The creation of Banking Union and the way

The creation of Banking Union and the way to Market Union March 2016

Outline - Financial Supervision – Why and how - The Path to the Banking Union - The Banking Union - From the Banking Union to the Capital Market Union 2

Outline Financial Supervision – Why and how 3

The reasons of Supervision The financial sector needs much closer supervision and stricter regulation than other economic sectors, because: financial institutions are critical to the operation of the economy finance is based on public trust. Financial regulation addresses negative externalities by modifying private agents' incentives, constraining their action, and putting mechanisms in place to prevent the most damaging effects of failures, particularly those of banks. Financial supervision is needed to monitor agents' behaviour and to enforce the rules 4

Supervision-categories Supervision can be grouped into three broad categories: (i) microprudential supervision: surveillance of the safety and soundness of individual institutions; (ii) macroprudential supervision: monitoring the exposure to systemic risk, identifying potential threats to stability arising from macroeconomic or financial market developments, and from market infrastructures; (iii) customer protection: monitoring business conduct and the disclosure of information to customers and other stakeholders. 5

The Models of Supervision Designing the ‛optimal model’ of a regulatory and supervisory architecture is a daunting task. The empirical evidence does not prove the dominance of any particular model over the others, although several studies have pointed out that weaknesses in regulation and supervision might be factors leading to a financial crisis (Cihák, Demirgüç-Kunt, Martinez Peria and Mohseni-Cheraghlou, 2013). 6

The Models of Supervision In principle, in any given jurisdiction these functions can be assigned to different authorities on the basis of two different (orthogonal) criteria: 1) sector 2) function 3) a third option is a ‘hybrid’ model. In addition to this, the authorities, whatever their scope, can be placed within the national central bank or outside it. 7

The Models of Supervision In the ‘sectorial’ (‘vertical’) model there is a regulator/supervisor for each main sector within the financial system – banks, insurance companies, non-bank financial intermediaries, securities markets, etc. – which is in charge of all functions: micro, macro, and customer protection. In the ‘twin-peaks’ model, there is one authority for prudential supervision and another responsible for market conduct and customer protection. Each of them extends its competence over all sectors of the financial system. The ‘integrated’ model combines the preceding two in a sort of universal authority responsible for both prudential and business conduct regulation/supervision for the entire financial industry. 8

The reasons of Supervision Theoretically, all these models have advantages and disadvantages. 1 The merits of one model are always the demerits of another, and vice versa. The main arguments in favour of greater integration are: i) economies of scope, ii) better assessment of risks, iii) effectiveness (better cooperation within one organization than between many agencies), iv) less regulatory arbitrage or supervisory gaps, and v) increased accountability. The main drawbacks of integration cited in the literature are: i) dominance of one goal over the others, ii) misalignment of incentives (for example, focus on a particular objective only because it is more easily monitored by public opinion), iii) excessive bureaucracy, iv) a tendency to assign an ever-increasing range of functions to a unified agency, and v) an excessive concentration of power. 9

Supervision within the Central Bank? This specific debate on the benefits and risks of entrusting a central bank with banking supervision is a long standing one. The literature generally concludes that no single pattern of division of supervisory responsibilities between the central bank and other authorities is unquestionably superior. Goodhart (1988) argues that central banks have been historically involved in supervisory functions because of their role in stabilizing the financial system, acting as lenders of last resort (LOLR). In the late 1990 s in many countries financial supervision was moved outside central banks, into cross-sectorial or specialized authorities The most widely cited benefits of having monetary policy and bank supervision residing under one roof are related to: i) the exchange of information, ii) shared concern for financial stability. 10

Supervision within the Central Bank? Informative advantage The first benefit may be well illustrated by the UK experience: the failure of supervisors to head off problems in Northern Rock and prevent the first bank run in more than a century is an outcome widely attributed to imperfect coordination and inadequate information-sharing between the FSA and the Bank of England (Eichengreen and Dincer, 2011). Bank-specific information is very important for central banks when they act as lenders of last resort. The central bank is the ultimate guarantor of financial stability during a crisis. In performing its LOLR function, the central bank has to assess the liquidity and solvency of its counterparts. More generally, central bank risk management would benefit from better access to information on the financial health of banks to assess the quality of the collateral that these banks provide. Especially in times of tensions, having such information in house increases the timeliness of the information flow. 11

The reasons of Supervision Bernanke (2007) underlines that supervisory responsibilities give the central bank access to a wealth of granular on each bank’s organization, management structure, lines of business, financial condition, internal controls, risk-management practices, and operational vulnerabilities. This is beneficial for the conduct of monetary policy because banks play a central role in the transmission of monetary policy impulses. For example, supervisory information on bank capital is useful to assess the contribution of capital constraints to credit developments (Bernanke and Lown, 1991). Similarly, monitoring the portfolio choices of banks is useful to assess the consequences of monetary policy on the accumulation of risks. This information improves the ability of central banks to prevent financial instability. 12

Pros & Cons Financial Stability The second benefit is related to the common concern for financial stability. Historically financial stability has been a main task for central banks, even without an explicit mandate. In many countries it has been a fundamental factor for their establishment. Central banks conduct monetary policy to achieve price stability – in most cases their primary goal – and this in turn fosters broader macroeconomic stability and contributes to financial stability. But often central banks have specific responsibilities in the financial stability sphere, as this is a key precondition for price stability. Central banks with prudential supervisory powers can pursue the objectives of price stability and financial stability with a wider set of instruments, whereas a central bank with monetary policy powers only might end up being overburdened. 13

Outline The Path to the Banking Union 14

Banking Union represents a response to the financial crisis. It rests on three pillars: 1. a Single Supervisory Mechanism, 2. a Single Resolution Mechanism 3. the harmonization of existing national deposit guarantee schemes. The idea underlying the design for Banking Union was to restore confidence in the European banking sector and to preserve and enhance financial integration. The ultimate objectives are safeguarding financial stability and ensuring efficient resource allocation within the euro area so as to support economic growth. The project was launched in 2012. 15

The path to the creation of the Banking Union 16

The path to the creation of the Banking Union 17

The path to the creation of the Banking Union 18

The path to the creation of the Banking Union 19

The path to the creation of the Banking Union 20

The path to the creation of the Banking Union 21

The path to the creation of the Banking Union 22

The path to the creation of the Banking Union Establishment at the European level of a working groups to enucleate the possible architectural changes of the system (De Larosiere Group). Main problems lack of a single Rulebook Lack of effective Macroprudential Supervision 23

The path to the creation of the Banking Union The first institutional response is the creation of the European System of Supervisory Authorities. Network approach 3 Sectoral authorities according to sectoral segmentation + an Institution devoted to systemic Risk analysis EBA – European Banking Authority ESMA – Financial Markets EIOPA – Insurance + European Systemic Risk Board 24

The path to the creation of the Banking Union 25

Outline The Banking Union 26

The Istitution of the Banking Union The Single Supervisory Mechanism (SSM), has been up and running since November 2014. Drawing on the EU single rulebook, it provides a euro-area approach to supervision, as well as better monitoring of cross-border banking groups. The ECB has also been equipped with new macroprudential powers and tools that may complement instruments available to national competent authorities in addressing systemic risks, such as those that may arise from the procyclicality of credit supply, a key driver of many detrimental boom-bust cycles. 27

The Istitution of the Banking Union The benefits of the SSM became visible even before it came in operation. The start of the SSM was preceded by a comprehensive assessment that has stimulated a substantial strengthening of euro area banks’ balance sheets, setting the preconditions for their renewed ability to adequately finance the economy. The ECB and the national supervisors are working to gradually remove national discretions and heterogeneities. The final objective should be to further foster financial integration so that banks operate in a full level playing field. 28

The Istitution of the Banking Union The Single Resolution Mechanism (SRM), the second pillar of the Banking Union, will be fully in place as of January 2016. Ensuring the timely and effective resolution of failed banks is a crucial component of a stable financial system. By promoting better crisis resolution, the SRM will also improve market discipline and reduce excessive risk-taking. 29

The Istitution of the Banking Union The SRM will make use of the harmonized tools provided by the EU Bank Recovery and Resolution Directive. The inclusion of a bail-in provision in the Directive marks a radically new approach to resolving bank crises, whereby the necessary resources should be drawn first of all from the bank’s shareholders and creditors in order to avoid or minimize potential costs for the taxpayers. Let me recall that bank deposits protected by the deposit insurance system are excluded from bail in. Besides these deposits, other deposits held by individuals and by small- and mediumsized enterprises would receive preferential treatment with respect to other instruments. 30

The Istitution of the Banking Union The introduction of bail-in tools may have an impact on the banks’ funding costs. In addition, in placing their securities, banks must be most careful to comply with the investor protection rules, since subscribers may be called on to contribute to the resolution costs. Customers must be given exhaustive information on the characteristics of the different instruments, the riskiest of which should be expressly reserved solely to institutional investors. 31

The Istitution of the Banking Union But resolution is just the final step when a financial institution is undergoing a crisis. Recovery is as, if not more, important. In order to avoid having to resort to resolution – or, should resolution become necessary, to make it efficient and avoid undermining the provision of important financial services – banks are required to be prepared in advance to confront stress, and must make recovery plans readily available – a set of actions that the bank itself would undertake in order to restore or maintain its viability and financial soundness 32

The Istitution of the Banking Union It is the responsibility of supervisory authorities to assess the quality and credibility of these recovery plans and to require their implementation as an early intervention measure. On the other hand, resolution authorities will draft resolution plans to identify the resolution strategy that best fits the organizational and operational structure of the bank and adopt measures to improve resolvability, where adjustments are required. Given the need to duly take into account the impact on the ongoing business and the stability of banks, supervisory and resolution authorities should cooperate closely in defining such measures. 33

The Istitution of the Banking Union Finally, completing the Banking Union requires further steps, including the construction of its third pillar, the proposed European Deposit Insurance Scheme. A common, privately-funded scheme would be consistent with the main idea underpinning the Banking Union, i. e. that effective crisismanagement is in the best interest not only of the Member States in which banks operate but also of the euro area as a whole given the interconnections that characterize a financially integrated market. 34

The Istitution of the Banking Union It is expected that the establishment of the Banking Union will foster structural changes in the European banking sector, for example consolidation via crossborder M&As. The structure of the sector might also be affected by the adoption of the European Commission’s proposal that sets limitations for the biggest and most complex banks in risky proprietary trading and the possibility for supervisors to require separation between certain potentially risky trading activities and deposittaking business in case of threats to financial stability. 35

Outline From the Banking Union to the Capital Market Union 36

The Istitution of the Capital Market. Union The crisis has not only underlined the need for revising and strengthening prudential regulation and aiming for higher standards of bank supervision but has also made evident the limits of a financial system that relies excessively on banks, thus highlighting the importance of diversifying the sources of financing. Going forward, capital markets and non-financial intermediaries will have to take on a larger role in financing investment and economic activity. This goal is even more important given that the crisis-induced reforms of the international regulatory framework impose tighter capital, liquidity and leverage requirements on banks with the objective of building a safer financial sector and with long-term effects on their lending capacity. Overall, banks will become more selective in their credit decisions and will adjust their business models accordingly. 37

The Istitution of the Capital Market. Union The European Commission proposal unveiled in February 2015 to establish a Capital Markets Union (CMU) by 2019 has among its primary objectives the lowering of barriers to accessing equity and bond markets. Obstacles are particularly severe in the case of small- and medium-sized enterprises aiming at raising risk capital. This objective implies that particular attention should be given to the complementarities between bank financing and market financing, rather than considering the two as obvious alternatives. And such complementarities are indeed numerous, both at a macro and a micro level. 38

Grazie. 39