European Union: Banking Union And Sovereign Exposures | Europe's Risk Averse Risk Sharing

Last Updated: 30 March 2016
Article by David Strachan and Scott Martin

Most Read Contributor in UK, August 2017

When the EU launched the Banking Union, the ultimate objective of the project was to be able to share risks between countries, rather than retain them at the national level. It is an aspiration that faces many complex political challenges, including the trade-off necessarily made by countries involved between risk sharing and risk reduction. The current EU debate on European deposit insurance, the so-called third pillar of the Banking Union, and the sovereign exposures of banks, reflects precisely such a compromise.

Risk sharing is something that Europe has been exploring for years. Several proposals have been put forward to share risks fiscally, with some form of common issuance or 'Eurobonds' mechanism, but these ultimately failed to gain enough traction to proceed. It was in spring 2012, however, that the growing threat from banking risk hastened the EU to conceive its most ambitious project since the launch of the Euro; an effort to establish a Banking Union that would "break the vicious circle between banks and their sovereigns." Since banking crises have triggered many of Europe's fiscal crises, sharing the risks associated with bank stability promised Europe a path to mostly achieve the kind of risk mutualisation that it couldn't with Eurobonds.

In 2016 that project is in part underway. Both a common supervisor, the Single Supervisory Mechanism (SSM), and a resolution authority, the Single Resolution Board (SRB) have been established and granted significant powers over the Eurozone's banks. The task is, however, as yet incomplete.

The bank-sovereign nexus in the Banking Union

Making a clean break between banks and sovereigns requires a number of additional steps. Some of these missing pieces were brought into uncomfortable definition during the close-call negotiations with Greece in 2015 that highlighted two ways in which the health of governments is still tied to the health of their banks:

  • The lack of pan-European/Eurozone deposit insurance: depositor worries during the Greek crisis triggered a bank run and the need for capital controls, even to protect SSM-supervised banks.
  • The exposure of banks to home-country sovereign debt: worries about a Greek government default called the solvency of Greek banks into question, and contributed to the bank run, which in turn, caused widespread economic harm and further weakened the Greek government's fiscal position.

The risk sharing – risk reduction trade-off

Common deposit insurance and doing something about bank exposures to sovereign debt are not new issues. Both have been discussed extensively in the past, but both were also areas that have been slow to make any progress in political and regulatory negotiations. This may now be changing.

Late in 2015, the European Commission's proposal to create a European Deposit Insurance Scheme (EDIS) was a determined push to deal with one of the two missing pieces mentioned above. It would create a European Deposit Insurance Fund (DIF) that would gradually take on greater responsibility for guaranteeing bank depositors in the Banking Union (so far just the Eurogroup countries), reaching a level of "full insurance" after seven years.

Politically, however, this quickly ran into trouble. A number of EU Member States, including Germany, the Netherlands and Finland called this a step too far that would run the risk of amplifying moral hazard in countries with riskier banking systems. They demanded that if Europe wanted to deal with the outstanding issues underlying the bank-sovereign nexus, it should not tackle them separately, but address both deposit insurance and sovereign exposures together. In other words, they insisted that the price to be paid for greater risk sharing had to include credible commitments to risk reduction.

The insistence on this quid pro quo was so strong that, in Brussels, the European Council's special working group established to look at these two is likely to formulate a risk reduction agenda first (of which sovereign exposures is the biggest part) and only begin negotiating deposit insurance when an EU-wide commitment can be made on some kind of constraint on bank holdings of government debt.

Reducing risk: options for dealing with sovereign exposures

Bank exposures to home-country sovereign debt, which are not limited or risk-weighted under the current EU bank capital rules, is one of the last unaddressed issues in the post-crisis capital framework. It's been identified as an important weakness in a much broader context than just the Banking Union, it's something that the Chairs of the SSM and SRB have both said Europe needs to act on, and it prompted the European Systemic Risk Board (ESRB) to make the declaration last March that "such debt can no longer be regarded as having zero credit risk and may also not be liquid."

Nevertheless, doing something about the risk-free regulatory treatment of sovereign exposures is enormously complicated, and is particularly difficult for countries whose banks hold relatively large amounts of their government's bonds.

Incidentally, those countries are, for the most part, also those that are pushing the hardest to establish a European system of risk sharing and deposit insurance. So, despite heated discussions on both sides, talks around what regulatory reforms are needed for such a trade-off have progressed to the point that at least three different options for dealing with sovereign exposures are now on the table:

  • Risk weights: would require banks to hold a certain amount of capital against their sovereign exposures to cover for risk. This approach, however, may face challenges over the lack of any limit on overall exposures and the potential for risk weights to act pro-cyclically in a crisis as sovereign credit ratings are downgraded.
  • A large-exposure limit: this would cap the exposure that banks can have to a single sovereign at a certain level, potentially around 25% of that bank's regulatory capital. While simple in design, this option could force banks to offload large amounts of sovereign debt, and has been opposed by senior lawmakers in some EU Member States.
  • A combination approach: there is some scope to take elements of the two options above to allow for a risk-free or low-risk-weight treatment of sovereign exposures under a certain limit, with a higher or increasing risk-weight applied to exposures exceeding that limit. While more sophisticated, this option would come with a more complex design requiring careful calibration that would determine its eventual effect on banks. 

As talks continue in Brussels, European negotiators are also contributing to a parallel discussion on sovereign risk in the Basel Committee, which has pledged to review the issue in a "careful, holistic and gradual manner" and is expected to tread carefully in making any recommendations. Aligning the European and international approaches makes good sense, but Europe's added impetus to address the issue in order to allow negotiations on common deposit insurance to start in earnest have potentially fast-tracked this process in the EU. How European officials ultimately choose to embed an approach to sovereign exposures into the prudential framework and how they align this with any Basel standards will be difficult but important decisions to make. Market participants should therefore watch closely for signals of progress from the EU over the course of this year.

In the end, whatever approach is taken to addressing the sovereign-bank nexus, and whatever trade-off is made between deposit insurance and sovereign exposures, the negotiations going on now stand to mark a crucial juncture in the long process of Europe determining how it will better absorb financial shocks, and potentially take a meaningful step towards more fiscal integration. This process, however, demonstrates that although the EU deciding how it shares the burden of risk is a fundamental project, the Union's soul searching over just how risk averse it will eventually be is no less significant.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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