By end 2014, the European Banking Union will be a reality. Aside from being aimed at restoring banking sector stability, there are far-reaching implications for fiscal discipline.
The long-awaited European Banking Union is set to be operational by the end of 2014. The Eurozone’s 128 biggest banks will have to undergo comprehensive asset quality reviews and capital stress tests this year before the recently created Single Supervisory Mechanism of the ECB takes over their direct supervision from domestic authorities.
Fragmented supervisory regimes will give way to an unprecedented, unified system of supranational monitoring and market discipline for the European banking industry. The effects will have profound implications for the European economy, which, contrary to the US, relies more on banking intermediation than capital markets.
The banking union has not been the result of a grand design slowly developed by indolent Eurocrats over years of negotiations behind the scenes. Rather, like most aspects of European integration, it has been the consequence of necessity and haste.
While facing initial resistance, the eventual response of policymakers to the Eurozone crisis took the form of deeper economic integration. The banking union has been the first offspring of this process, which many hope will be followed by similar fiscal developments. Although fiscal integration is off the table at present, the unintended consequences of the banking union could at least spur fiscal discipline.
The main contagion mechanism of the Eurozone crisis was the vicious cycle of sovereign distress and banking insolvency. Governments and their national banking industries seemed to share the same fate – for better or worse – as either party was mutually dependent on the other through domestic bank bail-outs and sovereign debt placements.
The banking union, via the Single Resolution Mechanism (SRM), European Stability Mechanism (ESM) and the Single Supervisory Mechanism (SSM), has the explicit goal of terminating moral hazard on the banking side by introducing a new doctrine for bank resolution with an emphasis on bail-in and burden sharing between the private and the public sector.
On the regulatory side, the unification into one single supervisory entity also aims to overcome concerns over the credibility of some national regulators following poor prudential management in their respective domestic banking crises. All this combined could spark stricter risk management and more responsible investments decisions in the banking sector.
Meanwhile, since the vicious cycle is equally broken for both banks and sovereigns, governments will also have to operate under a different set of constrains and incentives.
Sovereign debt has been predominantly sold to domestic investors in the past few years. According to one study, the share of foreign government bonds stood at 20 percent of total sovereign debt holdings in the banking sector as of June 2013. This does not mean there is no foreign appetite for domestic debt, as the same study shows that this share reached 50 percent in 2005 in the run-up to the global financial crisis.
As the banking union gradually takes effect, there will no longer exist a purely domestic banking industry. That will mean that governments will have to again pass the supranational test to place sovereign bonds or to obtain bank borrowing.
The ECB, through its role as SSM, will most certainly be a more stringent banking supervisor than its national predecessors. To protect financial entities from sovereign contagion and to put an end to the so-called “preferential treatment” of sovereign debt, European banking authorities may move to limit the exposure of their banks’ portfolio to the public sector.
As a result, national governments will not be able enjoy the same easy access to their traditional funding backstop, namely their domestic banking industry. Furthermore, they will have to court supranational banks with looser domestic ties to their national or sub-national governments.
A single supervisory regime and regulatory framework will mean stronger business rationale for mergers and acquisitions. Market players have already indicated that, after weathering the storm of the stress test scheduled for this summer, there will be “pre-conditions” for a pan-European consolidation of the industry.
There are real implications of market consolidation and single supervision for fiscal discipline. Sovereign debt issuance will have to face more severe market scrutiny and market discipline as well as potentially require higher amounts of regulatory capital for banks to meet minimum ratios. Fiscal largesse could be effectively deterred, as stricter requirements for sovereign debt holdings will mean higher bond pricing for states running large primary deficits.
Despite being originally targeted at restoring banking sector stability, the banking union could be a game changer on the fiscal side with salutary effects on public finances across the continent.