The banking union negotiations in the Eurozone have been stuck ever since, in the Ecofin Council of June 2016, the Italian government managed to assemble a blocking minority opposing any further discussions on proposals to reduce legacy risks in banks’ balance sheets. Completing the banking union should now again be given priority, because the current half-baked banking union – lacking a common system of (cross-border) deposit insurance (European Commission 2015) – leaves the Eurozone exposed to idiosyncratic financial shocks capable of endangering its survival. Tackling legacy risks The request that banks’ balance sheets be cleared of legacy risks, before moving to the full mutualisation of losses with the European deposit insurance scheme (EDIS), is legitimate and should be
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The banking union negotiations in the Eurozone have been stuck ever since, in the Ecofin Council of June 2016, the Italian government managed to assemble a blocking minority opposing any further discussions on proposals to reduce legacy risks in banks’ balance sheets. Completing the banking union should now again be given priority, because the current half-baked banking union – lacking a common system of (cross-border) deposit insurance (European Commission 2015) – leaves the Eurozone exposed to idiosyncratic financial shocks capable of endangering its survival.
Tackling legacy risks
The request that banks’ balance sheets be cleared of legacy risks, before moving to the full mutualisation of losses with the European deposit insurance scheme (EDIS), is legitimate and should be heeded. Legacy risks mainly arise from the large stocks of non-performing loans (NPLs) and banks’ exposures to their national sovereigns.
The stock of NPLs in the Eurozone still hovers around €800 billion, or about 5.5% of bank loans, and is concentrated in a few countries – notably Italy, Cyprus, Portugal, Ireland, and, to a lesser extent, Spain. While it is true that the stock has been diminishing too slowly, the robust economic recovery is now adding momentum to their reduction. In Italy, the precautionary recapitalisation of Monte dei Paschi di Siena and the liquidation of two medium-sized Veneto banks and some other small banks will result in the reduction of NPL stock by about one-fourth in the current year.
In addition, new policies to address the issue have been adopted by the Supervisory Board of the Single Supervisory Mechanism (SSM) and the Ecofin Council. Last March, the SSM issued its comprehensive Guidance to banks on non-performing loans (ECB 2017a); banks’ performance in managing NPLs will be part of the SSM Pillar Two supervisory evaluations which, if considered unsatisfactory, may lead to additional bank-specific prudential requirements, possibly including the request to raise capital.1 These measures are already leading to an acceleration in the disposal of NPLs.
Moreover, at its meeting on 11 July, the Ecofin Council called for a comprehensive approach to NPL disposal combining policy action at the national and European levels to improve the efficiency of judicial processes and debt recovery frameworks, develop secondary markets for distressed loans, and foster restructuring of banking systems to adapt to the new business environment (Ecofin 2017).
An even more important legacy risk is banks’ heavy exposure to their sovereign. The EBA 2016 transparency exercise has shown that some three-quarters of total sovereign exposure is vis-à-vis the home sovereign; and bank holdings of their national sovereign typically are on average around 140% of Tier1 capital, with some countries hovering around 200% (e.g. Belgium, Germany, and Italy). This situation raises the possibility of a re-emergence of the doom loop between sovereign distress and banking crisis, in the event investors lose confidence in the sustainability of the sovereign debt of one Eurozone member state.
ESRB (2015) identified two main options to address the problem: i) introducing risk-weighting for sovereign holdings by banks (mainly based on market ratings), thus raising capital requirements; or ii) applying to those holdings some variant of the prudential rules on large exposures.2
Risk-weighting national sovereigns would inevitably affect sovereign markets of highly indebted countries, in the expectation of large sales by banks. Another notable drawback of risk-weighting is its pronounced procyclicality, as risk assessment varies with economic and financial conditions. And, finally, unless risk-weighting were also adopted by non-Eurozone regulators, it would place Eurozone banks at a severe competitive disadvantage. In any event, no agreement on this seems in sight within the Committee on Banking Supervision meeting in Basel, due to the opposition of non-EU countries such as Japan.
A rigid application of the large exposure threshold of 25% of eligible capital currently in force may also prove disruptive both to banks’ balance sheets and (some) sovereign markets, as it would force banks to undertake massive liquidations of sovereigns. However, a gradual entry into force and careful calibration of the new prudential limits could reduce such adverse effects and yet provide sufficiently strong incentives for bank portfolio diversification. Useful proposals for designing the new rule have been developed by Enria et al. (2016) and Véron (2017). Such curbs to exposure would eschew the drawbacks of sovereign risk-weighting since they would be set independently of any credit risk-assessment and therefore would also avoid procyclical effects. They would not distort the level playing field relative to other jurisdictions.
Sovereign portfolio diversification would be favoured by, and indeed require, the establishment of a European ‘safe asset’ that investors – including banks – could turn to in their quest for sovereign risk diversification (Enria et al. 2016). Several proposals have been tabled to address the problem, but so far these have not been favoured by either member states or investors.3 An alternative that has not yet been considered would be to let the ESM offer to exchange banks’ excess sovereign holdings to be disposed of under the new prudential rules with newly issued ESM bonds. The credit risk on sovereigns thus acquired by the ESM should remain with the selling banks and, in case of need, would fall back onto the national deposit insurance funds.
Getting EDIS off the ground
Integrated credit and asset markets within EMU would make it possible to hedge against country-specific sources of risk through capital markets. More importantly, EMU should be resilient – i.e. it should not unravel and become per se a source of instability – in the face of large financial and economic shocks (ECB 2017b).
However, without EDIS, market fragmentation is likely to persist. This seems to reflect to an important extent the uncertainty generated by political events calling into question the future of the monetary union. As has been established by solid academic research, following the seminal paper by De Grauwe (2011), this happens because of a special externality created by the combination of a common currency managed by an independent central bank, and fiscal and economic policies managed at the national level. When the latter diverge, doubts are likely to arise on the sustainability of the sovereign debts of some countries, since the liquidity for their orderly roll-over depends on the willingness of the ECB to intervene as lender of last resort for distressed sovereigns – an intervention that persistent divergence in economic fundamentals makes highly controversial within the ECB Governing Council and official policy circles.
There is an evident paradox here. We can effectively reduce market fragmentation and obtain more private risk-sharing from credit and capital markets only to the extent that investors in financial markets believe that the likelihood of a fresh financial crisis in highly indebted countries is very low – but this requires that the institutional arrangements of EMU provide strong insurance against liquidity shocks hitting either sovereign markets or the banks. This should be recognised as a strong argument in favour of completing the banking union with EDIS – while, of course, continuing work towards risk reduction – because it would eliminate or reduce to a minimum the possibility that a large liquidity shock in one national banking system will again set in motion the doom loop between banking and sovereign crises.
The European Commission (2017) has now aired the idea that in an initial phase of EDIS, the system would only provide a liquidity line to cover any liquidity shortfall of national deposit guaranty schemes (DGSs). The rest would be covered by national DGSs, if needed by charging additional ex post contributions on the banks in that country. In addition, the transition to subsequent phases where national banking losses would be progressively mutualised, would be subject to a targeted asset quality review (AQR) to verify progress in the reduction of NPLs and sovereign exposures.
EDIS could move forward immediately by providing in its early phase that the ESM would offer a liquidity line to national DGSs that had exhausted their funds, with no sharing of losses. Meanwhile, risk reduction would accelerate through the stronger policies already established by the SSM for the reduction of NPLs and a fresh approach to the reduction of banks’ sovereign exposures, based on a modified version of the large exposure prudential policy.
Author’s note: This column summarises the analysis contained in Micossi (2017).
Brunnermeier, M K, L Garicano, P Lane, M Pagano, R Reis, T Santos, S Van Nieuwerburgh and D Vayanos (2011), “ESBies: A Realistic Reform of Europe’s Financial Architecture”, VoxEU.org, 25 October.
Brunnermeier, M K, S Langfield, M Pagano, R Reis and S Van Nieuwerburg (2016), “ESBies: Safety in the tranches“, ESRB Working Paper Series No 21 / September.
De Grauwe, P (2011), “The Governance of a Fragile eurozone“, CEPS Working Document No. 346.
Delpla, J and J von Weizsäcker (2010), “The Blue Bond proposal“, Bruegel Policy Brief 2010/03.
ECB (2017a), Guidance to banks on non-performing loans, March.
ECB (2017b), “Financial Integration in Europe”, May.
ECOFIN (2017), Council conclusions on Action plan to tackle non-performing loans in Europe’, 11 July.
Enria, A, A Farkas, and L L J Overby (2016), “Sovereign Risk: Black Swans and White Elephants“, European Economy, 8 July.
ESRB (2015), ESRB report on the regulatory treatment of sovereign exposures’, European Systemic Risk Board, Frankfurt /Main.
European Commission (2015), Proposal for a Regulation of the European Parliament and of the Council amending Regulation (EU) 806/2014 in order to establish a European Deposit Insurance Scheme, COM (2015) 586 final, 24 November.
European Commission (2017), Communication to the European Parliament, the Council, the European Central Bank, the European Economic and Social Committee and the Committee of the Regions on completing the Banking Union, COM (2017) 592 final, 11 October.
German Council of Economic Experts (GCEE) (2011), Euro Area in crisis, Annual Report 2011/12, Third Chapter, GCEE, Wiesbaden, 18 November.
Lenarcic, A, D Mevis and D Siklos (2016), “Tackling sovereign risk in European banks“, ESM Discussion Paper 1, Luxembourg: European Stability Mechanism.
Micossi, S (2017), A Blueprint for Completing the Banking Union, CEPS Policy Insights No. 2017-42/November.
Véron, N. (2017), “Sovereign Concentration Charges: A New Regime for Banks’ Sovereign Exposures”, prepared in the context of the Economic Dialogues between the European Parliament Economic and Monetary Affairs Committee with the President of the Eurogroup, November.
 Art. 97 of CRD IV provides for the supervisory review and evaluation process (SREP) which is part of the Pillar 2 of Basel Accords. The key purpose of SREP is to ensure that institutions have adequate arrangements, strategies, processes and mechanisms as well as capital and liquidity to ensure a sound management and coverage of their risks, to which they are or might be exposed, including those revealed by stress testing as well as other risks that institution may pose to the financial system.
 For a full description of the regulatory treatment of sovereign exposures in banking regulations, see Enria et al. (2016) and Lenarcic et al. (2016).
Various proposals to establish such a ‘Eurobond’ were discussed earlier this decade, such as the red-and-blue bond proposal by Delpla and von Weiszächer (2010) and the Redemption Fund advocated by the GCEE (2011). These proposals proved controversial for they entailed some backup by the European institutions or the member states, which was seen as a fresh source of moral hazard for highly indebted member states. More recently, Brunnermeier et al. (2011 and 2016) have proposed the use of securitisation structures to create a liquid multi-country sovereign exposure – so-called European Safe Bonds, or ESBies – by pooling member states’ sovereigns according to pre-defined rules. ESBies would not entail any public backup nor sharing of losses that might arise from single sovereigns, but would nonetheless create highly rated ‘tranches’ least exposed to sovereign credit risks, thanks to structured finance technology.