Since the crisis started in 2008, the European Commission has worked hard to learn all the lessons from the crisis and create a safer and sounder financial sector. The Commission has proposed 28 new rules to better regulate, supervise, and govern the financial sector so that in future taxpayers will not foot the bill when banks make mistakes. Most of these rules are now in force or being finalised.
Graphic 1: Key pieces of the EU-wide financial reform puzzle
As the financial crisis evolved and turned into the Eurozone debt crisis in 2010/11, it became clear that, for those countries which shared a currency and were even more interdependent, more had to be done, in particular to break the vicious circle between banks and their national public finances. (See box 1)
That is why, in June 2012, Heads of State and Government agreed to create a banking union, completing the economic and monetary union, and allowing for centralised application of EU-wide rules for banks in the euro area (and any non-euro Member States that would want to join).
The new regulatory framework with common rules for banks in all 28 Member States, set out in a single rulebook, is the foundation of the banking union. Common rules will help to prevent bank crises in the first place (in particular Capital Requirements Directive and Regulation MEMO/13/690) and, if banks do end up in difficulty, set out a common framework to manage the process, including a means to wind them down in an orderly way (Directive on Bank Recovery and Resolution (BRRD) MEMO/14/297). Common rules will also ensure that all EU savers are guaranteed that their deposits up to €100 000 (per depositor/ per bank) are protected at all times and everywhere in the EU (Directive on Deposit Guarantee Scheme –DGS MEMO/14/296). However, national DGS can be vulnerable to large local shocks. The Commission’s proposal for a European Deposit Insurance Scheme (EDIS) would provide a stronger and more uniform degree of insurance cover for all retail depositors in the banking union (MEMO/15/6153).
The banking union ensures the common implementation of those rules in the Eurozone. First, as of November 2014, the European Central Bank (ECB) will be the supervisor of all 6000 banks in the euro area in the framework of the Single Supervisory Mechanism (MEMO/13/780). In order to ensure that the ECB has a clear view of the situation of banks it supervises from the outset, a comprehensive assessment of banks' financial health has been carried out. The ECB has confirmed that the balance sheets of the banks covered by its Comprehensive Assessment of 2014 are now sufficiently resilient, even under significant economic and financial stress.
Second, in the rare cases when banks fail despite stronger supervision, the Single Resolution Mechanism (SRM) (MEMO/14/295) will allow bank resolution to be managed more effectively through a Single Resolution Board (SRB) and a Single Resolution Fund (SRF). If a bank fails, the SRM with clear decision-making rules for cross-border banks and highly experienced staff will be much more effective in carrying out resolutions than the existing patchwork of national resolution authorities.
Together with the new EU wide regulatory framework for the financial sector, the banking union is a big step in the economic and monetary integration of the EU (MEMO/14/244). It will put an end to the era of massive bailouts paid for by taxpayers and will help restore financial stability. This, in turn, creates the right conditions for the financial sector to lend to the real economy, spurring economic recovery and job creation (see box 2).
Moreover, the Five Presidents' Report of June 2015 sets out a number of steps to further strengthen European Monetary Union (EMU). One of them is to move towards EDIS as a further step to a fully-fledged Banking Union. EDIS would mark an important step towards reinforcing financial stability by further weakening the link between banks and their national sovereigns and by delivering even greater trust in the safety of retail bank deposits, regardless of a bank's location in the Union. Ultimately, greater confidence in bank deposits would enable greater lending to the economy, meaning more growth and jobs for Europe.
The completion of the banking union will reinforce financial stability in EMU by restoring confidence in the banking sector through a combination of measures designed to both share and reduce risks.
Box 1: The link between banks and their national public finances
The Eurozone sovereign debt crisis highlighted the potentially vicious circle between banks and the debt of their sovereign.
How does the vicious circle work?
The banking union will help to break the link between banks and their sovereigns:
- Banks will be stronger and more immune to shocks: Common supervision will ensure effective enforcement of stronger prudential requirements for banks, requiring them to keep sufficient capital reserves and liquidity. This will make EU banks more solid, strengthen their capacity to adequately manage risks linked to their activities, and absorb losses they may incur.
- Failing banks will be resolved without taxpayers money, limiting negative effects on governments' fiscal positions: bank resolution will be financed by banks' shareholders and creditors, and by a resolution fund financed by industry. Banks should not be bailed out and government fiscal position will not be weakened further.
- Banks will no longer be "European in life but national in death", as they will be supervised by a truly European mechanism and any failure will also be managed by a truly European mechanism.
- Depositors would ensure the same level of protection across the whole banking union: EDIS would increase the resilience of the banking union against future financial crises by reducing the vulnerability of national deposit guarantee schemes to large local shocks and further reducing the link between banks and their home sovereign.
Box 2: Making it easier for banks to lend to businesses and households
Uncoordinated national responses to bank failures, sometimes recurring to ring-fencing of funding within national borders, and high interdependencies between banks and the Member States where they are based led to a serious fragmentation of the Single Market in lending and funding. This fragmentation was particularly damaging within the euro area, where it impeded efficient lending to the real economy and thus growth.
Recent figures show that 80% of German SMEs who ask for a loan succeed in getting all of the credit requested. This percentage falls to 40% in Southern European countries and even to 25% in Greece. Moreover, there are still differences in interest rates offered to businesses and households, which could impair the emerging recovery.
As in the Banking Union all banks are subject to the same supervisor and to the same resolution mechanism, confidence in all banks should increase. Banks' market credibility will depend on their specific risk profile and less and less on the financial strength of the Member States where they are based. This should make it easier for banks in all Member States to access funding on equal terms which in turn makes it easier for them to lend once again to households and businesses across the EU.
2. How does the banking union create a safer banking sector in the Eurozone?
We are learning all the lessons of the crisis. And we now have a toolbox of measures to deal with banks comprehensively. We are:
- making all banks safer in the first place (crisis prevention),
- ensuring that if they do face problems, supervisors can intervene early to manage them (early intervention)
- and if the worst still happens, making sure that we have the tools in place to manage a crisis effectively (bank resolution).
Moreover, the Commission’s proposal on EDIS would increase the resilience of the banking sector within the banking Union against future financial crises by reducing the vulnerability of national deposit guarantee schemes to large local shocks and further reducing the link between banks and their home sovereign.
2.1 Stage 1: Crisis prevention
The European Commission has made 28 legal proposals covering all financial actors and products to better regulate, supervise, and govern the financial sector. They form the single rulebook. Banks have to comply with it across the Single Market. This is crucial to ensure that there is strong regulation everywhere, without loopholes, so that we can guarantee a level playing field for banks and a real Single Market for financial services. It benefits banks, the wider financial sector as well as citizens, consumers and taxpayers.
2.1.1 A stronger, independent supervisor to ensure that banks apply the rules
The Single Supervisory Mechanism gives the European Central Bank (ECB) responsibility for supervision over banks in the euro area (and other SSM participating Member States).
The ECB will ensure a truly European supervision mechanism that is not prone to the protection of national interests, will weaken the link between banks and national finances and will take into account risks to financial stability. The ECB has taken over its new role as single supervisor in November 2014. It will ensure that the single rulebook is applied consistently and coherently in the euro area. The ECB has already carried out a comprehensive assessment of significant banks and the balance sheets of those banks. Danièle Nouy was appointed as the first Chair of the Single Supervisory Mechanism board (MEMO/13/1155).
2.1.2 Stronger prudential requirements for more resilient banks
The package on capital requirements for banks, the so called "CRD IV package (consisting of the Capital Requirements Directive IV)" and the Capital Requirements Regulation)" (see MEMO/13/690) implements the new global standards on bank capital (commonly known as the Basel III framework) into the EU legal framework.
The new rules in force since 1 January 2014, ensure banks now hold sufficient level of capital, both in quantity and in quality. With these rules, the EU has met its commitment to the G20 to implement the Basel III framework in a timely manner.
2.1.3 Timely planning for banks in a critical condition
The financial sector in the whole European Union can now rely on a strong framework for when banks get into difficulty. This bank crisis and resolution (MEMO/14/297) framework requires banks to draw up recovery plans describing the measures they would take to remain viable if their financial situation were to deteriorate and resolution plans for their orderly resolution if they are no longer viable.
In the banking union, that authority responsible for those resolution plans is the Single Resolution Board. These plans would set out the options for applying resolution tools (for example transferring assets to a bridge bank, writing down capital instruments or other liabilities in a bail in) and ways to ensure that critical functions can continue.
2.2 Stage 2: Timely corrective action when problems occur - early intervention
We now have rules allowing for early intervention when banks face problems. Bank supervisors are accorded an expanded set of powers to enable them to intervene if an institution faces financial distress (e.g. when a bank is in breach of, or is about to breach, regulatory capital requirements), but before the problems become critical and its financial situation deteriorates irreparably.They are set out in the recovery plans of banks and include the possibility of dismissing the management and appointing a special manager, convening a meeting of shareholders to adopt urgent reforms, and prohibiting the distribution of dividends or bonuses. Other measures which the relevant supervisor can insist on are requiring the bank to reduce its exposures to certain risks, increase its capital, or implement changes to its legal or corporate structures.
In the banking union, if the viability of a bank is deemed at risk, the ECB as single supervisor will supervise the early intervention in coordination with the Single Resolution Board and the relevant resolution authorities.
2.3 Stage 3: When a bank's financial situation deteriorates beyond repair: crisis management which protects depositors and taxpayers
2.3.1 Protection of tax-payers
Repeated bailouts of banks have increased public debt and imposed a very heavy burden on taxpayers. The approved state aid measures in the form of recapitalisation and asset relief measures between October 2008 and December 2012 amount to €591.9 billion or 4.6% of EU 2012 GDP (Commission). If we include guarantees, this figure would amount to €1.6 trillion or 13% of EU GDP (Commission) for the period 2008-2010 only. See IP/13/1301.
If the financial situation of a bank were to deteriorate beyond repair, the BRRD would ensure that banks' shareholders and creditors would have to pay their share of the costs through a "bail-in" mechanism. (see box 3)
The Single Resolution Mechanism ensures the centralised and effective delivery of those rules in the banking union. It ensures that the complicated decisions which have to be taken when a resolution happens, in particular a cross-border resolution, can be done quickly with binding effect for all Member States in the banking union.
The Single Resolution Mechanism is built around a strong Single Resolution Board and involves permanent members as well as the Commission, the Council, the ECB and the national resolution authorities. In most cases, when a bank in the euro area or established in a Member State participating in the Banking Union needs to be resolved, the ECB will notify the case to the Board, the Commission, and the relevant national resolution authorities. The decision-making procedures have been carefully calibrated so that it will be possible to decide on a resolution case swiftly. (see graphic 2)
To avoid taxpayers being called upon, all banks in the EU will need to pay towards a fund to aid smooth resolution. In the banking union, those funds are pooled together gradually so that if additional resources are needed to make medium-term funding available to the bank to enable it to continue to operate while being restructured, these would be taken from the Single Resolution Fund to which all the banks in the banking union countries will contribute as from 2016 and which will amount to EUR 55 billion by 2024.
Box 3: How will the bail-in mechanism work in practice?
Bail-in: Recapitalisation through the write-down of liabilities and/or their conversion to equity would allow the institution to continue as a going concern, would avoid the disruption to the financial system that would be caused by stopping or interrupting its critical services, and would give the authorities time to reorganise it or wind down parts of its business in an orderly manner.
In short: if a bank needs to resort to bail-in, authorities would first write down all shareholders and would then follow a pre-determined order in bailing in other liabilities. Shareholders and other holders of instruments such as convertible bonds and junior bonds would bear losses first.
Deposits under € 100 000 would never be touched: they are entirely protected at all times.
To the furthest extent possible, the responsibility of covering bank losses is placed on private investors in banks and the banking sector as a whole; not taxpayers.
2.3.2 Protection of depositors
Bank deposits in all Member States will continue to be guaranteed up to €100 000 per depositor per bank even if a bank fails. This guarantee gives savers a sense of financial stability and means that they do not rush to make excessive withdrawals from their banks, thereby preventing severe economic consequences.
Furthermore, depositors will have their money paid out more quickly, within 7 working days (down from 20), and national deposit guarantee schemes will be much better financed to back up their guarantees, notably through a significant level of ex-ante funding: 0.8% of covered deposits will be collected from banks over a 10-year period. If the ex-ante funds prove insufficient, the Deposit Guarantee Scheme will collect immediate ex-post contributions from the banking sector, and, as a last resort, the deposit guarantee scheme will have access to alternative funding arrangements such as loans from public or private third parties. There will also be a voluntary mechanism of mutual borrowing between deposit guarantee schemes from different EU countries. MEMO/13/1176)
Under the Bank Recovery and Resolution Directive (BRRD), individuals and small businesses with deposits of more than EUR 100 000 will benefit from preferential treatment ("depositor preference"). They will not incur any losses beforeother unsecured creditors so are at the very bottom of the bail-in hierarchy. Member States can even choose to use certain flexibility to exclude them fully.
However, national DGS can be vulnerable to large local shocks. A European Deposit Insurance Scheme (EDIS), as proposed by the Commission, would provide a stronger and more uniform degree of insurance cover for all retail depositors in the banking union, ensuring that the level of depositor confidence in a bank would not depend on the bank's geographical location.
Any divergences, perceived or real, between national DGS can contribute to market fragmentation by affecting the ability and willingness of banks to expand their operations cross-border. EDIS would ensure a level playing field for banks across the Banking Union by reducing the vulnerability of national DGS to large local shocks, weakening the link between banks and their national sovereign and boost depositor confidence overall.
2.3.3 Different stages of EDIS and interaction with DGS
The architecture of EDIS would follow the typical Banking Union construction: a single rule book in the form of the existing DGS Directive, for all 28 Member States, complemented by EDIS, which would be mandatory for Euro area Member States and open to non-Euro area Member States wishing to participate. In view of the close links between EDIS and single supervision and resolution, non-Euro area Member States joining the banking union would be required to participate in all three parts of the banking union.
EDIS would be established in three sequential stages:
- The first stage would be a reinsurance scheme and would apply for 3 years until 2020. In this stage, EDIS would provide a specified amount of liquidity assistance and absorb specified amount of the final loss of the national scheme in the event of a pay-out or resolution procedure. In order to limit moral hazard and avoid “first-mover advantages”, a DGS can only benefit from EDIS in this stage if it has met its requirements and filled its national fund to the required level, and only if those funds have been fully depleted. There are also robust safeguards to avoid any possible abuse of the system.
- The second stage would be a co-insurance scheme and would apply for 4 years until 2024. For this phase, a national scheme would not have to be exhausted before accessing EDIS. EDIS would absorb a progressively larger share of any losses over the 4-year period in the event of a pay-out or resolution procedure. Access to EDIS would continue to be dependent on compliance by national DGS with the required funding levels.
- In the final stage, EDIS would fully insure deposits and would cover all liquidity needs and losses in the event of a pay-out or resolution procedure.
While the reinsurance and coinsurance stages would share many common features, ensuring a smooth gradual evolution, the costs for covering deposits would be increasingly shared among the national DGS and EDIS under the co-insurance stage. The full insurance of depositor in the Banking Union would fall under EDIS from 2024 onwards.
A well-functioning SSM and SRM should significantly reduce the likelihood of bank failures and should ensure that taxpayers are protected from the costs of any bank resolution. Further protection is provided by the wide range of prudential measures, which have been taken in respect of banks to strengthen supervision and crisis management; improve the amount and quality of capital; reduce concentration of exposures; encourage deleveraging; limit pro-cyclical lending behaviour; reinforce access to liquidity; address systemic risk due to size, complexity and interconnectedness; underpin depositor confidence; and incentivise proper risk management through governance rules.
However, even this extensive menu of prudential and crisis management measures cannot eliminate entirely the risk that public funding may be required to boost the financial capacity of resolution funds. For this reason, Member States have agreed that the banking union requires access to an effective common fiscal backstop to be used as a last resort. Such a backstop would imply a temporary mutualisation of possible fiscal risk related to bank resolutions across the banking union. However, use of the backstop would be fiscally neutral in the medium term, as any public funds used would be reimbursed over time by the banks (via ex-post contributions from the banking sector).
2.3.5 Banking union will reduce risks in the banking sector
The banking union was established primarily in response to the financial crisis that evolved into a sovereign debt crisis, in particular in the euro area. The crisis was driven by the link between banks and their respective national sovereigns. Breaking this direct link has therefore become an overriding objective of the different elements of the banking union.
The Commission is now proposing one of the missing elements: a common deposit insurance scheme for the banking union. Member States should also start work on reinforcing the agreed bridge-financing arrangements for the SRF and on developing a common fiscal backstop. These steps to complete the banking union are logical in the context of efforts to deepen economic and monetary union.
A common feature of these steps is that they reduce the links between banks and sovereigns in individual Member States by means of risk sharing among all the Member States in the banking union, and thereby help achieve its key objective.
The risk sharing implied by steps to reinforce the banking union would be accompanied by risk reduction measures designed to break the bank-sovereign link more directly. The Commission will work to ensure that these measures are taken in parallel with ongoing work to establish EDIS, including any necessary regulatory changes.
This package of measures to share and reduce risks in the banking sector would ensure a level playing field in the banking union.
3. What happens if problems occur before the whole system is operational?
If capital shortfalls are identified for banks in the banking union the existing agreed cascade for recapitalisation kicks in: in a first instance, banks should raise capital on the markets or through other private sources. Should this not be sufficient, public money could be engaged at national level, under strict conditions and in line with State aid rules (see box 4). In the second instance, if national backstops are not sufficient, instruments at the European level may be used, including the European Stability Mechanism.  If banks are no longer viable, they may be put into resolution according to national regimes.
Box 4: State aid rules
The European Commission adapted its temporary State aid rules regarding public support to financial institutions during the crisis. A European Commission Communication set out the updated EU crisis rules for State aid to banks during the crisis from 1st August 2013.
The main change was a strengthening of “burden-sharing”: Banks are required to work out a sound plan for their restructuring or orderly winding down before they can receive recapitalisations or asset protection measures. Moreover, the burden-sharing requirements have been strengthened: if banks have capital shortfalls, their shareholders and junior creditors are now required to contribute as a first resort, before public funding is granted.