The plans to create a European banking unionneed to be expanded to include countries in Central and Eastern Europe, which suffered when the financial crisis hit Western European Banks, the EBRD said in its Transition Report for 2012.
The report, under the headline “Integration Across Borders,” praised the latest proposalsin the European Union to unify bank supervision and to harmonize bank resolution mechanisms, saying they were “large steps in the right direction.”
But it said the plans remained “incomplete by limiting full membership to eurozone members and by maintaining resolution authority at the national level.”
“This had raised concerns, particularly within emerging Europe, that banks headquartered outside the eurozone would be disadvantaged,” the EBRD’s report said.
It noted that until the financial crisis, the benefits of an integrated banking system in Europe “were not seriously doubted,” with cross-border and multinational banking seen as a “natural element” of integration at an economic level, in trade and services.
“The 2008-2009 crisis changed this perception,” the EBRD’s report said. “Foreign banks seemed to be a (or even the) main culprit of the 2005-08 credit bubble in foreign currency, which burst by 2009 and contributed to large falls in output.”
In addition, foreign banks were one of the conduits that transmitted the crisis from the West to the East. “As a result, foreign banks mutated from paragons of integration to pariahs of the crisis within barely a year,” the report noted.
WESTERN BANKS DOMINATE
In Central and Eastern European countries, with few exceptions, the banking sectors are dominated by foreign banks, which have more than 50% of banking systems, sometimes close to 100%. The report said that foreign bank subsidiaries in emerging Europe “generally reduced lending earlier and faster” than domestically-owned banks.
The combination of local systemic importance and foreign ownership threatened financial stability in several countries in the region, especially those, like Hungary and Romania, which had experienced booms in foreign-currency denominated loans and led to the establishment of the Vienna Initiative, under which foreign banks committed to keeping their CEE subsidiaries funded.
One of the problems was supervision. In normal, “non-crisis” times, supervisors in a bank’s home country may have little incentive and capacity to supervise subsidiaries abroad, unless they are of systemic importance to the banking group, rather than the host country, the EBRD’s report said.
Host country supervisors, on the other hand, may not have much information about the parent banks of subsidiaries that operate in their country, with information exchange between national supervisors “mostly difficult,” it said.
Supervisors in host countries will also find it more difficult to limit lending by subsidiaries than that carried out by locally-owned banks, as they will have no control over the amount of funding the parent bank can extend.
Home-host supervisory cooperation could solve these issues but “differences in mandates and incentives are likely to undermine such attempts,” the report said.
In crisis times, supervisors will have an incentive to either retrieve liquidity behind national borders or ring-fence to prevent liquidity or assets from leaving the country, it added.
The currently proposed single supervisory mechanism would be open to EU members outside the eurozone but they would not benefit from the possibility of direct bank recapitalization by the European Stability Mechanism (ESM), the EBRD noted. It added that another flaw of the banking union proposal is that, while it would give the European Central Bank (ECB) responsibility for all banking supervision, bank resolution would remain at the national level, albeit within a common EU bank framework.
MORAL HAZARD
This means that coordination problems in solving banking issues will likely continue, even among eurozone members, while they will also persist between the banking union authorities and the countries left out of the arrangement.
Also, “maintaining resolution authority at the national level while raising ultimate fiscal responsibility to the supranational level could be a source of moral hazard,” the report said.
To eliminate the moral hazard, there should be an ex ante agreement between national fiscal authorities and the eurozone fiscal backstop that would force the countries to take some fiscal losses if, or before, they are taken at an European level, the EBRD proposed.
It also recommended the creation of one or several cross-border stability groups for emerging Europe, with membership made up of the host country authorities, the ECB, the European Banking Authority (EBA) the European Commission, the European Financial Committee – representing the European Council – and home-country authorities.
These stability groups would aim to minimize coordination problems in crises, address any remaining supervisory coordination issues and create a link between resolution authorities and the ECB.
The EBRD also proposed that the ESM treaty be changed to allow non-eurozone EU members to join the rescue fund if they also join the single supervisory mechanism – in other words, if they become full members of the banking union, without necessarily adopting the single currency. The countries should also be allowed access to euro liquidity through swap lines with the ECB.
It could also be possible to establish an “associate member” status in the banking union, which would give them access to euro liquidity from the ECB in the form of foreign exchange swap lines similar to those opened by the Federal Reserve, the ECB and the Swiss National Bank during the 2008-2009 crisis.
In return, national supervisors would agree to share information with the ECB and would submit to a periodic review of their supervisory policies.