Chapter 3

Addressing the concerns of emerging European eurozone members

To eurozone members that are not directly affected by the eurozone crisis, implementation of the Commission's proposal offers three main benefits.

To the extent that it breaks the vicious circle between sovereign stress and banking system stress in crisis-hit eurozone countries, it should contain the crisis, and significantly reduce the chances that multinational banking groups based in the eurozone could come under serious pressure. This is a critical benefit for the majority of emerging European countries, in which subsidiaries of such groups have systemic importance. Even the Baltic countries, whose banking sectors are mostly owned by banks based in Sweden and other Nordic countries, have much to lose from continuing financial instability in the eurozone.
By giving broad authority to the ECB it should remove all home-host coordination problems in respect of supervision, at least as far as eurozone-based multinational banks are concerned.
By granting potential access to direct recapitalisation by the ESM it creates a framework that could provide future support to countries which may not be in existing need. In the case of Slovenia, which has some banking sector issues of its own (see Country Assessments later in this report), this could be of more than just theoretical value.

At the same time, the proposal leaves important problems unaddressed – in particular, coordination failures with respect to resolution and with supervisory authorities outside the single supervisory mechanism – and may involve costs. Members of the eurozone would share fiscal responsibility (through the ESM) for crises elsewhere. A slightly less obvious but widely held concern is the possibility that the ECB might devote less attention to the supervision of a small country's financial system than a national supervisor. This could happen if the ECB were to focus supervision on large groups (essentially displaying the bias that has been attributed to home-country authorities) at the expense of preventing local banking crises which are unlikely to pose a systemic threat to Europe as a whole. Note that the Commission proposal gives the ECB supervisory responsibility for each individual financial institution – including the subsidiary level – rather than only the group level. However, there is scepticism on the side of the smaller countries on whether the ECB would have sufficient incentives to focus on the local as well as the union-wide systemic level.

To address these gaps and concerns, the European Commission's proposal could be complemented as follows.

First, the creation of one or several cross-border stability groups for emerging Europe, following the example of the Baltic-Nordic Stability Group (see Box 3.5). Membership would include host-country authorities, the ECB, the EBA, the European Commission, the European Financial Committee (representing the European Council), and home-country authorities (particularly Ministries of Finance, but also non-eurozone supervisory authorities).42 The purpose of these groups would be three-fold.

Following the example of the Baltic-Nordic Stability Group, they would attempt to minimise coordination problems in a crisis by undertaking crisis management exercises and agreeing ahead of time on how resolution cases would be approached.
They would address any remaining supervisory coordination issues. This could arise when either host or home supervisors remain outside the single supervisory structure (the latter could include the Nordic countries, for example, or the United Kingdom).
Lastly, they could create a link between resolution authorities and the ECB. The ECB would be aware of the concerns of resolution authorities – including, of course, host-country authorities – and could exercise its early intervention powers in coordination with these authorities. This may also assuage the concern that the ECB might not care enough about domestic financial stability in the smaller countries.

Second, the supervisory function within the ECB should be structured in a way that gives smaller members of the banking union sufficient voice. For example, in addition to a board that takes the main decisions, the supervisory function could be governed by a larger "Prudential Council" that would include representatives of national supervisors, which would exercise oversight over the actions of the executive board.⁴³

Third, national authorities of member countries could be given the option to impose certain macro-prudential instruments, such as additional prudential capital buffers, on subsidiaries and domestic banks. These may be justified, for example, to deal with more volatile credit cycles in emerging European countries, or to offset higher macroeconomic and financial vulnerabilities. The ECB could set minimum buffers and retain a veto over national decisions which are deemed to run counter to system‑wide stability.

Lastly, there should be an ex ante fiscal burden-sharing agreement between national fiscal authorities and the eurozone fiscal backstop that forces the national level to take some fiscal losses if (or indeed before) they are taken at the European level. Such burden-sharing may be implicit in the current proposal, but it is worth making it explicit. In the absence of such a rule, the combination of a European-level safety net with national resolution authority could give rise to moral hazard. Furthermore, national authorities inside the eurozone would retain additional policy instruments that could influence the probability and magnitude of banking crises. Fiscal instruments that could affect the behaviour of banks and borrowers would remain under national control (for instance, taxation of the financial sector or subsidisation of certain lending, guarantee or investment programmes) and so would policies that affect the housing sector – which historically have been the key source of banking problems, as clearly demonstrated by the mortgage-related banking collapses in Iceland, Ireland, Spain and the United States. Box 3.6 describes several channels through which policies governing this sector can affect the asset quality of banks – for example, by facilitating the development of a rental market and therefore providing housing services to population groups who might otherwise represent high-risk borrowers.

As with any insurance, some degree of moral hazard may be unavoidable and does not invalidate the case for insurance. However, moral hazard can be minimised, specifically by making insurance partial rather than full, and in a way that does not undermine the basic purpose of the fiscal backstop, which is to prevent sovereign liabilities resulting from banking sector problems rising to a level that triggers national bankruptcy. For example, losses could initially be shared equally – reflecting the joint responsibility of European authorities (through the single supervisory mechanism) and national authorities (through other channels such as housing policies). In the event that losses exceeded a pre-determined and catastrophic point, they would have to be fully absorbed at the European level, although not before.

⁴³ See Véron (2012).