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Why the ECB needs the Banking Union! Will it be enough?

The Banking Union ("BU") will not solve the challenges of the real economy in the euro area. However it is legitimate to question how will contribute to this goal, or otherwise, there will be little justification for such ambitious venture. On other words, why is this a necessary condition of the capability of Europe to rebound in terms of investment and growth, and, why can not be, by itself the solution for growth of investment in the euro-area.

Why is BU a necessary condition for the rebound of investment both in the context of conventional and unconventional monetary policy in the euro area?

Europe is a loan-based economy in opposition to the US that is a market-based economy. Therefore it is hard to assume that market financing or private equity will automatically substitute for bank financing. Shadow banking in Europe is relatively thin when compared to the USA and other forms of direct finance (investment funds) have still a long way to go before they became material.

This evidence shows that the lending channel is vital for the success of ECB accommodative policy. The rational behind is rather straightforward: provide cheaper funding to banks will maximise the chances they will pass funding relief to borrowers (Peter Praet, Dec 2014, “Is the ECB Doing Enough?”). This belief is behind the targeted longer term refinancing operations (known as “TLTROs”) to provide funding for banks at very low fixed rates for a period of up to four years. The same logic applies to other programs to purchase asset-backed securities and covered bonds, ultimately tailored to help lubricate further the transmission of lower funding costs from banks to customers.

But even if ECB moves out to unconventional measures the lending channel continues to be critical for the effectiveness of the monetary policy. The purchase of bonds issued by euro-area non financing companies is an exception, however the private debt market in euro area is thin and occupied mostly by large size companies, therefore with little effect on borrowing costs of small and medium companies. The alternative left is the euro-area sovereign bonds market. Though larger in size it will rest as other conventional measures, on the ability of banks to transfer cost relief to its customers. This is not necessarily a dead end for the monetary policy. On the contrary if the ECB wants to signal a committed accommodative policy it will inevitably have to rely on banks to channel the benefits for the economy. Banking Union fits into this puzzle by enhancing more transparency to banks ‘balance sheets (ECB "comprehensive assessment"), together with less exposure to bad loans and better-capitalized banking sector. As Mario Draghi spoke it will help to “dispel the fog” around bank balance sheets in the euro area. However there are manifold views to counter argue this perspective.

The BU will not contribute to resolve the distortion of the lending channel, if it fails to create the same playing field for banks and unless clarifies key open issues

This argument draws from a less optimistic reading of the ability of the BU to deepen the single market for financial services and make it more effective through a single rulebook. The main criticism shares the view that CRD IV (Basel III) leaves too much room to the competent national authorities ("CNAs") to incorporate idiosyncratic measures in the transposition of the directive and in particular in its interpretation. How will the BU find the right balance between coordination and decentralisation as regards the concrete implementation of Basel III?

The second line of scepticism is embedded on the transition from Basel II to Basel III and its implications for investment and growth. What is at stake is the good dose of the new prudential rules. For sure the business model of banks is likely to change, but the final effect will depend on the possible adjustments in the definition of the long-term liquidity ratio (NSFR for net stable funding ratio).

The third source of scepticism in relation to the goal of creating the same playing field for all banks is associated to the required coordination between ECB and CNAs. In the Single Supervisory Mechanism (“SSM”), the ECB and the CNAs will have to cooperate to assess the quality of internal models used by banks to compute their risk-weighted assets (RWA). The obvious solution will allocate to the ECB the rating of large banks’ internal models while the CNAs will focus more on small and medium-sized banks. If the two levels of decision are not fully consistent and allow any significant discrepancy between them, they could generate competitive distortions. However, reality may be more complex and require a different labour division. The recent experience in Cyprus showed that small and medium size banks can raise systemic risks, whereas CNAs will not gave up easily the follow-up on large size and important national banks.

The separation of banking activities will drive further complexity and operational and funding costs

Parallel to the implementation of BU, regulators prepared a range of widely varying regulations aiming to insulate deposit-insured retail banking from the risks arising from trading activities, ranging from the Volcker rule in the US, to the Independent Commission on Banking (ICB) proposals in the UK and the Liikanen report (EU High-Level Expert Group). These reforms were triggered by the financial crisis (although the subprime crisis was very classical: the outburst of a real estate bubble had nothing to do with proprietary trading (Goodhart, “Bruges European Economic Policy Briefings 32/2014”)), and its defenders claim the separation of banking activities will bring back market discipline (Basel III, pillar III). In the US the Dodd-Frank Act and in particular the Volcker rule (2010) took the option of a “soft” separation between banks and hedge funds. It is “soft” since this re-regulation of banking activities in the US is much less ambitious than the Glass-Steagall Act (1933) (Christian de Boissieu, “Bruges European Economic Policy Briefings 32/2014”). The UK is the most committed to ring-fencing and is pressing ahead with the Independent Commission on Banking (“ICB”) proposals to ring-fence the retail bank. In Europe, the Liikanen proposals suggested a comprehensive ring-fencing of trading activities, although national proposals (e.g. France and Germany) are somewhat more narrowly focused (Morgan Stanley, Wholesale & Investment Banking Outlook Global Banking Fractures: The Implications, 2013). On the other side of the spectrum criticism argues that this approach to moral hazard and risk-taking activities may jeopardise the financing of the real economy, growth and employment. Why? Because operational separation would inevitably create some duplication while increasing the complexity of management, may drive lower ratings and increased funding costs (due to separation of legal entities). In Europe, given the uncertainty around some regulatory outcomes, decisions will drag on for “wait and see” on this question, which will not favour the investment outlook.

All in one, although the BU is a remarkable breakthrough to restore the functionality of the lending channel and make the monetary policy more effective, there are still many open issues that may jeopardise the ultimate goal of contributing to financing of the real economy, growth and employment.

Lisbon, January 12, 2015

José Gonzaga Rosa

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