Banking union is the most fundamental change in the institutional design of the European Union since the advent of monetary union. The centralisation of responsibilities for the supervision and resolution of significant credit institutions is a ‘game changer’ in the history of European integration. This contribution considers several gaps in the governance of banking union with emphasis on the ‘missing pillar’: lender of last resort. It argues that the European Central Bank should be the ultimate provider of liquidity in the Euro area, both in cases of market liquidity (where it already has competence) and in cases of individual emergency liquidity assistance (where the competence is national, albeit seriously constrained by a normative framework) at least for significant credit institutions. The future of Europe depends on its ability to build a green, digital, and inclusive economy that fosters intergenerational equity. This requires the completion of both banking union and capital markets union.
Keywords: banking union, supervision, resolution, crisis management, lender of last resort
In contrast to the construct of European monetary union (EMU) – a long and protracted journey that commenced with the establishment of the European Monetary System in 1978–1979 and only became a reality when the Maastricht Treaty was signed in 1992 – the formation of European banking union (EBU) was a much quicker process. Although the intellectual foundations for centralised supervision were advocated by some from the very start of EMU, the urgency with which the actual banking union plan was conceived in 2012 and subsequently executed was made possible by the political consensus that surrounded the need to provide European supervision and crisis management of Euro area credit institutions lest the Euro area disintegrate. The advent of EBU took place at a time in which the vicious link between bank debt and sovereign debt was engulfing the Euro area.
However, like any project adopted under such tense and tight circumstances, there are gaps in the resulting governance structure. Banking union is an incomplete building.
In the ensuing paragraphs I elaborate briefly upon the gaps, inconsistencies, and missing components in the construct of EBU.
Firstly, EMU suffers from a congenitally flawed institutional design; in the words of Alexandre Lamfalussy, EMU rests upon a strong ‘M’ (the monetary pillar with the euro as the single currency and the European Central Bank (ECB) as the monetary authority) and a weak ‘E’ (the economic pillar, where economic – fiscal – union is in fact a misnomer, and what we have is economic coordination).
‘The great weakness of EMU is the E. The M part is institutionally well organized. We have a solid framework. We don’t have that for economic policy.’2
The weakness of the ‘E’ and by extension the weakness of the supervisory pillar became apparent during the twin financial and sovereign debt crises in the Eurozone.
Secondly, there is divergence in the actual construction of the three pillars upon which banking union rests, given their different legal bases (Art. 127.6 of the Treaty on the Functioning of the EU (TFEU) in the case of the Single Supervisory Mechanism (SSM), Art. 114 TFEU in the case of the Single Resolution Mechanism (SRM)), their governance structure, and the actual degree of centralisation achieved so far.
Thirdly, as discussed in some detail in this article, there is the ‘missing pillar’, a fourth necessary pillar for a working banking union, namely lender of last resort.
Fourthly, in the absence of a true fiscal union, there is a limited fiscal backstop in the form of the European Stability Mechanism (ESM). The EU recovery fund and the so-called Corona bonds are steps in the right direction.
Fifthly, the ECB faces fundamental challenges in the pursuit of multiple goals (monetary stability, financial stability, climate change mitigation, and sustainability) in line with its primary and secondary mandates according to Art. 127 (1) TFEU.
Sixthly, there are the problems of jurisdictional domain, with the single market on the one hand and EBU on the other hand, plus the related issues of complexity, coordination, legitimacy, and accountability.
Seventhly, since the contours between supervision, early intervention, recovery, and resolution are porous and since there are multiple authorities involved in what effectively is a seamless process, gaps in coordination can arise. Time is of the essence in any crisis situation! There is also a need for EU harmonisation of bank insolvency rules (UNIDROIT has launched a Working Group of which I am a part on the subject of harmonisation of bank insolvency rules).3
Eighthly, there is incompleteness in the pursuit of systemic risk control and financial stability, since banking union (and centralised supervision) only extends to credit institutions, while responsibility for the supervision of securities and insurance remains mostly at the national level. The European financial architecture for the single market, with the European Banking Authority (EBA), the European Securities and Markets Authority (ESMA), and the European Insurance and Occupational Pensions Authority (EIOPA), is an example of increasing federalisation of financial supervision but does not constitute centralisation of supervisory responsibilities. The ‘financial trilemma’ conceived by Niels Thygesen and developed by Dirk Schoenmaker4 looms in the background: you cannot have financial stability, integrated markets, and national supervision. The latter has to go – and not just for banks.
Ninthly, gaps can arise from the exercise of macro-prudential supervision since responsibility for it is divided between the ECB, the European Systemic Risk Board (ESRB), and national authorities.
Finally, there is the question of what constitutes ‘adequate supervision’ given the need to adopt a comprehensive approach that assesses – as the acronym CAMELS indicates – the different elements that determine bank soundness.
2. The pillars of banking union
European banking union is based upon three pillars.5 The first pillar, ‘single supervision’, has already been completed with the establishment of the SSM. The second pillar, ‘single resolution’, with the SRM and a Single Resolution Fund, is aligned with the EU Bank Recovery and Resolution Directive (BRRD).6 The third pillar, ‘common deposit protection’, is yet to be constructed (though a proposal was published in November 2015).7 As indicated in the introduction, there is a missing pillar: a clear lender of last resort role (LOLR) for the ECB (see Lastra, 2015b, 2015c).8
3. Challenges for the ECB with the advent of banking union
The ECB is no longer just a price stability-oriented monetary authority.9 Since November 2014, with the entry into force of the SSM Regulation, the ECB has exclusive supervisory responsibilities for the significant credit institutions in the Eurozone (according to Art. 4(1) of the SSM Regulation, as confirmed by the European Court of Justice in Berlusconi and Fininvest and other cases).10
A price stability-oriented independent central bank was a basic tenet in the early 1990s, supported by economic theory and empirical evidence, which became embedded in the Maastricht Treaty and widely accepted in the developed and developing world. This explains why price stability is unambiguously mentioned in Art. 127(1) TFEU as the primary objective of the European System of Central Banks (ESCB) while the tenuous reference to financial stability in Art. 127(5) TFEU indicates the hesitant tone of the treaty drafters in giving this goal equal footing to the goal of price stability (‘The ESCB shall contribute to the smooth conduct of policies pursued by the competent authorities relating to the prudential supervision of credit institutions and the stability of the financial system’). The enabling clause advocated by Tommaso Padoa-Schioppa auspiciously found its way into the final text of the Treaty – Art. 127(6), thus providing a Treaty basis for the SSM. Times have changed since the Global Financial Crisis and though in practice the primary objective of central banking has become financial stability (also for the ECB) (Buiter, 2015; Lastra and Psaroudakis, 2020), the Treaty remains unaltered.
Functionally, when it was created the ECB resembled the ‘Bundesbank model’ of one agency (the central bank), one primary objective (price stability), and one main instrument (monetary policy), in line with the Tinbergen rule. This relative simplicity (one goal, one instrument, one authority) in the pursuit of monetary stability contrasts with the multiplicity and complexity that characterise the pursuit of financial stability and the conduct of central banking in the aftermath of the Global Financial Crisis.
Financial stability coexists with other goals; there are multiple instruments to achieve this goal (supervision, regulation, lender of last resort/emergency liquidity assistance (ELA), resolution and crisis management, monetary policy, fiscal policy, and others) and the central bank shares responsibility for maintaining financial stability with other authorities at different levels of governance (national, European, and international).11 Financial stability (systemic risk control) is a goal that transcends geographic boundaries and institutional mandates. But the very definition of financial stability remains a matter of controversy.
The Dodd–Frank Act of 2010 in the United States reinforced the financial stability mandate of the Federal Reserve System (the overriding objective), and the law governing the Bank of England in the United Kingdom has also been revised to reflect the twin mandate of monetary stability and financial stability. At the EU level, while the hierarchy of objectives remains (price stability reigns supreme in the Treaty), the mandate of the ECB has been substantially expanded via secondary legislation (the SSM regulation and ensuing normative) into the field of prudential supervision.
The ECB also has some macro-prudential powers, according to Art. 5 of the SSM Regulation. And the ECB is also involved in the pre-insolvency phase in resolution. Early intervention (in the context of the SSM regulation) comprises actions taken before the threshold conditions for resolution are met, and before the institution is insolvent or likely to become insolvent. The boundaries between supervision at the ‘end of the supervisory spectrum’, early intervention/prompt corrective action (PCA), recovery, and resolution are not always clear. Given its powers for early intervention and that the ECB is empowered to ‘pull the trigger’ for resolution with the declaration of ‘failing or likely to fail’ (Art. 18 SRM Regulation), the ECB plays a significant role in the commencement of resolution proceedings.12
Supervision and crisis management are part of a seamless process which requires timely communication and coordination between the competent authorities, as well as judgement in the exercise of discretion. Supervision is also a thankless task, prone to litigation. The ECB’s role in the pursuit of financial stability must take into account the interconnection between banking markets and other markets (sovereign debt, securities, derivatives, etc) and the designation of systemically important financial institutions.
The financial architecture of Europe is now rather complex both jurisdictionally and structurally. The jurisdictional domain of the European Supervisory Authorities and European Systemic Risk Board is the whole EU/single market, while the jurisdictional domain of the SSM is restricted to the Eurozone and those countries that adopt close cooperation agreements with the ECB. The structure of supervision is now divided between centralisation of powers in banking on the one hand and decentralisation and segmentation in other areas of the financial sector on the other. This will require the ECB/SSM to cooperate very closely with national securities and insurance regulators.
4. The missing pillar of banking union: lender of last resort
Though LOLR is not included as a pillar of the current banking union plan, in my opinion it is clearly the fourth, ‘missing pillar’. Central banks provide liquidity when no other sources of liquidity are readily available (or at least when they are not available at ‘reasonable market prices’).
The decision to serve as lender of last resort can be taken either to support a single bank suffering from a liquidity crisis (individual bank liquidity) or to preserve the stability of the banking system as a whole, by supplying extra reserves to all banks suffering from large cash withdrawals (market liquidity).
LOLR therefore comes in two forms. The first form is the traditional Thornton–Bagehot ‘LOLR model’ of collateralised lines of credit to individual illiquid but solvent banks (Wood, 2000; Lastra, 2015a: chapter 10);13 the second form is the provision of ‘market liquidity assistance’ via ordinary open market operations and via extraordinary or unconventional measures.
The ECB has clear competence – a competence which it has exercised widely – when it comes to the second form, while, due to its own restrictive interpretation of the ESCB Statute, it does not yet have competence with regard to the first form. In 1998, the ECB adopted a restrictive reading of the ECB competences, concluding that the provision of LOLR assistance (ELA) to specific illiquid individual institutions was a national task of the national central banks (NCBs) in line with Art. 14.4 of the ESCB Statute (a provision which allows NCBs to perform non-ESCB tasks on their own responsibility and liability).14 Therefore the classic collateralised lines of credit to individual institutions remain the responsibility of the NCBs, at their own cost, but with the fiat of the ECB and constrained by a normative framework at the EU and national level. The risks and costs arising from such ELA provision are incurred by the relevant NCB, although a number of procedures ought to be followed (see Goodhart, 2000; Kremers, Schoenmaker, and Wierts, 2001: chapters 4, 5; Padoa-Schioppa, 2004: chapters 7, 8; Freixas, 2003: 110).15 This interpretation was reaffirmed in a resolution of the Governing Council of 17 October 2013.16
When prudential supervision was at the national level, it was perhaps logical to assume that the national authorities had the adequate expertise and information to assess the problems of banks within their jurisdictions (assistance on a rainy day, supervision on a sunny day). But now that supervision is European, the ECB should at all events be LOLR for all those institutions it now supervises.
Granting the ECB a clear LOLR does not require a Treaty change. The ECB is already competent to provide liquidity assistance to ‘financially sound’ banks. All that is needed in my opinion is a reinterpretation of Art. 14.4 of the ESCB Statute in the light of new circumstances (banking union) and in accordance with Art. 18 and the principle of subsidiarity; at the very least, such an interpretation is required for significant institutions (see Dietz, 2019).
Since the SSM became operational on 4 November 2014, the ECB should formally be the ultimate provider of liquidity in the Euro area, both in cases of market liquidity and in cases of individual liquidity assistance, as a necessary consequence of the transfer of supervisory powers from the national to the European level.17 The national competent authority (NCA) is neither the monetary policy authority nor the supervisor. The only advantage of continuing with the current interpretation is that any eventual loss is not shared (but it would have an impact on the whole Euro area).
The ECB has always been competent to act as LOLR if the crisis originates in the payments system, according to Art. 127(2) TFEU, which states that the ESCB is entrusted with the ‘smooth operation of payment systems’. The ECB is also competent in the case of a general liquidity dry-up to provide market liquidity according to Art. 18 of the ESCB Statute, and the ECB has amply used this competence during the crisis, even leading to legal questioning of whether it has exceeded its mandate. Indeed, even before banking union, Art. 18 provided a perfectly valid legal basis for the ECB to provide the two forms of ELA/LOLR. And, according to Art. 5.3 TEU (principle of subsidiarity):
In areas which do not fall within its exclusive competence, the Union shall act only if and insofar as the objectives of the proposed action cannot be sufficiently achieved by the Member States, either at central level or at regional and local level, but can rather, by reason of the scale or effects of the proposed action, be better achieved at Union level.
In a crisis, action by the ECB is more effective than action by a national central bank or national authority. National supervisory authorities do not have the ability, authority, or inclination to deal effectively with externalities with cross-border effects. The ECB is able to better judge the risk of contagion.
As I wrote in an article with Luis Garicano in 2010: ‘The lender of last resort function can only be undertaken by a central bank. The involvement of central banks in financial stability originates in their role as monopolist suppliers of fiat money and in their role as bankers’ bank’ (Garicano and Lastra, 2010, p.609; see also Lastra, 2015a: chapters 7, 10; Lastra, 2013; Lastra et al., 2014).
While the US Fed and the Bank of England have emphasised the complementarity between monetary policy, macro-prudential policy, LOLR, and micro-prudential supervision,18 the ECB has highlighted the separation between monetary policy and banking supervision in a Decision of 17 September 2014, in accordance with Article 25(2) of the SSM Regulation.19
Conflicts of interest between monetary policy and banking supervision are of course possible, but there are ways to solve or mitigate them. The SSM Regulation establishes a mediation panel to deal with such conflicts.20
LOLR/ELA links monetary policy and supervision. Only the ultimate supplier of money can provide the necessary stabilising function in a nationwide scramble for liquidity, as the financial crisis amply demonstrated, with conventional and non-conventional monetary policy measures (quantitative easing (QE) and others).
5. Fiscal assistance and state aid rules
The problem with having the ECB as LOLR is, of course, the ‘fiscal backstop’ if the institution receiving the assistance is no longer illiquid but is insolvent. The only way to deal with this effectively is to stick to the ‘true nature’ of LOLR (assisting illiquid but solvent institutions), combined with a clear and strict application of the EU state aid rules, the prohibition of monetary financing of Article 123 TFEU, and other provisions in the Treaty.
As Goodhart points out, ‘a central bank can create liquidity, but it cannot provide for new injections of equity capital. Only the fiscal authority can do that’ (2004: xvii). The central bank should not lend over an extended period of time, committing taxpayers’ money, without the explicit approval of the fiscal authority. Any extended lending becomes the responsibility of the fiscal authority.
A limited fiscal backstop in Europe is provided via the ESM.21 The ESM is modelled upon the International Monetary Fund (but with more limited funding, with lending capacity of €500 billion, backed up by an authorised capital of €700 billion), though it also has a direct recapitalisation instrument.22
In the US and the UK the central bank (Bank of England in the UK and Federal Reserve System in the US) and the Treasury have worked together in bank crisis management. The problem at the EU level – as the Global Financial Crisis amply demonstrated – is that the relevant fiscal authorities are by definition national. Fiscal policy in the Euro area remains decentralised and the member states are competent, albeit subject to increasing coordination, conditionality, and stringent rules. Thus, while the Bank of England is ultimately backed by the fiscal resources of the UK Treasury and the Federal Reserve System is ultimately backed by the fiscal resources of the US Treasury, the ECB does not yet have a European fiscal counterpart. In the US, while the Federal Reserve System provided ample liquidity assistance (both market liquidity and individual liquidity assistance), the Treasury provided the necessary capital with the Troubled Asset Relief Programme (TARP).
A further twist is provided by the need to comply with EU rules on state aid. Because an inherent subsidy exists whenever the central bank lends to an insolvent institution, under the EU rules on state aid, the granting of emergency aid to banking institutions can be considered illegal in some cases. The Luxembourg Court of Justice recognised, in a ground-breaking decision in the Züchner case, that EU competition rules are also applicable to the banking sector.23
On 5 December 2007, the EU Commission in its approval of the rescue aid package for Northern Rock concluded ‘that the emergency liquidity assistance provided by the Bank of England on 14th September 2007, which was secured by sufficient collateral and was interest-bearing, did not constitute state aid’.24 The Commission Communication of 13 October 2008 further reiterated this point: ‘In establishing a single market in financial services, it is important that the Treaty’s state aid rules are applied consistently and equally to the banking sector, though with a regard to the peculiarities and sensitivities of the financial markets.’25
In August 2013 the Commission published another Communication extending the ‘crisis rules’ for banks.26 According to paragraph 53 of this August 2013 communication:
Liquidity support and guarantees on liabilities temporarily stabilise the liability side of a bank’s balance sheet. Therefore, unlike recapitalisation or impaired asset measures which in principle must be preceded by the notification of a restructuring plan by the Member State concerned and approval by the Commission before they can be granted, the Commission can accept that Member States notify guarantees and liquidity support to be granted after approval on a temporary basis as rescue aid before a restructuring plan is approved.
Paragraph 62 further clarifies:
The ordinary activities of central banks related to monetary policy, such as open market operations and standing facilities, do not fall within the scope of the State aid rules. Dedicated support to a specific credit institution (commonly referred to as ELA) may constitute aid unless the following cumulative conditions are met:
- the credit institution is temporarily illiquid but solvent at the moment of the liquidity provision and is not part of a larger aid package;
- the facility is fully secured by collateral to which appropriate haircuts are applied, in function of its quality and market value;
- the central bank charges a penal interest rate to the beneficiary;
- the measure is taken at the central bank’s own initiative, and in particular is not backed by any counter-guarantee of the State.</NL></EXT>
It is interesting that the Thornton–Bagehot doctrinal principles find their way into a legal text. Paragraph 63 of this 2013 Communication further specifies that ‘interventions by deposit guarantee funds to reimburse depositors in accordance with Member States’ obligations under Directive 94/19/EC on deposit-guarantee scheme do not constitute state aid’.
The European Commission launched consultations in 2021 (a targeted consultation and a public consultation) on the review of the bank crisis management and deposit insurance framework and focused on three EU legislative texts: the Bank Recovery and Resolution Directive (BRRD), the Single Resolution Mechanism Regulation (SRMR), and the Deposit Guarantee Schemes Directive (DGSD). The consultations sought to gather stakeholders’ views on the revision of the framework, which is part of the debate on the completion of the banking union and in particular its third pillar, the European Deposit Insurance Scheme or EDIS.27
6. Responses to the COVID-19 pandemic and steps ahead
Robert Schuman famously argued that ‘Europe will not be made all at once, or according to a single plan. It will be built through concrete achievements which first create a de facto solidarity.’ (Schuman declaration 1950).28 This was as much a prediction as it was a challenge. One of the most important characteristics of any effective policy is its ability to adapt to unexpected circumstances and redefine what solidarity means. In its response to the COVID-19 pandemic, arguably Europe has passed the test.
COVID-19 delivered the largest shock to the European economy since the Second World War. An overriding imperative was to prevent a wave of bankruptcies and job losses that would have caused untold harm to the lives of Europeans. The priority for national authorities was to ‘freeze’ the economy to temporarily absorb the losses arising from lockdown measures. In parallel, monetary policy was called on to be supportive, with further QE measures and new lending facilities.
The adoption of the Next Generation EU (NGEU) is a commendable exercise in EU solidarity in response to the pandemic. NGEU is an exceptional temporary recovery instrument included in the EU’s Multiannual Financial Framework (MFF) 2021–2027. The NGEU funding programme for the development of Europe is designed to boost recovery post-COVID-19 (€2.018 trillion). It aims to build a greener, more digital, and more resilient Europe. Coupled with the EU’s long-term budget it will increase flexibility mechanisms to guarantee it has the capacity to address unforeseen needs.
NGEU is under way and is being supplemented by both local funds and private investments.29 As part of the flexibility embedded in the programme, and in response to the Russian war of aggression on Ukraine, the EU recovery fund can be repurposed. Countries such as Poland have welcomed over two million Ukrainian refugees. It is an exercise in solidarity to offer help in these exceptional circumstances.30
With the EU’s fiscal rules suspended due to the extraordinary situation, EU Member States have pushed through unprecedented programmes of fiscal support. Loose monetary and fiscal policies have reinforced each other, while two features of the Euro area economy – the reliance on bank-based financing and a desire to protect jobs through furlough schemes – have become cornerstones of the EU response to the COVID-19 crisis.
In addition to the ECB facilities designed for the pandemic, in particular the pandemic emergency purchase programme (PEPP),31 the ECB has also facilitated access to euro liquidity outside the Euro area by setting up a series of bilateral swap and repo lines with other central banks and launching a Euro system repo facility. This has helped in stabilising financial markets, especially in countries where the euro is used extensively, and has contributed to fostering the euro’s international role.
According to Will Boonstra, the incomplete banking and capital markets union, in particular ‘the absence of a well developed market for EMU wide common safe assets (securities issued by the EU with a guarantee from all member states)’, is one reason for the stagnation of the euro’s development in the international arena. However, as Boonstra notes, ‘[t]he first serious steps in this area were taken in 2020 with the issuance of the so-called “corona bonds” by the European Commission’.32 ‘In times of turmoil, many investors still take into account the so-called “redenomination risk”, i.e., the risk that the eurozone will ultimately break and the euro will cease to exist’ (Boonstra, 2022: 3).
European banking union (though incomplete) has contributed to a more robust and resilient banking sector. However, progress is needed in the area of capital markets union (CMU),33 and this should be a priority for France while holding the presidency of the European Council. A CMU will be needed to restore growth and investment and to diversify sources of funding as well as to improve the efficiency of our financial system.
The capital markets union (CMU) is a plan to create a single market for capital. The aim is to get money – investments and savings – flowing across the EU so that it can benefit consumers, investors and companies, regardless of where they are located. A capital markets union will:
- provide businesses with a greater choice of funding at lower costs and provide SMEs [small and medium-sized enterprises] in particular with the financing they need
- support the economic recovery post-Covid-19 and create jobs
- offer new opportunities for savers and investors
- create a more inclusive and resilient economy
- help Europe deliver its new green deal and digital agenda
- reinforce the EU’s global competitiveness and autonomy
- make the financial system more resilient so it can better adapt to the UK’s departure from the EU.34
7. Concluding observations
This article considered several gaps in the governance of European banking union with emphasis on the missing pillar of banking union, namely LOLR/ELA.
In the United States, federalisation of liquidity assistance and supervision took place in 1913 with the establishment of the Federal Reserve System, while federalisation of bank insolvency (today resolution) and deposit insurance took place in 1933 with the establishment of the Federal Deposit Insurance Corporation (FDIC). In EU supervision, just as we went from Lamfalussy to De Larosière to the SSM, when it comes to crisis management, the SRM is a significant first step, while EDIS is needed to complete the framework. With the advent of banking union, the ECB should be the ultimate provider of liquidity in the Euro area, both in cases of market liquidity (already an ECB competence) and in cases of individual liquidity assistance (in accordance with Art. 18 of the ESCB Statute, Art. 127 of TFEU, and the principle of subsidiarity).
The future of Europe depends on its ability to regenerate its economies after the COVID-19 pandemic and to establish a competitive position in the global arena, one built on a green, digital, and inclusive agenda that fosters intergenerational equity.
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