The following post comes to us from Eilis Ferran, Professor of Company and Securities Law, University of Cambridge Faculty of Law, and is based on her recent paper, “European Banking Union: Imperfect, But It Can Work,” which is available here.

European Banking Union (EBU) is an odd construction born of compromises and shaped to fit into legal territory bounded by EU Treaty constraints that cannot be adjusted in the current political environment. The structure has been criticised, with terms such as “deeply unsatisfactory,” “deficient” and “flawed” featuring prominently in much of the commentary. But a more positive assessment – one that is pragmatic about the strengths and weaknesses of expediency as a driving force – is possible.

The main elements of the European Banking Union

European Banking Union centralises the responsibility for the supervision and resolution of banks in the euro area. EU Member States that do not use the euro as their national currency can opt into Banking Union but none seems to be in a rush to do so. The key institutional pillars are the Single Supervisory Mechanism (SSM) and the Single Resolution Mechanism (SRM).

The SSM has the ECB as its hub.  From November 2014, the ECB is to be in overall charge of prudential supervision of euro area banks. The most significant banks (around 130 of the euro area’s 6000 banking groups representing around 85 per cent of the banking assets in the euro area) will be under its direct supervision. With regard to the less significant banks that will continue to be prudentially supervised on a day-to-day basis by national competent authorities, the ECB is responsible for the general oversight of the system, and has certain specific powers, including a power to take an institution into direct supervision when it considers this to be necessary to ensure the consistent application of high supervisory standards.  A notable prudential task not conferred on the ECB is the application of capital buffers and other macro-prudential tools but there is provision for the ECB, if necessary, to apply more stringent measures than these applied by national authorities.

A new European agency, the Single Resolution Board (SRB), is at the heart of the Single Resolution Mechanism (SRM). The SRB is responsible for the resolution of the significant banks and cross border groups, although it will rely on national resolution authorities in the actual execution of a resolution scheme. National resolution authorities are responsible for domestic and non-significant banks (provided there is no call on the Single Resolution Fund) but the SRB can decide to exercise its powers directly to domestic and less significant banks when necessary to ensure the consistent application of high resolution standards. The SRB will work closely with the ECB in coming to a decision to put a bank into resolution. The European Commission and the Council (representing the Member States) also have a role in resolution decisions.  There is to be an industry-funded Single Resolution Fund (SRF), which is to be filled to a target level (of €55 billion) over a period of no more than eight years by contributions from the banking sector that are raised at the national level by Member States and transferred to the SRF.  The SRF will start out by being divided into national compartments but will be gradually mutualised over a transitional period of up to eight years. The need for backup financing from national sources or the European Stability Mechanism to bridge the gap between the resolution funding available from the operation of bail-in tools and the SRF has been acknowledged by the euro area Member States and they have committed to develop a common backstop during the transitional period to facilitate borrowings by the SRF itself. Use of the SRF must follow the same rules as interventions by national financing arrangements and that aspect of the resolution procedure is to be overseen by the European Commission from a State aid perspective.

Risks to effectiveness

There are numerous potential weaknesses in the design of the SSM and the SRM. For example, on the supervisory side, one of the key concerns revealed by the euro sovereign debt crisis, namely the unwillingness of local supervisors to intervene quickly and decisively in struggling banks, may not be solved by the SSM if the troubled banks in a particular country are less significant ones, as the ECB may not have sufficient visibility of emerging problems quickly enough for timely intervention: much will depend on the quality of information flows. With respect to resolution, the list of vulnerabilities is particularly long (and this has implications for supervision because of interdependencies). To pick out just two: the SRB’s elaborate internal governance arrangements and the additional potential impediments to swift decision-making that could flow from the involvement of the Commission and the Council in resolution decisions are not helpful in a context in which speed is of the essence; and the cumbersome structure of the SRF, its limited financial firepower and the remaining uncertainties around the contentious issue of a common backstop from public funds all raise serious questions about its robustness.

Condemned to fail?

If it were possible to start with a clean sheet not already criss-crossed by legal and political redlines, EBU would almost certainly look quite different from the structure that has actually emerged. The ECB would probably still be in the driving seat as regards supervisory functions, reflecting the relearning of lessons about the role of central banks in prudential supervision, but the allocation of responsibilities between national supervisory authorities and the ECB would be cleaner and clearer. The ECB’s remit would be broader, to include not only banks but also other entities, such as major insurance companies and market infrastructure providers, that could cause systemic harm. The smooth transition from supervision to resolution would be facilitated by the establishment of a free-standing EU resolution authority that has a rock solid legal mandate and a more streamlined decision-making apparatus. That resolution authority might be the ECB itself, although there are strong arguments either way. There would also be from the outset a fully mutualized industry-financed resolution fund as well as strong public-sector supported backstops. And, the pooling of deposit insurance, a topic so politically sensitive it is been largely marginalized in the process of creating EBU thus far, would also be brought within a centralized framework.

To understand why EBU does not look like this it is necessary to go into detailed matters in EU law and into the complexities of the politics of EU integration as well as issues of balance between the EU institutions. This task is undertaken in my paper, European Banking Union: Imperfect, But It Can Work. The analysis in that paper provides grounds for a cautiously optimistic evaluation.

Key points are that there has been a remarkable shift of power from national to supranational (EU and euro area) authorities. These institutional changes have been matched by a massive upgrading of the EU regulatory framework; whilst these regulatory changes apply across the EU as a whole and are not confined to the euro area, they will be particularly helpful in smoothing the path for the ECB and SRB to function effectively in their supervisory and resolution roles. The links between banks and sovereigns may not have been fully broken but they have certainly been considerably weakened.

“Falling” or “muddling” forward incrementally by means of piecemeal reforms or technocratic fixes is not ideal but bold reform has drawbacks too. For example, there are legal and institutional concerns (such as the permissible limits of delegation to agencies such as the SRB under EU law and the mechanisms by which such bodies can be held properly accountable) that demand a careful and cautious response to ensure that the streamlining of procedures and practices does not lead to imbalances. In its ruling on the legality of a delegation of power to the European Securities and Markets Authority to ban short selling in limited circumstances, the Court of Justice of the EU has provided encouraging signs that the process of gradual and careful adaptation of the law in order for specialist agencies to function effectively in increasingly complex settings is well underway.  Political sensitivities around burden sharing and, at a more fundamental level, with respect to the Pandora’s box that a move to change the EU Treaties will surely open, are a fact of life and workarounds have to be found.

The chain reaction approach that is embodied in the “falling forward” thesis is therefore the best available option in these circumstances. Fierce objections to expanding the scope or powers of new institutions that are put in place at critical junctures do not necessarily survive the evolution of those institutions – fears can recede in the face of proven institutional usefulness, and issues that were once highly controversial can lose their political saliency as affected parties become accustomed to the new order. After all, real life financial supervisory structures are always different from stylized models because they grow and develop over time and are susceptible to different influences. EBU will be no different in this respect.

The success of EBU in the longer term will depend on the operational efficiency and effectiveness of its various components in delivering an orderly and safe environment in which finance can flourish.  In the more immediate future, however, EBU can work by changing perceptions: in a context in which levels of trust and confidence can move markets, perceptions matter.  The ECB is already making its mark on supervision through its comprehensive review, which involves serious legacy issues, so that the SSM can start on a strong footing. The ECB has made it clear that it means business and the powerful impact of this work in terms of the efforts that banks are making to strengthen their capital base, bodes well. What this points to is that there has been put in place a legal framework that, on balance, is sufficiently robust to equip the institutional apparatus of EBU with sufficient authority and credibility to begin to rebuild confidence and, in that way, to contribute to the reversal of the trend towards EU financial market disintegration. That is progress.