ESM reform strengthens European banking union

Economic opinion

At the end of 2020, the Eurogroup approved a reform of the European Stability Mechanism (ESM). This will allow the ESM to act as a backstop for the European Bank Resolution Fund by creating a credit line for the fund with the ESM. It adds a missing piece to the Single Resolution Mechanism for banks, the second pillar of the European banking union. The reform of the ESM was somewhat overshadowed by the discussion on the European Recovery Fund (Next Generation EU). Yet it is good news in itself. It strengthens the banking union by taking a new step towards its completion. Moreover, the step could be taken earlier than the initially set deadline because sufficient progress has been made in strengthening Europe’s banks. But the step does not complete the banking union, because, among other things, the third pillar (a common deposit guarantee) is still in its infancy.

Crisis management in the euro area

On 30 November 2020, the European Ministers of Economy and Finance of the euro area (Eurogroup) approved a reform of the European Stability Mechanism (ESM). The reform treaty will be signed in January and will enter into force from 2022 onwards, after ratification by the Member States. 

The ESM was established in 2012 as one of the instruments to strengthen the stability of the euro area. It is an intergovernmental institution of the 19 euro countries that participate in the capital of the ESM according to the ECB capital key. This makes the ESM1 highly creditworthy and allows it to issue loans in capital markets on favourable terms. Its core task is to lend this money, under strict conditions, to euro countries that can no longer finance their public debt themselves via the financial market, although their debt is in principle sustainable. 

The ESM contributes to solving one of the many initial structural weaknesses in the architecture of the euro area, which the euro crisis painfully exposed 10 years ago. This particular problem arose when, in 2010, financial markets refused to finance the Greek and later the Irish, Portuguese and Spanish governments. The lack of a crisis management tool in the Union escalated into the dramatic euro crisis. Member States had to resort to temporary ad hoc solutions to prevent the union from collapsing. The ESM now offers structural solutions through different types of credit lines2 that Member States can draw on under strict conditions in the event of funding emergencies.

Emergency funding in the banking union

The insufficient European integration of the banking system was another architectural flaw that was brought to the fore by the euro crisis. In this respect, the political agreement in June 2012 on the European banking union was a milestone. The banking union brought the banks of the euro countries under a European Single Supervisory Mechanism led by the European Central Bank (ECB). The 115 most important banks have been under direct supervision by the ECB since November 2014; the others are under indirect supervision through national supervisors. That supervisory mechanism is the first pillar of the banking union. 

The Single Resolution Mechanism is the second pillar. It ensures the efficient resolution of failing banks. For the most important banks, specific European rules have been drawn up that are applied by the Single Resolution Board (SRB). These rules must ensure that failing banks can be restructured or wound down without disrupting financial stability and without using public money. In principle, the losses should be borne by the shareholders and other private lenders, with the exception of holders of protected deposits. 

In order to safeguard financial stability, the SRB must have access to extra money quickly if necessary, for instance to recapitalise (parts of) a failing bank or to bridge temporary liquidity shortfalls. In crisis conditions, such money cannot always be mobilised in sufficient amounts or sufficiently fast via the private market. And the ECB, as a central bank, cannot assume its function as lender of last resort either, because a failed bank is by definition insolvent and a central bank can in principle only grant credit to solvent banks. 

Therefore, the resolution mechanism provides for a Single Resolution Fund (SRF), which the SRB can call upon. The fund is being gradually financed by contributions from all banks in the euro area, not by public money. These contributions are “mutualised” so that it will be a fully European fund by the end of 2023. The “mutualisation” or transfer to the European level is important because it means that the resolution of a bank will in principle no longer affect the public finances of the bank’s country of origin. If both bank supervision and crisis management are European, banks from euro countries can increasingly be seen as truly European banks and no longer as a bank from country A or country B. 

The amount envisaged3 is substantial but may still be insufficient in exceptional circumstances, such as when several large financial institutions run into trouble at the same time. One of the ESM reforms just decided upon4 is that the SRF will have a credit line with the ESM as of 2022. The credit line is conceived as a backstop, meaning that it can only be called upon when all other sources of financing have been exhausted. This credit line should help to prevent the resolution of bank failures from still endangering financial stability. By drawing on the lending capacity of the ESM, this can be avoided without directly calling on national public budgets.

Strengthening the banking union

The expansion of the ESM’s role as a backstop for the SRF is an important step in the completion of the banking union. Already in 2013 it was decided in principle to give this role to the ESM after the end of the build-up phase of the SRF, i.e. from 2024 onwards. In 2018, it was decided that the ESM could take up this role earlier, if banks in all countries had made sufficient progress in reducing bad loans (NPLs) from the past and had sufficiently increased their capacity to absorb losses themselves. 

The fact that the ESM can take up the role two years earlier than initially planned is thus twice good news. Not only is an important step being taken in the completion of the banking union. The fact that this step can be taken earlier than initially foreseen also means that sufficient progress has been made in the meantime in strengthening the banks. In a number of countries, including Belgium, this had already been the case for a long time. But especially in Greece and Cyprus, there was still a lot of work to be done. It also means that the European banking system is now in a stronger position to deal with the challenges that the covid-19 crisis is likely to bring.

But the reform does not complete the banking union. The resolution mechanism remains largely untested until today. Its practical functioning therefore cannot yet be evaluated. In a recent study, the ECB also pointed to the need for a European guarantee framework, which new banks emerging from the resolution of a failed bank should be able to rely on if they want to finance themselves from the ECB without having sufficient collateral themselves. Moreover, the third pillar, a common deposit guarantee, is still in its infancy (see KBC Economic Opinion of 14 November 2019). 

So, there remains work to be done.

 

 

1 704.5 billion in subscribed capital, of which 80.5 billion was paid up..

2 Unlike the new European Recovery Fund decided on in 2020 in the wake of the Covid-19 crisis, the ESM can only grant loans to the Member States and not subsidies or transfers

Minimum 1% of guaranteed deposits or approximately EUR 60 billion.

4 The other reforms are about emergency aid to the Member States.  

Disclaimer:

Any opinion expressed in this KBC Economic Opinions represents the personal opinion by the author(s). Neither the degree to which the hypotheses, risks and forecasts contained in this report reflect market expectations, nor their effective chances of realisation can be guaranteed. Any forecasts are indicative. The information contained in this publication is general in nature and for information purposes only. It may not be considered as investment advice. Sustainability is part of the overall business strategy of KBC Group NV (see https://www.kbc.com/en/corporate-sustainability.html). We take this strategy into account when choosing topics for our publications, but a thorough analysis of economic and financial developments requires discussing a wider variety of topics. This publication cannot be considered as ‘investment research’ as described in the law and regulations concerning the markets for financial instruments. Any transfer, distribution or reproduction in any form or means of information is prohibited without the express prior written consent of KBC Group NV. KBC cannot be held responsible for the accuracy or completeness of this information.

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