Daniela Gabor

UWE Bristol

Banking Union seems to be the best solution to secure European financial stability and,
at the same time, to have a possible governance regime given divergent national
interests. Satisfactory compromises appear to have been reached regarding this issue,
however, banking union proposals have not tackled the fundamental challenges posed
by the architecture of European finance, shaped by large, complex and systematically
interconnected banks.

Economic Policy Brief No. 3, 2014

...while financial integration is ultimately a market-driven process,

policy plays a key role in creating the conditions for its progress.
Mario Draghi, February 20141
Since 2010, European policy makers have been struggling with a dilemma: what
governance regime would work best to secure European financial stability vs. what
governance regime is possible given divergent national interests? By March 2014, the
desirable and the possible converged into (some argue, Germanys vision of) the banking
union: a single supervisory mechanism (SSM) for large, cross-border European financial
institutions and a single resolution mechanism (SRM) financed by banks.
In an optimistic reading, satisfactory compromises appear to have been reached. First,
crucial elements of supervision and resolution have been moved at European level,
promising to resolve the challenges of coordinating the governance of large crossborder banks. Such coordination between home and host regulators, we know from
Eastern Europes experience, is difficult. When at the height of the banking crisis in
2011, Austria announced tighter lending standards on the subsidiaries of Austrian banks
in Eastern Europe, regulators there interpreted this as a poorly-masked attempt to
strengthen the balance sheet of the Austrian parents by clawing back funding from
subsidiaries. Faced with vocal protests, the Austrian central bank backtracked.
Similarly, since 2010, Hungary has come under sharp criticism from parent regulators
when it forced its banks mostly foreign-owned (Austrian, Italian, Belgian) - to
renegotiate the terms of mortgages in exotic currencies (Japanese yens, Swiss francs)
and to fund mortgage relief plans. Unilateral actions, it is hoped, would no longer be
necessary once the ECB takes over. This will help reverse the financial fragmentation
brought by the crisis.
Second, its architects argue, the banking union will significantly loosen the dangerous
embrace between banks and governments - the sovereign-bank feedback loop- that
nearly destroyed the eurozone. Under the ECBs careful supervision, banks will no
longer pursue aggressive expansion strategies that would render them large and
vulnerable enough to destabilize their governments (as in Irelands case) and equally
important, governments will no longer rely on their banks to gobble up debt in order to
avoid the market discipline imposed by other, less co-dependent investors. The Single
Resolution Fund will ensure that banks, rather than individual member states, bear the
burden of shutting down failing banks. Better decision making structures will allow for
urgent solutions to banking stress.
Critics have focused on the details of the compromise. The resolution fund - projected to
reach EUR 55 bn over the next eight years through levies on banks - is dwarfed by the
size of Europe banking sector assets, in 2013 calculated at around EUR 31 trillion.
Financial integration and banking union. Speech at the conference for the 20th anniversary of the
establishment of the European Monetary Institute, Brussels, 12 February 2014. available at
http://www.bis.org/review/r140213a.htm
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Member states still retain veto power over failures, and historical precedent suggests
these will not hesitate to use it, particularly where the failure of large cross-border
banks is at stake. Furthermore, hopes that ECB will resist pressures from both
governments and banks when, for example, it conducts the stress-test exercise in late
2014 may be misplaced. After all, it is worth remembering that German opposition
delayed Draghis whatever it takes moment until 2012, a long two years into the
sovereign debt crisis. This promise, rather than the announcement of banking union
plans, restored stability in Europe.
Concerns about details, this brief argues, mask a larger issue. The banking union
proposals have not tackled the fundamental challenges posed by the architecture of
European finance, shaped by large, complex and systemically interconnected banks. The
predicament of the European project is that financial integration has been achieved by
encouraging European banks to become too important to fail through business models
reliant on market-based activities, including shadow banking. Indeed, it is no
coincidence that two out of three banks rescued in Europe had become vulnerable
through their substantial trading activity. The dichotomy bank vs. market-based
financial systems no longer holds for Europe. Its financial systems may be bank-based,
but systemic European banks are increasingly market-based .
Policy initiatives since the crisis, including the recent push for re-energizing
securitisation, highlight the enduring faith that European governments and policymakers have placed in market-driven financial integration. Yet this commitment,
unshaken by the banking and sovereign debt crisis, has not generated an institutional
architecture that can mitigate its systemic vulnerabilities. While the sovereign-bank loop
is central to those vulnerabilities, its resilience stems from the crucial role that
government debt has come to play in the stability of market-based banking and finance
broadly defined. Such structural change blurs the line between safeguarding financial
stability and monetizing government debt. Financial stability requires either a
fundamentally different mandate for the ECB (normalizing Outright Monetary
Transactions) or legislating into existence a European safe asset.
Market-driven financial integration.
Before the crisis, member states, the ECB and the European Commission supported a
financial integration agenda largely set by private finance that promised substantial
benefits without any apparent political costs. For member states, market-driven
integration would (a) create a de facto fiscal union, where financial institutions would
provide market liquidity to all sovereigns, thus eroding differences in funding costs; (b)
enable national banking champions to become global players, competing successfully
with US financial institutions and (c) allow cross-border banks to finance the most
effective firms, improving the allocation of capital across eurozone. For the ECB,
integrated markets would strengthen the effectiveness of its interest rate decisions
across the Eurozone (the transmission mechanism).
The project of financial integration delivered on its promises at an uneven pace. While
retail banking remained highly segmented, securities and wholesale money markets
where financial institutions lend to each other, issue debt or trade risk - integrated
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faster. By 2008, Eurozone banks lent 85 of every 100 euros to domestic borrowers, 12 in
cross-border loans to Eurozone residents and only 3 outside Eurozone. In contrast,
around 40% of lending between banks took place in cross-border markets, while one of
every two EU bonds belonged to portfolios of institutions residing elsewhere in Europe.
Yield differentials between eurozone sovereigns narrowed substantially.
This dismantling of wholesale borders can be traced to banks collective migration to
market-based business models focused on high-risk, high-leverage activities, as Andrew
Haldane, from the Bank of England, put it. Traditional retail banking activities remained
largely confined by national borders and only generated a third of European banks
balance sheets by 2008. In turn, banks grew balance sheets by purchasing and trading
assets issued in other (including eurozone) countries, and funded them by borrowing
from each other in short-term debt-based markets. Capital flew from banks in the
European north to the periphery, where it financed current account deficits, credit and
housing booms. For example, German banks exposure to Greece, Ireland, Italy, Portugal
and Spain (GIIPS) increased from EUR 100 bn in 2000 to around EUR 500 bn in 2008.
But this was not only a European affair. Rather, European banks became global players
through aggressive expansion strategies. Consider the list of financial institutions that
the Financial Stability Board describes as global systemically important financial
institutions (G-SIFIs) on criteria of size, complexity and systemic interconnectedness.
Half of the 29 G-SIFIs that made it on the FSB list in 2011 were headquartered in Europe,
ten in Eurozone. Some of these had grown close in size to (Deutsche Bank, Unicredit,
Societe Generale), or even bigger than (BNP Paribas, Barclays), the economy of the home
country by 2008. Implicit guarantees from governments gave large banks cost
advantages, lowering their funding costs by as much as 90 basis points, according to
recent IMF estimations. Global operations, often driven by strategic regulatory and tax
considerations, saw European banks become big players in the US shadow banking
world. A good example is the US market for asset-backed commercial paper (ABCP), the
first to experience problems in 2007. Large European banks funded their investments in
higher-yield US asset-backed securities in that market, through off-balance sheet
vehicles (read regulatory arbitrage). Seven out of the ten largest bank-sponsors of ABCP
conduits were European, while the ten largest bank-conduits all had European bank
sponsors. When subprime mortgage problems ignited runs on the ABCP market,
European banks were left with large US dollar funding shortages that were eventually
met by coordinated action from the US Federal Reserve and the European Central Bank.
Crucially, European policy makers, often coordinating explicitly with finance lobbies,
have put in place policies that encourage(d) banks to accelerate financial integration by
developing market-based activities. This, for instance, is the stated intention of recent
efforts to re-launch the integration project by reviving European securitization markets.
Indeed, the ECB has been working hard to change the narrative around securitization,
since the crisis conceived as the Achilles heel of (shadow) market-based finance. With
proper transparency in place, the ECB argues, high-quality securitization would lead to
more diversified funding in Europe, easing financing conditions for small and medium
companies. To incentivize banks to issue SME loans and then securitize them, the ECB
has proposed lower capital requirements on these instruments, and simultaneously,
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promised to accept asset backed securities as collateral for its loans to banks.
Transparency is the new mantra for harnessing the positive potential of securitization
activities for the European integration project.
Doubts about the transparency emphasis aside, it is more interesting to ask why the ECB
has abandoned the focus on its erstwhile favourite market for promoting financial
integration, the repo market. After all, the European repo market, the main source of
short-term funding for banks, is now more fragmented than ever. One possible answer is
that the crisis has made repo markets politically salient as systemic shadow banking
markets, in need of closer regulation. Until the FSB, the ECB and the European
Commission finish their regulatory deliberations, the repo market cannot carry the
burden of re-energizing financial integration. More important, however, is that the repo
market has become inconvenient for the financial integration narrative since it
highlights the dependence of European banks on government debt for funding, and the
importance of government debt for financial stability. Market-based banks need safe
assets to preserve access to market funding, and since the crisis, to meet a litany of new
regulations.
...and the changing role of government debt in market-based finance
The repo (repurchase agreement) technique is in economic terms a loan against
collateral and in legal terms, a sale of an asset with a commitment to repurchase it at a
later date. The distinction matters in that a repo lender of cash, the legal owner of
collateral, can sell that collateral in case the borrower defaults, and thus recover the
cash loan without waiting for tedious bankruptcy procedures.
Repos connect several markets that provide or require collateral, including securities
market, government bond markets, the unsecured money market, derivative and swap
markets. This is why the ECB and the European Commission pushed for the integration
of national repo markets, expected to support a market-driven integration of the various
markets that repos connect. The Commission, through the 2002 Financial Collateral
Directive, unified legal framework for the cross-border use of collateral. In a similar
move to current securitization initiative, the ECB, who uses repos to lend to banks,
designed a collateral framework that treated all eurozone sovereign debt as equal
collateral. It hoped that private repo markets would follow suit - which they did - leading
to a de-facto integration of government bond markets .
Under such (policy) incentives, the European repo market grew rapidly to become the
largest source of short-term funding for European banks. It tripled in size between 2002
and 2008, to around EUR 8 trillion, similar in size to the US repo market. Unlike that
market, the European repo market was, and remains, dominated by large banks. In
2008, the 10 largest banks generated, around 55% of repo transactions, a share that
increased above 80% for the 20 largest European banks. The repo instrument proved
attractive because it allowed banks to grow balance sheets at low costs: a bank could
fund purchases of new securities by using these as collateral to raise cash in the repo
market. Leverage was cheapest where banks used sovereign debt as collateral.

Thus, 80% of collateral circulating through repo networks was issued by European
governments. Reliance on short-term repos made sovereign debt crucial for bank
leverage, so that demand for government debt - and the improved liquidity of sovereign
debt markets - also reflected banks leverage strategies. Rather than systemic risks,
European institutions and member states chose to see the financial integration benefits
of this (sovereign-bank) process: by 2008, GIIPS sovereign bond markets together
supplied around 25% of sovereign European collateral, on similar terms to what we now
describe as safe sovereigns. Italy alone, with one of the worlds largest sovereign debt
markets, accounted for over 15% of collateral supporting EU repo markets, only
surpassed by Germany (with a 20% share). Italy and other periphery governments
benefited from increased demand from global banks in the north, who built
geographically diversified portfolios of government debt to fund their global expansion
strategy. In turn, banks in periphery countries diversified less, since they could use the
debt of the home sovereign as collateral to borrow from, say, German banks.
Then, the banking crisis made apparent that the repo-market based relationship
between governments and banks may quickly turn from mutually beneficial into a
deadly embrace, as commentators now routinely describe the sovereign-bank loop.
Scholars and policy makers now recognize that modern runs in market-based financial
systems start, and/or are propagated, through the repo market . What matters in a crisis
of market-based finance is the confidence that financial actors have in the liquidity of
assets used as collateral to roll over short-term funding. This is why, for example, Basel
III introduced mandatory liquidity ratios for banks. Only the safest of assets retain their
high-quality collateral status, while fire-sales spread through lower-quality collateral
markets. In Europe, however, the determinants of safety are not clear-cut precisely
because European institutions allowed the European repo actors to establish their own
architecture for a market that turned out to be systemic but has no official backstops.
The ECB initially hesitated to provide backstops to the European repo market that it
helped create in the first place. Throughout 2009, its extraordinary liquidity injections
helped stabilized European repo markets since the ECB took from banks low quality
collateral that would not have been accepted in private repo markets. Yet throughout
2010 the ECB send various signals that it would not deal with a growing collateral crisis
but instead push ahead with its exit plans. It refused to intervene in Greek government
bond markets even though contagion threatened sudden stops in other eurozone
sovereign debt markets. Despite that threat, the ECB then tightened collateral standards
(charging higher haircuts on lower-rated government debt), and pressed Ireland to
weave Irish banks off its emergency liquidity support.
Doubts about the safe asset status of eurozone sovereigns spread, with systemic
consequences since a quarter of the repo market, it is worth recalling, was collateralized
with the debt of sovereigns whose banking systems had financed housing booms and
large current account deficits. Northern European banks that had lent to periphery
banks against periphery sovereign collateral before the crisis were no longer willing to
do so, to avoid two-way risk that banking problems may undermine the sovereign and
vice-versa. Systemic repo actors - such as LCH Clearnet, Europes largest clearer of repos
with government bonds - introduced new sovereign risk management frameworks with
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triggers to make repo financing more expensive if the spread between sovereign
collateral and German bonds went above a certain level, a clearly pro-cyclical practice
that affected both Irish and Portuguese government bonds . By 2012, the sovereign debt
of Portugal, Greece and Ireland no longer circulated in repo markets, while the share of
Italian and Spanish sovereign collateral was falling rapidly. Europes crisis of (shadow)
banking and collateral reversed financial integration, just as much as the repo market
helped it before the crisis.
From a collateral angle, the ECBs whatever it takes moment was such game changer
precisely because it put an end to the uncertainty about the collateral qualities of
eurozone sovereign debt. It crystallized two years of hesitant purchases under the
Securities Market Program into an unequivocal commitment to provide a backstop to
European repo markets, even if that meant supporting European governments. This
commitment was so effective that markets never tested it.
.beyond the banking union
The shift to market-based banking in Europe has created an important gap in the
institutional architecture that must be filled with clear rules for governing cross-border
collateral flows and for providing backstops to European repo markets. For member
states, this is important because the standing of a sovereign in financial markets is
evaluated through the collateral quality of its debt, in turn influenced by a series of
factors outside its control: the expansion strategies of its banks and vulnerability to
short-term funding shocks, the portfolio decisions of both resident and non-resident
debt holders, the risk management frameworks of private repo actors and of the
European Central Bank.
Without a different mandate for the ECB and/or single safe asset, several avenues are
possible:
First, governments can independently intervene in repo markets, as some do already.
Indeed, a 2012 survey undertaken by the Italian treasury across sovereign debt
management agencies showed that governments are increasingly concerned about what
it means to be part of the shadow-banking world through repo markets. The survey
documented significant diversity, contrasting sovereign debt management offices that
intervene actively with those, such as Italy, that do not intervene at all. Such diversity of
operational frameworks is surprising given that repo markets may introduce, the survey
recognizes, (speculative) volatility in government bond markets. However, even if
interventions become normalized, sovereign debt managers are better placed to address
collateral shortages than sudden stops in collateral markets.
Second, European regulators could introduce a stronger regulatory/taxation regime to
modify the architecture of repo markets. Given the pro-cyclical effects of collateral
practices, European policy makers may ask whether the repo promises - liquidity and
financial integration - are illusory. Governments could impose counter-cyclical haircuts
on repos collateralized with government bonds to delink the collateral function from
leveraged bank activities, proposals that FSB has now dropped from its repo reform
agenda. Alternatively, governments could tax repo liabilities, making repo-based
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leverage more expensive. The avalanche of protest against the European Commissions
proposals to tax repos in the Financial Transactions Tax suggests this route is less likely.
Third, regulatory incentives could be put in places for the market driven creation of a
euro area safe asset. This is the ECBs favourite route, one that circumvents the political
difficulties of either changing its mandate or convincing governments to pool
sovereignty. Transparent, high-quality securitization, is expected to be a first step in this
direction, generating reliable collateral to substitute government debt. The next step is
to convince banks, particularly in the periphery, to look beyond their sovereign. The
difficulty, of course, is that geographical diversification may end up benefiting Germany,
now the de facto issuer of the euro area safe asset. Germany is happy to enjoy the
benefits of safe asset status but notably reluctant to probe into the conditions that create
that status, or indeed, to ask broader questions about the role of central banks and
government debt in market-based financial systems.