Transactions) or legislating into existence a European safe asset.

Market-driven financial integration….

Before the crisis, member states, the ECB and the European Commission supported a

financial integration agenda largely set by private finance that promised substantial

benefits without any apparent political costs. For member states, market-driven

integration would (a) create a de facto fiscal union, where financial institutions would

provide market liquidity to all sovereigns, thus eroding differences in funding costs; (b)

enable national banking champions to become global players, competing successfully

with US financial institutions and (c) allow cross-border banks to finance the most

effective firms, improving the allocation of capital across eurozone. For the ECB,

integrated markets would strengthen the effectiveness of its interest rate decisions

across the Eurozone (the transmission mechanism).

The project of financial integration delivered on its promises at an uneven pace. While

retail banking remained highly segmented, securities and wholesale money markets – where financial institutions lend to each other, issue debt or trade risk - integrated


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faster. By 2008, Eurozone banks lent 85 of every 100 euros to domestic borrowers, 12 in

cross-border loans to Eurozone residents and only 3 outside Eurozone. In contrast,

around 40% of lending between banks took place in cross-border markets, while one of

every two EU bonds belonged to portfolios of institutions residing elsewhere in Europe.Yield differentials between eurozone sovereigns narrowed substantially.

This dismantling of wholesale borders can be traced to banks ‘collective migration’ tomarket-based business models focused on high-risk, high-leverage activities, as Andrew

Haldane, from the Bank of England, put it. Traditional retail banking activities remained

largely confined by national borders and only generated a third of European banks’balance sheets by 2008. In turn, banks grew balance sheets by purchasing and trading

assets issued in other (including eurozone) countries, and funded them by borrowing

from each other in short-term debt-based markets. Capital flew from banks in the

European ‘north’ to the ‘periphery’, where it financed current account deficits, credit and

housing booms. For example, German banks’ exposure to Greece, Ireland, Italy, Portugaland Spain (GIIPS) increased from EUR 100 bn in 2000 to around EUR 500 bn in 2008.

But this was not only a European affair. Rather, European banks became global players

through aggressive expansion strategies. Consider the list of financial institutions that

the Financial Stability Board describes as global systemically important financial

institutions (G-SIFIs) on criteria of size, complexity and systemic interconnectedness.

Half of the 29 G-SIFIs that made it on the FSB list in 2011 were headquartered in Europe,

ten in Eurozone. Some of these had grown close in size to (Deutsche Bank, Unicredit,

Societe Generale), or even bigger than (BNP Paribas, Barclays), the economy of the home

country by 2008. Implicit guarantees from governments gave large banks costadvantages, lowering their funding costs by as much as 90 basis points, according to

recent IMF estimations. Global operations, often driven by strategic regulatory and tax

considerations, saw European banks become big players in the US shadow banking

world. A good example is the US market for asset-backed commercial paper (ABCP), the

first to experience problems in 2007. Large European banks funded their investments in

higher-yield US asset-backed securities in that market, through off-balance sheet

vehicles (read regulatory arbitrage). Seven out of the ten largest bank-sponsors of ABCP

conduits were European, while the ten largest bank-conduits all had European bank

sponsors. When subprime mortgage problems ignited runs on the ABCP market,

European banks were left with large US dollar funding shortages that were eventually

met by coordinated action from the US Federal Reserve and the European Central Bank.

Crucially, European policy makers, often coordinating explicitly with finance lobbies,

have put in place policies that encourage(d) banks to accelerate financial integration by

developing market-based activities. This, for instance, is the stated intention of recent

efforts to re-launch the integration project by reviving European securitization markets.

Indeed, the ECB has been working hard to change the narrative around securitization,

since the crisis conceived as the Achilles’ heel of (shadow) market -based finance. With

proper transparency in place, the ECB argues, high-quality securitization would lead to

more diversified funding in Europe, easing financing conditions for small and medium

companies. To incentivize banks to issue SME loans and then securitize them, the ECBhas proposed lower capital requirements on these instruments, and simultaneously,


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promised to accept asset backed securities as collateral for its loans to banks.

Transparency is the new mantra for harnessing the positive potential of securitization

activities for the European integration project.

Doubts about the transparency emphasis aside, it is more interesting to ask why the ECB

has abandoned the focus on its erstwhile favourite market for promoting financial

integration, the repo market. After all, the European repo market, the main source of

short-term funding for banks, is now more fragmented than ever. One possible answer is

that the crisis has made repo markets politically salient as systemic shadow banking

markets, in need of closer regulation. Until the FSB, the ECB and the European

Commission finish their regulatory deliberations, the repo market cannot carry the

burden of re-energizing financial integration. More important, however, is that the repo

market has become inconvenient for the financial integration narrative since it

highlights the dependence of European banks on government debt for funding, and the

importance of government debt for financial stability. Market-based banks need safe

assets to preserve access to market funding, and since the crisis, to meet a litany of new

regulations.

...and the changing role of government debt in market-based finance

The repo (repurchase agreement) technique is in economic terms a loan against

collateral and in legal terms, a sale of an asset with a commitment to repurchase it at a

later date. The distinction matters in that a repo lender of cash, the legal owner of

collateral, can sell that collateral in case the borrower defaults, and thus recover the

cash loan without waiting for tedious bankruptcy procedures.

Repos connect several markets that provide or require collateral, including securities

market, government bond markets, the unsecured money market, derivative and swap

markets. This is why the ECB and the European Commission pushed for the integration

of national repo markets, expected to support a market-driven integration of the various

markets that repos connect. The Commission, through the 2002 Financial Collateral

Directive, unified legal framework for the cross-border use of collateral. In a similar

move to current securitization initiative, the ECB, who uses repos to lend to banks,

designed a collateral framework that treated all eurozone sovereign debt as equal

collateral. It hoped that private repo markets would follow suit - which they did - leading

to a de-facto integration of government bond markets .

Under such (policy) incentives, the European repo market grew rapidly to become the

largest source of short-term funding for European banks. It tripled in size between 2002

and 2008, to around EUR 8 trillion, similar in size to the US repo market. Unlike that

market, the European repo market was, and remains, dominated by large banks. In

2008, the 10 largest banks generated, around 55% of repo transactions, a share that

increased above 80% for the 20 largest European banks. The repo instrument proved

attractive because it allowed banks to grow balance sheets at low costs: a bank could

fund purchases of new securities by using these as collateral to raise cash in the repo

market. Leverage was cheapest where banks used sovereign debt as collateral.


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Thus, 80% of collateral circulating through repo networks was issued by European

governments. Reliance on short-term repos made sovereign debt crucial for bank

leverage, so that demand for government debt - and the improved liquidity of sovereign

debt markets - also reflected banks’ leverage strategies. Rather than systemic risks,European institutions and member states chose to see the financial integration benefits

of this (sovereign-bank) process: by 2008, GIIPS sovereign bond markets together

supplied around 25% of sovereign European collateral, on similar terms to what we now

describe as ‘safe’ sovereigns. Italy alone, with one of the world’s largest sovereign debtmarkets, accounted for over 15% of collateral supporting EU repo markets, only

surpassed by Germany (with a 20% share). Italy and other ‘periphery’ governments

benefited from increased demand from global banks in the ‘north’, who builtgeographically diversified portfolios of government debt to fund their global expansion

strategy. In turn, banks in ‘periphery’ countries diversified less, since they could use the

debt of the home sovereign as collateral to borrow from, say, German banks.

Then, the banking crisis made apparent that the repo-market based relationship

between governments and banks may quickly turn from mutually beneficial into a

‘deadly embrace’, as commentators now routinely describe the sovereign-bank loop.

Scholars and policy makers now recognize that modern runs in market-based financial

systems start, and/or are propagated, through the repo market . What matters in a crisis

of market-based finance is the confidence that financial actors have in the liquidity of

assets used as collateral to roll over short-term funding. This is why, for example, Basel

III introduced mandatory liquidity ratios for banks. Only the safest of assets retain their

high-quality collateral status, while fire-sales spread through lower-quality collateral

markets. In Europe, however, the determinants of ‘safety’ are not clear-cut preciselybecause European institutions allowed the European repo actors to establish their own

architecture for a market that turned out to be systemic but has no official backstops.

The ECB initially hesitated to provide backstops to the European repo market that it

helped create in the first place. Throughout 2009, its extraordinary liquidity injections

helped stabilized European repo markets since the ECB took from banks low quality

collateral that would not have been accepted in private repo markets. Yet throughout

2010 the ECB send various signals that it would not deal with a growing collateral crisis

but instead push ahead with its exit plans. It refused to intervene in Greek government

bond markets even though contagion threatened sudden stops in other eurozone

sovereign debt markets. Despite that threat, the ECB then tightened collateral standards(charging higher haircuts on lower-rated government debt), and pressed Ireland to

weave Irish banks off its emergency liquidity support.

Doubts about the ‘safe asset’ status of eurozone sovereigns spread, with systemicconsequences since a quarter of the repo market, it is worth recalling, was collateralized

with the debt of sovereigns whose banking systems had financed housing booms and

large current account deficits. Northern European banks that had lent to periphery

banks against periphery sovereign collateral before the crisis were no longer willing to

do so, to avoid ‘t wo-way risk’ that banking problems may undermine the sovereign and

vice-versa. Systemic repo actors - such as LCH Clearnet, Europe’s largest clearer of reposwith government bonds - introduced new sovereign risk management frameworks with


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triggers to make repo financing more expensive if the spread between sovereign

collateral and German bonds went above a certain level, a clearly pro-cyclical practice

that affected both Irish and Portuguese government bonds . By 2012, the sovereign debt

of Portugal, Greece and Ireland no longer circulated in repo markets, while the share ofItalian and Spanish sovereign collateral was falling rapidly. Europe’s crisis of (shadow)

banking and collateral reversed financial integration, just as much as the repo market

helped it before the crisis.

From a collateral angle, the ECB’s ‘whatever it takes’ moment was such game changer

precisely because it put an end to the uncertainty about the collateral qualities of

eurozone sovereign debt. It crystallized two years of hesitant purchases under the

Securities Market Program into an unequivocal commitment to provide a backstop to

European repo markets, even if that meant supporting European governments. This

commitment was so effective that markets never tested it.

….beyond the bank ing union

The shift to market-based banking in Europe has created an important gap in the

institutional architecture that must be filled with clear rules for governing cross-border

collateral flows and for providing backstops to European repo markets. For member

states, this is important because the standing of a sovereign in financial markets is

evaluated through the collateral quality of its debt, in turn influenced by a series of

factors outside its control: the expansion strategies of its banks and vulnerability to

short-term funding shocks, the portfolio decisions of both resident and non-resident

debt holders, the risk management frameworks of private repo actors and of the

European Central Bank.

Without a different mandate for the ECB and/or single safe asset, several avenues are

possible:

First, governments can independently intervene in repo markets, as some do already.

Indeed, a 2012 survey undertaken by the Italian treasury across sovereign debt

management agencies showed that governments are increasingly concerned about what

it means to be part of the shadow-banking world through repo markets. The survey

documented significant diversity, contrasting sovereign debt management offices that

intervene actively with those, such as Italy, that do not intervene at all. Such diversity of

operational frameworks is surprising given that repo markets may introduce, the surveyrecognizes, (speculative) volatility in government bond markets. However, even if

interventions become normalized, sovereign debt managers are better placed to address

collateral shortages than sudden stops in collateral markets.

Second, European regulators could introduce a stronger regulatory/taxation regime to

modify the architecture of repo markets. Given the pro-cyclical effects of collateral

practices, European policy makers may ask whether the repo promises - liquidity and

financial integration - are illusory. Governments could impose counter-cyclical haircuts

on repos collateralized with government bonds to delink the collateral function from

leveraged bank activities, proposals that FSB has now dropped from its repo reformagenda. Alternatively, governments could tax repo liabilities, making repo-based


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leverage more expensive. The avalanche of protest against the European Commission’s

proposals to tax repos in the Financial Transactions Tax suggests this route is less likely.

Third, regulatory incentives could be put in places for the market driven creation of a

euro area safe asset. This is the ECB’s favourite route, one that circumvents the politicaldifficulties of either changing its mandate or convincing governments to pool

sovereignty. Transparent, high-quality securitization, is expected to be a first step in this

direction, generating ‘reliable’ collateral to substitute government debt. The next step is

to convince banks, particularly in the ‘periphery’, to look beyond their sovereign. Thedifficulty, of course, is that geographical diversification may end up benefiting Germany,

now the de facto issuer of the euro area safe asset. Germany is happy to enjoy the

benefits of safe asset status but notably reluctant to probe into the conditions that create

that status, or indeed, to ask broader questions about the role of central banks and

government debt in market-based financial systems.

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2015.12.03_Daniela Gabor_Banking Union. a Response to Europe's Fragile Financial Integration Dreams - 2014