The European Central Bank has published a speech given by its President, Mario Dragi. The speech is entitled Financial integration and banking union.

Financial integration

In his speech, Mr Draghi explains that financial integration is necessary for an effective monetary union but that such integration was incomplete before the financial crisis. According to  Mr Draghi, while the interbank market was fully integrated, retail banking was fragmented. This led to a situation where banks used short-term and debt-based funding to increase lending to favoured domestic sectors such as real estate. “As bank’s assets were not well allocated, nor well diversified geographically, they were more vulnerable to domestic shocks. And as their foreign liabilities were mainly interbank, they could not share the subsequent losses with other jurisdictions.” So when the financial crisis hit, the cost of repairing balance sheets fell largely on their domestic fiscal authorities. “The result was the infamous bank sovereign nexus,” Mr Draghi says.

Banking union

Mr Draghi believes that the pre-crisis experience suggests that three changes are needed. First, stronger ex ante supervision to mitigate the possible destabilising effects of financial integration. Second, an improved policy framework to maximise the stability benefits, namely by encouraging deeper cross-border banking integration. Third, better ex post risk-sharing arrangements, such as resolution frameworks, so as to prevent shocks from spilling over to sovereigns.

SRM

Mr Draghi feels that EU banking union – the Single Supervisory Mechanism and the proposed Single Resolution Mechanism (SRM) –  can make a significant contribution to these objectives. On the SRM, Mr Draghi believes that there are some elements in the Council agreement that could be improved. He states that the main problem is uncertainty about resolution financing arrangements. “This is important, because if markets cannot ascertain ex ante how resolution will be financed, and in what quantities, they may find themselves having to price-in a residual risk of national government involvement, thus perpetuating the bank-sovereign nexus,” says Mr Draghi.

According to Mr Draghi, another issue that creates uncertainty is the protracted time period – currently 10 years – over which a single resolution fund will be created. He argues that there would be merits in doubling the pace to have a genuine European fund within 5 years. However, this would not imply that banks would have to pay higher fees. The fund would still reach its target level after 10 years, yet there would be a truly single fund after 5 years.

A further issue that Mr Draghi says needs clarifying, is what backstop arrangements need be in place in the transition period and also in the steady state. He argues that what makes resolution authorities credible is the knowledge that, when private sector solutions do not suffice, they can draw on temporary public bridge financing. Mr Draghi states that the single resolution fund should have a solid public backstop whether it be an ability to temporarily borrow from the market backed by guarantees from participating Member States, or access to a credit line, potentially from the European Stability Mechanism.

View Financial integration and banking union, 12 February 2014