On September 12, the European Commission published a proposal to establish a banking union in the Eurozone
1.
This proposal delegates the supervision of large cross-border banks to
the ECB. The ECB will also be responsible for supervising smaller banks,
in cooperation with national supervisors. The European Banking
Authority (EBA) can coordinate this through the proposed Single
Supervisory Mechanism.
What consequences do these new developments have for the ECB’s
functioning, reputation and credibility? We review the proposed new
supervisory regime in the light of the ECB’s three demands (Asmussen
2012):
- The primary mandate (price stability) must remain unaffected.
- Monetary policy has to remain independent.
- The ECB has to have access to all instruments necessary for banking supervision.
ECB involvement in banking supervision
The European Commission proposes that the ECB will ultimately be
responsible for all banking supervision in the Eurozone, starting with
banks deemed most important to the proper functioning of the system.
Delegating microprudential supervision to the ECB has several pros and
cons (Padoa-Schioppa 2000, Eijffinger 2009). Firstly, the ECB has an
interest in a stable financial system for the transmission of monetary
policy. It can ensure this with macroprudential oversight via the
European Systemic Risk Board (ESRB), but assessing systemic risks is
made easier by microprudential information. Secondly, the ECB possesses
significant expertise on the financial sector. Finally, the ECB is an
independent body and thus will be less prone to regulatory forbearance
than national regulators.
Will monetary policy remain separate from bank supervision?
However, the ECB’s new task may lead to conflicts with its primary
mandate. This means that monetary policy has to be organisationally
separated from bank supervision, which may prove to be a hard nut to
crack. This is may be especially hard considering the fact that the ECB
has only one instrument, the interest rate. Consequently, the ECB is
demanding new instruments, including access to microprudential
information, intervention rights and the right to close non-viable
banks. There are also reputational risks for the ECB: a bad performance
in its role as a supervisor may reflect badly on its reputation as an
inflation fighter.
Critiquing the proposed rules and structure
How will the banking union, with the ECB at its centre, be set up?
According to the Commission's proposal, the ECB should start supervising
the most systemically relevant banks from 1 July 2013 onwards. After 1
January 2014, the ECB should be responsible for supervising all banks in
the Eurozone. This, however, is unfeasible. There are simply too many
banks to supervise. Instead national supervisors, not the ECB, should
remain ultimately responsible for the supervision of smaller,
non-systemic banks. Coordination of this supervision is facilitated by
the ESRB (the macro) and the EBA (the micro), and this holds for
Eurozone as well as non-Eurozone member states. Furthermore, political
independence should be enhanced and the accountability rules improved
(Masciandaro et al. 2011). National supervisors should not only be
accountable to national parliaments, but also to the European
Parliament. This will level the playing field; there is less scope for
banks to ‘game the system’ by choosing the most favourable regulator.
Figure 1 schematically explains the supervisory structure that we
envisage.
Figure 1. Schematic overview of the new supervisory structure in the Eurozone
Liquidity and solvency instruments
Because the ability to control interest rates is also useful for
financial stability, the Commission proposal aims to officially appoint
the ECB as a lender of last resort. However, this new responsibility may
be accompanied by conflicts of interest between financial and monetary
stability. As long as both objectives can be achieved with one
instrument – e.g. both require lower interest rates – everything should
be fine. However, as soon as inflationary pressures rise whilst
financial stability is low, the two objectives conflict.
That said, it is certainly true that the ECB will have more control
over the banks it assists with liquidity because it can credibly impose
explicit conditionality.
The Commission proposes that the ECB will also have a solvency
instrument. In coordination with national resolution authorities it can
take microprudential early intervention measures. However, in practice
it might be difficult to distinguish where early intervention finishes
and resolution begins. This may cause quarrels over national sovereignty
as resolution efforts are still funded by member states (see the German
discontent with the proposal). Politicians have to reach a consensus on
a truly European resolution mechanism; the cases of Fortis and Dexia
demonstrate why. This should be funded by banks paying premiums based on
systemic risk (Huertas and Nieto 2012, Schoenmaker and Gros 2012).
Constructive ambiguity
However, we should go even further than burden sharing and delineate
new operational procedures. How will the ECB act as a supervisor? To
establish an incentive-compatible supervisory and resolution system it
is important that the ECB is sufficiently credible. This credibility
facilitates building confidence in regulation and thus helps the ECB in
carrying out its new supervisory task. It may be difficult to maintain
this credibility if the ECB’s reputation is impaired by mistakes or
spill overs from monetary policy.
We suggest a solution (Eijffinger and Nijskens 2012); the ECB should adhere to a policy of ‘constructive ambiguity’ ex ante.
This can serve as a solution to forbearance. In a liquidity provision
context (though this can also be applied to early intervention measures)
constructive ambiguity means that the ECB can commit to a mixed
strategy. Never bailing out is too costly and therefore not credible,
while always bailing out leads to obvious moral hazard problems. This
strategy leads banks to behave more safely on their own by holding more
liquid reserves and having a higher capital ratio.
Why adhere to ambiguity?
Adhering to ambiguity gives the ECB the possibility to retain
discretion until the moment that assistance is necessary, thereby
providing banks with the incentive to behave prudently. To see how this
works, consider two polar cases. If the ECB states that all banks will
always be assisted, banks take too much risk. On the other hand, if the
ECB announces it will never bail out any bank, banks become risk averse
and relinquish their function of risk and maturity transformation.
Therefore, by being ambiguous ex ante, the ECB can induce banks to take the appropriate amount of risk.
An important prerequisite for ambiguity is that the ECB has a sound
reputation and is credible. As the ECB is an independent, reputable
institution it is reasonable to assume that it is also credible; this
means it is able to pursue constructive ambiguity. However, some caution
has to be exerted. As Cukierman notes, too much uncertainty about
assistance can lead to risk-averse behaviour, e.g. flight to safety, and
can intensify panics (2012). Careful expectations management is
therefore needed, leading to a tradeoff between ambiguity and
transparency. To make this ambiguity strategy democratically sound, the
ECB should be accountable to the European Parliament.
Conclusions
The European Commision’s proposal assigns to the ECB the task of
systemic bank supervision, and ultimately the responsibility for bank
supervision in the whole Eurozone. It also suggests new microprudential
early intervention powers for the ECB.
Several components are missing from this picture. First, the ECB can
never supervise all 6000 banks in the Eurozone. Non-systemic banks
should be supervised by national supervisors in a harmonised framework
which is set up by the European Banking Authority. Second, supervision
must be separated from monetary policy to avoid conflicts of interest.
Furthermore, European-wide deposit insurance and resolution funds have
to be created. This is an important political issue as many member
states, but mainly Germany, will not accept the ECB as supervisory
authority while resolution is funded at the national level.
Will ambiguity be applied?
Finally and perhaps most importantly, how will the ECB assume its
supervisory task? Will ambiguity be applied? Until now, Mario Draghi,
president of the ECB, does the utmost to be as clear and transparent as
possible, and no sign of ambiguity is to be seen in the liquidity
domain. Perhaps this will change when the ECB is also responsible for
supervision and is able to impose more conditionality on banks receiving
assistance. Adhering to constructive ambiguity can then give banks the
appropriate risk taking incentives.
References
Cukierman, Alex (2012), “Monetary Policy and Institutions Before,
During, and after the Global Financial Crisis”, Paolo Baffi Centre
Research Paper, 115, July.
Eijffinger, Sylvester C.W. (2009), “What role for the ECB on
financial market supervision?”, Briefing Paper for the Monetary
Dialogue, March.
Masciandaro, Donato, Maria J Nieto and Marc Quintyn (2011), “Will
they Sing the Same Tune? Measuring Convergence in the new European
System of Financial Supervisors” in Eijffinger, S & D Masciandaro
(eds.) Handbook of Central Banking, Financial Regulation and Supervision, 485-530, Edward Elgar Publishing.
Padoa-Schioppa, Tommaso (1999), “EMU and Banking Supervision”, International Finance, 2(2), 295-308.
Schoenmaker, Dirk and Daniel Gros (2012),”A European Deposit
Insurance and Resolution Fund - An Update”, Duisenberg School of
Finance, policy paper, 26.
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