Address by Lars Frisell, Chief Economist, to the European Court of Justice conference

The economic rationale for a European banking union

I would like to thank Professor Thomas von Danwitz and the European Court of Justice for inviting me here today to discuss these crucial issues for Europe.

On 12 September 2012 the European Commission launched its proposal to establish a single supervisory mechanism (SSM) for the Economic and Monetary Union. This set of proposals is thought of as a first step towards an integrated “banking union” which shall include the further components common deposit protection and a single bank resolution mechanism. As set out in the Commission’s proposal, the ECB will be empowered to take over the supervision of any one bank in the Euro Area by the end of 2012 if it so decides, and by 1 January 2014 all banks in the Euro Area shall come under European supervision.

Amid the intense on-going work on both the operational and legal arrangements for the SSM, it may be worthwhile to review the underlying economic rationale. The overriding – and pressing - purpose of a banking union is to break the so-called bank-sovereign link. What is meant by this? My sense is that for many taxpayers in the Europe, it just means taking on other countries’ bank losses - a pure fiscal transfer. This is not what it is about. Indeed, we would not need to invent a whole new regulatory and supervisory structure to perform this.

As I see it, the bank-sovereign link, that has proven so vulnerable in a number of European countries during this crisis, entails three things. First, due to both business logic and regulation, banks hold large amounts of their own sovereign’s debt on their balance sheets. Sovereign bonds typically form the bulk of a bank’s most liquid reserves, used as collateral to raise cash via repo transactions.¹  According to the European capital directives – the current as well as the proposed future one – sovereign bonds from EEA countries denominated in their own currency have a risk weight of zero.²  In other words, they are by statute deemed risk free. Given both recent and historical experience of sovereign defaults, this can seem incongruous. But there is a strong rationale: sovereign states enjoy taxation power, enabling them to increase their revenue at will.³  No other debtors have this power. And as long as debt is issued in the country’s own currency, foreign exchange movements are no (direct) threat to its payment capacity.

Second, while it is a fact we may deplore, creditors of many banks in Europe have enjoyed an implicit government guarantee. Now and then this implicit guarantee becomes explicit, as in the case of Ireland. As you may know, the cost of the guarantee afforded to the creditors of the main Irish banks is one of the dearest recorded in history. But guarantees of different forms have been continuously granted to banks in Europe, where recent examples include Dexia in Belgium, Hypo Real Estate in Germany, Northern Rock in the UK and Parex Bank in Latvia. This means that investors can rationally expect that banks will continue to be bailed out. The value of these implicit guarantees can actually be estimated. For example, credit rating agencies routinely issue two parallel ratings for banks – with and without (the perceived) government guarantee - where each rating corresponds to an estimated probability that bondholders will suffer a loss. The value of the government guarantees for banks – by reducing their funding costs - can be very large, especially during market turbulence, corresponding to a sizeable share of their funding costs or hundreds of millions a year for a large bank.⁴  In other words, bank profits are hugely dependent on the credit worthiness of its country - even if the bank in question does not hold a single domestic bond on its balance sheet.

Finally, the behaviour of banks in return impacts the health of the overall economy. The strength of the banking sector determines its capacity to supply the real economy with credit for consumption and investments. As a case in point, after churning out a reckless flow of credit that fed the massive property bubble a couple of years ago, Ireland’s banks today face great economic uncertainty and pressure to deleverage that stifle their ability or willingness to supply the economy with credit at reasonable costs. Ireland and several other European countries risk facing a dilemma similar to that suffered by Japan during its “lost decade” in the 1990s, when many of its banks failed to shift their credit supply to new, viable enterprises.

To succinctly summarise the three points above: a strong sovereign reinforces its banks via stronger balance sheets and lower funding costs, and banks will in turn be able to supply adequate credit to promote the sovereign’s economic growth.

The strongest rationale for a banking union lies in the fact that this mechanism is self-reinforcing. A banking union does not, by any means, substitute for fiscal consolidation and structural reform in individual member states - but it may facilitate it. The mere suspicion that a State may not be able to meet its debt obligations – correctly or incorrectly - leads to higher bank risk, higher funding costs, more expensive credit to the real economy and ultimately lower growth and even higher sovereign debt ratios. Several European countries have experienced this phenomenon to varying degrees throughout this crisis. Sovereigns are struggling to consolidate their budget balance and may not be in a position to inject sufficient capital into their banks to restore confidence – precisely because this would add further to the Sovereign’s indebtedness and impede on confidence. If you will, States in this position are chasing their own tail. What is needed is a circuit-breaker, a common Eurozone backstop that can supply banks with both capital and liquidity without feeding the Sovereigns’ vicious debt circle. The equity and debt supplied in this manner does not need to be subsidised, but they have to be provided at terms compatible with a long-term view of the Sovereigns, and, crucially, on the intransience of the Eurozone. And if these backstops will be a Eurozone liability, it is natural that bank supervision is firmer under common Eurozone control.

This logic should provide the backdrop for a European banking union. But one must recognise the significant operational and legal challenges to master before this vision can be realised. We must make sure that the ECB, largely inexperienced in the art and science of banking supervision, is ready to take on this huge task with such a tight timeframe. We must work out the practical and legal arrangements between the ECB and the national regulators – and ensure proper accountability to both national and European stakeholders. We must safeguard that the ECB’s integrity as monetary authority remains intact. And we also have to make sure that the interests of non-euro countries in the Union are secured going forward. Today’s conference provides an opportunity to make progress on some of these important issues.

___________________________________________________________________________________________________

¹ This status has been reinforced by the proposed Liquidity Coverage Ratio in Basel 3, where sovereign bonds and a few other high-quality assets comprise the so-called level 1 assets of the liquidity reserve.

² Directive 2006/48/EC Annex VI, Part I, 1.2.4 .

³ Higher nominal tax rates will only increase revenue up to a certain point, where the disincentives to increase taxable output outweigh the higher rates. The relationship between tax rates and tax revenue is known as the Laffer curve.

⁴ See, for example McArthur (2009) and Ueda and di Mauro (2012).