Two proposals to resurrect the Banking Union: The Safe Portfolio Approach and SRB+
Two proposals to resurrect the Banking Union: The Safe Portfolio Approach and SRB+
A few days ago, the Eurogroup agreed to a reform of the European Stability Mechanism (ESM) and to accelerate the establishment of the ESM as backstop to the Single Resolution Fund. This is excellent news for Europe, as these reforms are essential to ensure a credible crisis management framework, particularly given the enormous economic impact of the Covid-19 pandemic and the likelihood of a banking crises once the unprecedented support measures are withdrawn.
But these measures are not sufficient. The Banking Union is incomplete – its second ‘pillar (resolution) does not really work, and the third ‘pillar’ (deposit insurance) does not exist. As a result, the banking market is more fragmented now than at the inception of the Banking Union. Mergers only seem to happen within member states, and home and host regulators continue to fight to ensure sufficient capital and liquidity in each national market in which a bank might operate. Without completion of the Banking Union, our Economic and Monetary Union will continue to be fragile and exposed to the return of the doom loop. What needs to be done?
In a recent CEPR Policy Insight (Garicano 2020), I seek to provide a politically and economically viable answer. This path rests on two legs. The first is creating a model ‘Safe Portfolio’ and, through a reform of the regulatory treatment of sovereign exposures, incentivising banks to move towards it. The second is reforming the resolution framework to empower the Single Resolution Board while simultaneously setting up, within it, a European deposit insurance based on the emerging consensus around a ‘hybrid model’.
Read “Two proposals to resurrect the Banking Union: The Safe Portfolio Approach and SRB+”, CEPR Policy Insight No. 108, here
Both of these legs are economically necessary as they break both aspects of the doom loop – deposit insurance cuts contagion from banks to sovereigns, while the Safe Portfolio approach, by diversifying bank balance sheets, cuts the link from sovereigns to banks. Politically, both legs are complementary: Northern countries insist against any risk sharing through a common deposit insurance unless there is also risk reduction through the diversification of bank’s sovereign exposures; Southern countries and their treasuries do not want to give up their reliance on their own banks without having a true third pillar of the banking union in place.
A European Safe Portfolio
The usual proposals to induce a diversification of bank sovereign debt portfolios revolve around either credit risk-based requirements (eliminating the 0% risk weight) or quantitative limits on sovereign exposures, as proposed by the German Council of Economic Experts (2015). Such proposals are lacking both political and economically. Politically, because highly indebted member states will never accept an asymmetric treatment of their debt that may endanger their ability to fund themselves. Economically, ratings-based risk weights have been found to be unreliable due to the arbitrariness of the whole rating system, and hard concentration limits are even less effective as banks would be able to arbitrage within the caps to increase their risky (and profitable) exposures (Alogoskoufis and Langfield 2019).
In October of 2019, the German Finance Minister Olaf Scholz proposed that a reform of regulatory treatment of sovereign exposures by establishing a “Safe Portfolio” – a portfolio of sovereign bonds deemed safe – and incentivising banks to move toward it (Scholz 2019). However, he left this Safe Portfolio largely undefined; with my proposal, I try to build on this idea. I propose that we define the Safe Portfolio as a portfolio of sovereign bonds with shares matching the capital contribution key of the ECB – Germany constituting 26%, France constituting 20%, Italy 17%, and so on – and that we set capital (or ‘concentration’) requirements, based on how far the sovereign debt portfolio of a bank is from this Safe Portfolio.
To calculate ‘how far’ the portfolio is from the Safe Portfolio, I would suggest a distance metric (perhaps using the vector difference between the ECB’s capital key and the bank’s portfolio). Thus, banks would be subject to marginal risk weight add-ons that would increase along with this distance. As illustrated below, the marginal penalty could be graduated to start small and increase over a transition period (see Garicano 2020 for details).
Figure 1 Capital risk charges as a function of concentration
This proposal has two key advantages that could allow it to overcome the political deadlock. First, it is in keeping with the demands of high-rated countries to reduce the degree of sovereign exposures of all European banks. Second, the proposal would end the preferential risk-free treatment of sovereign exposures, while ensuring that demand for all sovereign issuances is be maintained.
However, as the simulations by Alogoskoufis and Langfield (2019) show, quantity- and price-based measures to reduce credit risk will increase concentration risk, and quantity and price measures targeting concentration risk will increase credit risk. They conclude that, in order to reduce credit risk, a new ‘safe’ asset must be part of a proposal targeting concentration.
To avoid this problem, safety could be ensured through tranching the asset into a senior and a junior tranche, in the manner of the ESBies (Brunnermeier et al. 2011, 2016) proposal I made in 2011 with a group of co-authors and which was, under the name of SBBS, adopted by the European Parliament in April 2019. Doing so would overcome two key constrains: it would ensure that there is no implicit or explicit cross-country guarantee (no country is ‘on the hook’ for the bad decisions of others), and it would ensure that the asset is provided by the market.
Figure 2 The path towards a European Safe Asset
A new resolution framework: Deposit insurance under an Enhanced Systemic Risk Board (SRB+)
Since the approval of the Bank Recovery and Resolution Directive (BRRD) and the Single Resolution Mechanism Regulation (SRMR) five years ago, numerous cases have laid bare the weaknesses and ambiguities of our current regime. Since then, member states have provided €17.3 billion in capital injections and €17.7 billion in guarantees to banks in controversial bailouts. The cases of the Veneto banks and NordLB – where Italian and German authorities, respectively, circumvented the resolution framework and undertook substantial bailouts of politically sensitive banks – were particularly troubling given their large size.
Last month, the Commission officially announced a review of the crisis management framework (overall three regulations), and a proposal is expected by the end of 2021. The areas for reform are plenty, ranging from the role of the SRB before a bank is declared failing to the compatibility of our state aid framework with our resolution framework. However, I believe the review should focus on three key aspects for reform:
The Public Interest Assessment
The Veneto banks have set a worrying precedent for the SRB’s Public Interest Assessment. Now it is vital to add predictability and legal certainty. The aim should be for the assessment to cover the bank ‘middle class’, as identified by Restoy (2018) – i.e. banks that are too small to be resolved by the current SRB but too large to be liquidated under national law without causing serious problems for member states. Specifically, the assessment should be positive, at least by construction, for all SSM-supervised banks, as well as all banks operating in more than one member state.
Part of the difficulty of the ‘middle class’ problem is that these banks rely mostly on depositor funding and are too small to raise MREL instruments in the market (these are the debt instruments that are subject to bail in). Thus, to prevent senior bondholder and depositor bail-in, the main challenge that the SRB+ would confront, should it need to resolve these institutions as proposed, would be a lack of funding. To solve this, the SRB+ would obtain co-decision and coordination powers over national DGSs and resolution authorities and even (like the ECB right now) to take over if the competent national authorities fail to effectively deliver on their mandates.
To fully ensure that the SRB+ has sufficient funds to resolve banks, and that national DGSs and regulators have incentives to cooperate with them, the above reforms would have to be implemented along with a European deposit insurance. Towards this, we must start from a ‘hybrid’ model that would see the coexistence of national deposit guarantee schemes and a European compartment. Such a model would build on the little consensus achieved in the Council and also would be in line with the resolution reform outlined above.
I believe that my proposal is achievable in a short-term horizon (as opposed, for example, to proposals to harmonise liquidation in all member states, which would take decades). Moreover, after last week’s agreement by the Eurogroup, the window for implementing these proposals is wide open. The first leg, the Safe Portfolio Approach, could be implemented along with the transposition of the Basel III standards, with the Commission expected to present a proposal next year. The second leg, a deposit insurance within a stronger SRB, could be implemented along with the review of the resolution framework, for which the Commission is expected to present proposal next year too.
Author’s note: This column is written in a personal capacity, and not in the name of Renew Europe.
Alogoskoufis, S and S Langfield (2019), “Regulating the Doom Loop”, ECB Working Paper Series 2313.
Brunnermeier, M K, L Garicano, P Lane, M Pagano, R Reis, T Santos, D Thesmar, S Van Nieuwerburgh and D Vayanos (2011), ‘European Safe Bonds (ESBies)’, Euronomics Group.
Brunnermeier, M K, L Garicano, P Lane, M Pagano, R Reis, T Santos, D Thesmar, S Van Nieuwerburgh and D Vayanos (2016), ‘The sovereign-bank diabolic loop and ESBies’, American Economic Review Papers and Proceedings 106(5): 508–512.