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Policy contribution - 'The neglected side of banking union: reshaping Europe's financial system'

With the upcoming Asset Quality Review (AQR) by the European Central Bank, Europe has a chance to fundamentally reshape its financial system to make it both more stable and more efficient. This will require bold action not only to clean up bank balance sheets but also to set a genuine single market for financial services.

Prior to the crisis, Europe’s financial system had become increasingly integrated, especially inside the euro area. However, integration was far from complete. While the interbank market was highly integrated, both retail banking and capital markets remained largely fragmented along national lines. Bank mergers occurred predominantly between institutions of the same country, except in central and eastern Europe. As a result, the share of foreign owned banks’ assets in total assets is still below 10 percent in all the large western EU countries.  

With little retail banking integration, the euro area financial system inevitably fragmented when the interbank market froze as a result of the crisis. In addition, regulatory pressure by national supervisors completely eliminated the little retail banking integration that existed. Given the underdeveloped and fragmented corporate bond and equity markets in Europe, the situation in the banking sector led to massive financial instability and a huge credit crunch resulting in a massive drop in growth.

The AQR offers the opportunity to restore confidence in Europe’s bank balance sheets and terminate the crisis. So far, European countries have provided massive aid to their banks to avoid mergers and bank closures. Refusing to clean up the banks has prolonged rather than solved the banking crisis. Since 2008, only 13 US banks have received public support by the FDIC while more than 50 European banks have received state aids. At the same time, nearly 500 US banks have failed, while less than 50 did in Europe. The difference of approach towards banks between the two sides of the Atlantic has resulted in different outcomes in terms of bank credit, with Europe still mired in feeble lending.  

A tough AQR should be the first step in a process of restructuring Europe’s financial system. Significant recapitalisation and restructuring of the banking sector will be necessary. To de-link banks from sovereigns, the involvement of shareholders and senior bank creditors in the burden sharing will be unavoidable. For the non-viable banks, the key will be to implement restructuring and resolution that are sensible from a European perspective. Protecting national champions cannot be tolerated in Europe's banking union. Cross-border bank sales and mergers should be encouraged by the Single Resolution Mechanism that needs to be set in parallel with the Single Supervisory Mechanism. Only a more integrated retail banking sector would help to credibly break the vicious circle linking banks and sovereigns because it would mean less exposure to debtors, including the government, located in each bank's home country. Governments should provide enough capital to the European resolution fund to recapitalize those banks that are of vital importance for the European financial system. But European recapitalization should also mean European control. Later on, regulatory changes will have to be enacted to limit the exposure of European banks to sovereign debt.  

Reform should go beyond banking: the EU needs to develop a genuine cross-border equity and corporate bond market to be able to absorb shocks. The development of these markets will require further harmonisation of corporate governance, insolvency legislation and taxation. This would reduce the heavy reliance of the EU economy on bank funding and improve economic stability thanks to better financial risk sharing.

Governments should be fully aware that the AQR provides perhaps the last chance for Europe to restore the health of its banking system and to create at long last a stable and efficient financial ecosystem. The era of national champions must be ended. Restructuring and merger decisions must be taken by Europe’s banking union in Europe’s interest.  Choices that will be made in the coming months will determine the future of Europe’s financial system for a long time.  Insufficient and purely national cleaning-up of Europe’s banks will undermine growth and job creation for years. Governments need to do the necessary.

Policy contribution - 'The neglected side of banking union: reshaping Europe's financial system'