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Eurozone Banking Supervision - A Safe New World?

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On 4 November 2014, the European Central Bank will take over as the central supervisory authority for Eurozone banks under the Single Supervisory Mechanism (SSM) – which will be the world’s largest banking supervisory system. Even three years ago hardly any observers would have anticipated this development.

The SSM is the first part of the Eurozone Banking Union project and is uncharted territory for the ECB, national supervisors and banks alike. The latest Eurozone bank stress test establishes the immediate priorities for the ECB as the direct prudential supervisor for the 120 largest Eurozone banks. For Eurozone banks, on the other hand, old routines and relationships with supervisors are likely to change or even be replaced.

This note sets out the reasons why the SSM came into being and outlines its key features. It also explores its impact on the EU Single Market for financial services and expectations for the SSM’s first year of existence.

For more information please contact Brunswick Brussels: http://www.brunswickgroup.com/contact-us/brussels/

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Eurozone Banking Supervision - A Safe New World?

  1. 1. 1 Brunswick Group 03 November 2014 Talking Banking Supervision Eurozone Banking Supervision A Safe New World? On 4 November 2014, the European Central Bank will take over as the central supervisory authority for Eurozone banks under the Single Supervisory Mechanism (SSM) – which will be the world’s largest banking supervisory system. Even three years ago hardly any observers would have anticipated this development. The SSM is the first part of the Eurozone Banking Union project and is uncharted territory for the ECB, national supervisors and banks alike. The latest Eurozone bank stress test and balance sheet assessment (the results of which were published on 26 October 2014 alongside the EU-wide stress test by the European Banking Authority) establish the immediate priorities for the ECB as the direct prudential supervisor for the 120 largest Eurozone banks. For Eurozone banks, on the other hand, old routines and relationships are likely to change or even be replaced. This note sets out the reasons why the SSM was established and outlines its key features. It also lists some thoughts on its impact on the EU Single Market for financial services and expectations for the SSM’s first year of existence. The Eurozone Banking Union project The Crisis Background In most Member States the sudden necessity to prop up national banking sectors following the collapse of Lehman Brothers and the deterioration of financial market conditions in 2008/2009 triggered an unprecedented wave of state aid measures. This had an immediate effect on sovereign debt and led to an outcry by tax payers, who found themselves bailing out financial institutions across the board. Politicians at national and EU level realised that, should the crisis continue or worsen, they would have no realistic alternative to providing yet more state aid. Worse, many Member States, and possibly the EU collectively, would not be able to afford another wave of large scale bank rescues, especially not against the backdrop of weak economies also feeling the brunt of the crisis. This became even more obvious with the sovereign debt crisis, which began in Greece and soon spread to other parts of the Eurozone. The new imperative that “never again should tax payers have to bail-out failing banks” became the guiding theme of various targeted policy measures and the main motivation for establishing the Eurozone Banking Union. Why a Single Supervisory Mechanism (SSM)? The idea for the Banking Union was born in 2012 after a worsening of the Eurozone sovereign debt crisis led EU-leaders to pave the way for direct bank recapitalisations via the newly created European Stability Mechanism (ESM). Concerns that this would undermine the ESM and expose tax payers to greater risk led to calls by some Member States, notably Germany, that this tool should only be available once Eurozone banks were supervised by one new central body, rather than at national level. Brussels quickly launched an initiative for a “Banking Union”, as a first step to what Commission President Barroso envisioned as a “Deep and Genuine Economic and Monetary Union”. In September 2012 the European Commission presented a legislative proposal with the aim of making the European Central Bank (ECB) the new Eurozone prudential banking supervisor in the set-up of a new Single Supervisory Mechanism. This prospect, as well as the ECB’s own promise “to do whatever it takes” to stabilise Eurozone economies also led to more stability on the financial markets for some Eurozone members’ sovereign debt. The proposed framework sparked lively debates on, amongst other things, which banks should be directly supervised by the ECB, how a conflict between the ECB’s monetary and supervisory functions should be avoided, how the SSM fits into the European Single Market and how non-Eurozone countries wishing to participate in the SSM should be treated. Germany and France particularly had to compromise given the differences in national banking sector structures (e.g. diversity and decentralisation in Germany as opposed to a much more concentrated sector in France) while the UK strove to prevent the ECB from dominating decision making in the European Banking Authority. The European Parliament saw itself as the
  2. 2. 2 defender of democratic legitimacy. The SSM law was adopted in autumn 2013. The ECB had one year to take all steps necessary to prepare the SSM before the ECB takes on its supervisory duties on 4 November 2014. This includes the appointment of key staff, logistics, the agreement on the SSM’s supervisory culture and an in-depth health check (the “Comprehensive Assessment”) of all the banks which the ECB will supervise directly. Meanwhile Eurozone countries continued to finalise the rules according to which direct bank recapitalisation via ESM funds can become a measure of ‘very last resort’. Other Banking Union elements In 2013 the Commission proposed legislation for the second step of the Banking Union, a Eurozone Single Resolution Mechanism (SRM), in order to ensure that the ECB becomes a “watchdog with teeth”. This legislation will effectively – as of January 2016 – centralise decisions on bank resolution and measures such as bail-in of bondholders and creditors, restructuring etc., and take them out of the national competence. Eurozone banks will also need to pay into a Single Resolution Fund which will gradually supersede national resolution funding mechanisms. The third step of the Banking Union – a shared Deposit Guarantee Scheme (DGS) is considered politically unfeasible, at least for the time being. That said, a long pending piece of legislation has finally been adopted in order to harmonise national DGSs EU-wide. The Banking Union project remains politically charged. A careful compromise accommodates diverging national interests. Member States still do not see eye-to- eye on sharing decision making powers over the national banking sectors and pooling resources for necessary remedial action. SSM Facts Which banks are covered? The SSM covers the Eurozone’s more than 6000 banks as well as all banks in non-Eurozone countries which may – eventually – decide to join the SSM. The ECB will directly supervise the approximately 120 ‘significant’ Eurozone banks, covering about 85% of Eurozone bank assets. It will do so with the support and input of national supervisors, also referred to as national competent authorities (NCAs). For ‘less significant banks’ the ECB can issue instructions or take over direct supervisory responsibility as it sees fit. What makes a bank ‘significant’? To be determined by the ECB based on a set of criteria – and at the highest level of consolidation within a given Member State:  Balance sheet size: total of at least EUR 30bn & above 20% of GDP  Importance for the economy at Union or at Member State level  Significance of cross-border activities  Support requested or received from the European Stability Mechanism  And – in any case: ranking amongst the three most significant banks in a given SSM-country Note: SSM-zone branches of institutions established in non-SSM EU Member States can also be considered significant and are to be assessed separately from a subsidiaries belonging to the same group. For SSM purposes supervised entities are: a) all credit institutions (which also covers bank subsidiaries), or financial holding companies, established in a participating Member State; b) certain mixed financial holding companies established in a participating Member State; c) branches established in a participating Member State by a credit institution established in the EU (but not bank branches directly set up in the SSM-zone by third country banks). Supervised groups are: a) groups with parent institutions that are banks or financial holding companies with a head office in the SSM-zone; b) groups whose parent undertaking is a mixed financial holding company with a head office in the SSM-zone, depending, however, on whether its supervision is driven by a banking supervisor; c) certain types of centralised bank group structures. Which activities are covered by the SSM? National supervisors (also referred to as national competent authorities or NCAs) remain in charge of non-prudential supervision regarding payments services and consumer protection. The SSM covers micro- and macro-prudential supervision as specified by the EU Capital Requirements legislation (CRR/CRD IV), also referred to as the EU’s Single Rulebook. The ECB is exclusively competent to carry out micro- prudential tasks, based on preparatory work of the NCA for significant banks or delegated to NCAs for less significant banks, i.e.:  Ensuring compliance with relevant EU legislation: prudential requirements pertaining to own funds, securitisations, large exposures, liquidity, leverage, reporting and related public disclosure, as well as requirements related to corporate governance and staff qualifications  Supervisory reviews, including stress tests  Supervision on a consolidated basis  Supervisory tasks in relation to recovery plans and early intervention for banks/groups where the ECB is the consolidating supervisor  Authorisation to take up banking business and the withdrawal of bank authorisation  Acceptance of acquisitions of qualifying holdings
  3. 3. 3 For macro-prudential action (e.g. the setting of capital buffers), the hierarchy between ECB and NCAs is relatively flat, as both can make the decisions they see fit. SSM Organisation SSM Supervisory Board & ECB Governing Council In order to uphold the separation between monetary policy and banking supervision at ECB level, all supervisory decisions need to be prepared by the SSM Supervisory Board, with support by its Steering Committee. Yet, these decisions can only be adopted by the ECB Governing Council (where silence is regarded as assent). A dedicated Mediation Panel is to resolve differences between the SSM Board and the ECB Governing Council. Not all commentators are convinced that this arrangement will indeed maintain the independence of monetary policy. Some reason that, for example, new ECB asset purchase programmes could be at odds with the ECB’s responsibilities as a prudential supervisor. The SSM Supervisory Board is chaired by former French banking supervisor Danièle Nouy whose Vice Chair is Germany’s former chief banking supervisor Sabine Lautenschläger (early leaking of this information suggested that this arrangement was part of the overall compromise between the two countries). ECB and national supervisors For ‘significant banks’ ECB staff and national supervisors will work in joint supervisory teams, led by ECB coordinators – who in turn are assisted by national sub-coordinators. Supervisory teams run the Supervisory Review and Evaluation Process and also implement all supervisory decisions adopted by the ECB. The role of the NCAs is to assist the ECB according to their own initiative or based on instructions received. For ‘less significant’ banks/groups supervision remains largely at the national level. Yet national supervisors need to inform the ECB of any observed deterioration of a bank’s situation and submit certain supervisory decisions to the ECB for comment. The ECB can always decide to take over direct supervision. Direct and indirect supervisors alike are supported by a fourth Directorate General. This team will provide horizontal and specialized services, including crisis management, enforcement and sanctions, internal models, methodology and standard development, planning and coordination of the supervisory examination programme, risk analysis, supervisory quality assurance and supervisory policies. Moreover, an – internal – SSM Manual sets out the rules according to which the national supervisors and the ECB will fulfil their responsibilities. On the other hand for macro-prudential supervision the balance of power is not determined by whether a bank is ‘significant’ or ‘less significant’. Both ECB and national supervisors have room for manoeuvre and a considerable degree of independence, but need to communicate on the steps they intend to take. Affected banks can request the Administrative Board of Review to review a supervisory decision by the ECB. SSM Who’s Who Implications: The SSM and the EU’s Single Market for Financial Services One goal of the SSM is to ensure that at least within the Eurozone banks operate according to “one Single Rulebook” under a common supervisory culture and shared supervisory standards. National idiosyncrasies and a lack of comparability across banking sectors are considered to have contributed to the financial crisis and to have undermined confidence in banks and sovereigns alike. Yet, one obvious risk arising from the Banking Union project is that the EU Single Market will drift apart into the Banking Union versus ‘the Rest’. Here one question is whether non-SSM countries will be marginalised and lose influence over the supervision of their own banking sectors and EU-level rule- making and standard setting. Another possible risk is that the Banking Union may – eventually – create new borders for banking activities within the EU. Who will be in charge of pan-EU banking groups? The SSM changes the balance of power in EU banking supervision beyond the Eurozone. Especially with regard to ‘significant banks’ a shift of influence within the colleges of
  4. 4. 4 supervisors can be expected. For banks active in both the Eurozone and in the rest of Europe, non-Eurozone national supervisors now find themselves facing the ECB, rather than a group of national Eurozone supervisors with possibly diverging views and interests. These are concerns especially for Member States whose national banking sector is dominated by branches or subsidiaries of Eurozone banks/groups, as is notably the case in Central and Eastern European countries. Yet none of them has so far made use of the possibility to join the SSM (even though specific clauses exist in order to compensate for such countries’ inability to defend their interests in the ECB Governing Council). Looking ahead, joining the Eurozone – and hence the SSM on an equal footing – could become a more attractive prospect for these Member States. This might speed up the expansion of the Eurozone towards the East. Supervisors in Member States like the UK and Sweden, both without any intention of joining the Eurozone at any time, are also likely to find that for ‘their’ banks’ activities in the Eurozone the ECB will have a greater foot print than their previous national counterparts. Supervisors in the US, China and other third countries will also be faced with the ECB. This will be the case in the supervision of banks domiciled in the Eurozone and active outside the EU, as well as for third country banks’ subsidiaries (but not branches) in the Eurozone. How fast such shifts in power materialise in practise largely depends on how long it will take the ECB to fully incorporate its new role and make its mark. What about the European Banking Authority? The European Banking Authority (EBA), operational since 2011, is considered the guardian of the EU Single Market as far as banking is concerned. EBA, largely in charge of fine-tuning EU banking legislation, harmonising supervisory culture and running EU-wide stress tests, makes its decisions based on voting by national supervisors. When the SSM was introduced, EBA’s voting rules had to be changed – largely at the insistence of the UK and Sweden – in order to ensure that the ECB would not dominate EBA decisions in the relatively near future. For now it seems certain that a “balance” has been achieved for at least as long as more than four Member States have not joined the SSM. Yet, with the SSM in place, the balance of powers within EBA is still likely to change. In the medium term ECB and EBA alike will probably be challenged to prove that the SSM project does not fragment the EU internal market for financial services into “ins” and “outs”. Any obvious frictions or signs of the EU drifting apart into ”Banking Union versus the Rest” are likely to lead to a further legislative backlash, with the upcoming review of the European System of Financial Supervision (of which EBA is part) as one obvious battleground. The ECB and supervisory colleges for ‘significant’ groups/banks, depending on their headquarter (HQ) The next year – what to expect by the SSM’s 1st anniversary For the ECB the SSM is a great opportunity to prove itself, but it also carries risks. The ECB cannot afford mistakes which would undermine the confidence placed in it. Non-performance would also be a set-back for the Banking Union project and the Eurozone’s perceived ability to put the crisis behind it. The ECB will now have to live up to expectations and cement its credibility as a tough supervisor, all the more so as rules to deal with the Too-Big-To-Fail problem in the EU banking sector are still under implementation. A repeat, for example of a Cyprus- like crisis under the ECB’s watch would have severe repercussions, Comprehensive Assessment results add to the ECB’s to-do-list In order to make sure that it wouldn’t inherit undetected problems at individual banks, the ECB launched a “Comprehensive Assessment” in early 2014. The Comprehensive Assessment focused on 130 banks which the ECB had singled out as candidates for direct supervision. Its first stage was an Asset Quality Review (AQR), a ‘point-in-time’ exercise focused on detecting for example shortcomings in the recognition and provisioning of nonperforming loans and over-optimistic valuation of a range of other exposures. The AQR set the basis for the second stage, a stress test, which was coordinated with an EU-wide stress test run by the EBA. These stress tests were
  5. 5. 5 a forward looking exercise assessing the effect on bank balance sheets of two economic down-turn scenarios of differing severity. The results of the EBA and the ECB stress tests, released together on 26 October 2014, point to the same sample of “problem banks”, none of which are amongst the EU’s largest lenders (although Italy’s Monte dei Paschi di Siena comes close) and all of which are located in the Eurozone. Overview Comprehensive Assessment results (26 October 2014)  Capital shortfall of ca. EUR 25bn detected at 25 participant banks  Twelve of these banks have already fully addressed the capital shortfall, raising in total EUR 15bn capital. Thirteen banks still needs to comply with their restructuring plans/downsize as planned, or raise their capital levels  Banks’ asset values need to be adjusted by EUR 48bn, EUR 37bn of which did not generate a capital shortfall  The capital shortfall of EUR 25bn and the asset value adjustment of EUR 37bn imply an overall impact of EUR 62bn on banks  The thirteen banks which still need to take action include Monte dei Paschi di Siena and Banca Carige (Italy), National Bank of Greece (Greece), Banco Comercial Portugues (Portugal); the Österreichischer Volksbanken-Verbund (Austria), Permanent TSB (Ireland) and Dexia (Belgium) The ECB’s next task is to review those “problem banks’” work plans on how to address capital shortfalls, whether by downsizing balance sheets or by raising capital. Banks which failed the Baseline Stress Test will need to correct their capital shortfalls within six months. Banks which ‘only’ failed the Adverse Stress Test are given nine months to take corrective action. In both cases private sector solutions are to be the first options to be explored; any form of public support would come only according to EU state-aid rules and would involve creditor bail-in and restructuring obligations. In some cases national governments may also decide to resolve a bank or sell it to a competitor. Italy is under particular scrutiny due to the fragile economic situation and the fact that nine Italian lenders failed the Stress Test. That being said, the ECB will be able to start its mandate as new supervisor with a relatively clean slate and on the note that all-in-all the Eurozone banking sector is stable and solidly capitalised. To illustrate this, the ECB has already emphasised that the trigger for failing the stress test is well above EU minimum solvency requirements. The ECB also underlined that the significant amounts of capital raised by several banks ahead/early on during the Comprehensive Assessment were part of the overall success story. One additional issue which the ECB is ready to tackle – and where conflicts with national supervisors, not to mention banks, are highly likely – is the further elimination of national wriggle-room on the definition of capital and deferred tax assets. The AQR on its own also provides ammunition to the ECB to justify supervisory action in the near future, for example on banks’ classification of assets and their ability to deliver timely information to a (demanding) supervisor. Challenges for banks For banks with activities in the Eurozone it remains to be seen how much will change in day-to-day supervision. The ECB may choose to interact with the banks it directly supervises via designated correspondents and the opening of representations in Frankfurt by most ‘significant’ banks could be a logical next step. A lot also depends on how the relationship between the ECB and the ‘traditional’ supervisors develops in practice. Moreover, how will banks adapt their public communication strategies to the new set-up, for instance in the event where supervisory issues surface or news leaks prematurely? More generally the question arises if there is need for a new forum representing the views of ‘significant’ banks vis- à-vis the ECB as one group. Here it remains to be seen if the ECB will take control of the process, for example by establishing special stakeholder groups (inspired for instance by similar bodies supporting the work of EBA and its sister authorities). Or will it be left to the banking sector to come up with own solutions? Will existing associations (namely the European Banking Federation) play a central role, or will banks seek to build new, more direct platforms? If there are ambitions for the latter, can a common cause and shared concerns bridge deeper differences between banks and prevail over long established dividing lines resulting from market specifics, competition issues, ownership structures or business orientation? Great expectations versus reality? Looking ahead the ECB is already raising expectations for the international agenda. Prospects include the SSM bringing Europe closer to speaking “with one voice” on international fora like the Basel Committee and the FSB. Hopes are high that this will translate into a better representation of EU (or perhaps rather “continental” EU) interests and specificities in the development of international regulatory standards and supervisory approaches. In the short-to-mid-term, however, it stands to reason that opportunities will be checked by challenges. Whilst banks and national supervisors might struggle to adapt to the new supervisory environment, for the ECB and its (give or take) 800 strong new staff, too, not everything will be easy. Pressure to deliver – and to avoid mistakes – will be considerable and different supervisory and management cultures may require their own transition period before the ECB has found its own style as a banking supervisor and cooperation with national authorities becomes a smooth matter of routine. Learning by doing may easily take up an important part of the SSM’s first year. Contact Brunswick Brussels Address 27 Avenue Des Arts 1040 Brussels Belgium Tel. +32 2 235 6510 Fax +32 2 235 6522 Email brusselsoffice@brunswickgroup.com