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The Single Supervisory Mechanism - can the European Central Bank break the vicious cycle?

Banks and sovereign nations in Europe face a ‘vicious cycle’, where higher borrowing costs and fears a government may default can make it more difficult or expensive for banks to borrow, and vice versa. On 12th September (2013) the European Parliament approved new powers for the European Central Bank (ECB) to act as a central regulator for European banks, in conjunction with national regulators. Is this a meaningful step towards a European banking union? Can it break the ‘vicious cycle’? And what does it mean for Australia?

The ‘vicious cycle’ refers to a situation where bank and government debt can influence each other, making it harder or more expensive for each to borrow money. In Spain, the government acted as a last resort for some banks (as early as 2011) – but bail-out costs strained government finances. When Spain was seen at risk of defaulting (around June 2012), fears the government couldn’t pay its debt also made it more expensive for banks to borrow from the market, because Spanish banks held a large amount of government debt. Other mechanisms can reinforce this cycle, which at various points has put pressure on bank and government borrowing costs in Spain, Italy, and other European nations.

Adapted from 'European Safe Bonds' (The euro-nomics group).

In mid-2012, the European Commission advocated a banking union to improve financial stability, and break the link between governments and banks by ensuring that regulation and crisis management were a supranational responsibility. Key components of the banking union included a single supervisory mechanism, harmonised deposit insurance and a single mechanism for dealing with failing banks (a Single Resolution Mechanism). All are required in conjunction for an effective banking union.

At a June 2012 summit, Euro area heads of government agreed that it was ‘imperative to break the vicious circle between banks and sovereigns’, and that the European Commission would create a proposal for a Single Supervisory Mechanism (SSM), the first of the three elements. The Commission’s proposal, released in September 2012, became the basis of the changes recently approved by the European Parliament. Discussions about a single resolution mechanism are ongoing.

Currently, EU banking supervision occurs primarily at the national level, despite the high level of integration in European financial markets. Under the new SSM, the ECB will act as a central regulator, operating in cooperation with national regulators. After the EU Parliament’s regulation is given effect, the ECB has a year to put in place the institutional framework. The start date is expected to be sometime in 2014.

But the ECB will not be regulating all banks – only about 130 banks are expected to be above the thresholds for regulation. Other financial sector institutions will not be covered, and the ECB will not regulate insurers, hedge funds, pension funds, and other financial sector institutions. The ECB’s regulatory activities will not be funded by member states, but will draw on an industry levy, and the European Parliament has emphasized ‘a strict separation’ between the ECB’s monetary policy and regulatory roles.

Nations funding the European Stability Mechanism (ESM) have agreed that after the ECB becomes a bank regulator, the ESM will be able to fund banks directly. This is an important step, and could enable struggling banks to access another source of emergency funding beyond their home government. On its own, however, the SSM will only involve ongoing regulation of banks. National regulators and governments will still have responsibility for dealing with banks that fail.

For Australian banks, there will be little direct impact from the SSM. Most international assets held by Australian banks are in other markets. But the SSM matters to Australia because of its implications for European financial stability. The European crisis has already resulted in lower lending by European banks in Australia, and indirectly impacts Australia’s growth through its effect on some of Australia’s major trading partners such as China and India, and international financial markets.

Earlier this year, the Reserve Bank noted that ‘the euro area still faces significant challenges to its stability from fiscal and banking sector problems’. If the SSM serves as the basis for further progress towards a banking union, it will be good news for the world economy and Australia. But future reforms may prove more contentious. Germany’s Finance Minister expressed opposition to reforms that could make taxpayers in one country liable for bank debts in another, although this may change following the German election (22nd September). On its own, the SSM is a promising step forward; but it won’t break the vicious cycle, and leaves Australia exposed to continuing risks from European financial instability.

Image sourced from: Wikimedia
Diagram adapted from: European Safe Bonds, The euro-nomics group, p. 3.