Introduction
Ladies and Gentlemen:
Let me start by saying thank you to Tom (Arnold) the Director General of the Institute of International and European Affairs for his kind invitation to speak here this morning. As you all know this is a very important issue for Europe as well as for us here in Ireland, considering recent history. It is one I have spent a lot of time discussing and negotiating over the last 12 months, particularly during our Presidency, where we helped build consensus around the key aspects of banking union. Overall Banking Union has been the priority in our financial services agenda and I think it is fair to say that substantial progress has been made both in our Presidency and more recently by the Lithuanian Presidency.
Why do we need banking union?
Let me take a few minutes to recall that over the last 20 years or so we have seen some important foundations in the development towards a European banking union. In 1993 the single market in banking was inaugurated, transforming the legislative and regulatory environment for banking and financial markets. In the initial period, while the single market initiatives meant banks could operate across borders, with the safeguard of common capital standards and deposit protection, all cross-border activities still carried transaction costs and currency risks. With the introduction of the single currency for the Euro-area Member States in January 1999, these transaction costs were reduced and the currency risk was eliminated. This was a big step forward.
At this time the architects of the single currency believed that while an independent European central bank was essential, supervision should remain at national level, mainly because there was diversity in national regulation and trying to develop a common position would have been difficult. It was also believed that national supervisors understood their local market better than anybody else and, as such, were in a better position to address any difficulties that might arise. However, the door was left open to the possibility of joint supervision in article 127(6) of the Treaty which conferred upon the ECB specific tasks relating to the supervision of credit institutions.
The crisis begins to emerge
Before the crisis began to emerge in 2008, the benefits of the single currency and single market were seen in increased financial market integration and in the smooth operation of the interbank market, which responded efficiently to increasing credit demands of the EU. At the same time the balance sheets of banks were becoming more diversified. Yet, negative side effects were also beginning to emerge, which were not fully appreciated at the time, in particular large cross-border capital flows which helped generate significant sovereign and private sector imbalances throughout the EU, supporting asset price bubbles in a number of Member States including our own.
One of the reasons we did not have a full appreciation of the emerging imbalances was that the central focus of the supervisory system was at national level. Therefore we did not have a good overview at EU level to fully understand the impact of the direction we were taking and we did not appreciate the shortcomings of this approach to supervision.
As the crisis evolved, there was an overwhelming incentive for supervisors and Member State Governments to focus on addressing the problems that were arising in their own areas of responsibility and in protecting their own interests. In many instances this resulted in actions characterised by fragmentation on national border lines; often reducing cross border banking activities to maintain liquidity in national systems and adopting unilateral actions to ring fence banking operations for instance by limiting intra-group transfers and lending. The overall market effects were often negative and created much volatility in the broader EU and compounded an already difficult situation.
Another aspect of the banking crisis which has been well documented[1], is the speed at which banks grew over such a short period of time. We know a lot about this unfortunately! One of the impacts here was the failure of national supervisory authorities to respond appropriately. As a result by the time an insight was obtained into the scale of the problem, the capital shortfalls were so large that they overwhelmed the ability to respond effectively. Linked to this was the strong correlation between banks and the sovereign. Once particular banks were seen to be dependent upon government resources, the link between the sovereign and the banking sector was reinforced, particularly in peripheral countries. This resulted in a widening bond spread, compared with core countries, which were viewed as safe havens. Once this link between banks and sovereign was established private borrowing costs became aligned with the sovereign.
One of the major lessons learned from this period was the requirement for a more harmonised approach across the EU to banking supervision to ensure greater co-ordination of regulatory actions in order to deal in a cohesive fashion with the risks of how banks conduct their business. Clearly there was a need to ensure a level playing field by breaking the link between the sovereign and the banking sector while at the same time protecting the integrity of the single market. The establishment of the new supervisory bodies at EU level was part of the response; but a more developed banking union was also going to be required.
Steps to Banking Union
Let me now turn to the recent discussions that have taken place on banking union. As you know, the proposal for a banking union was first made in May 2012 and was an important part of restoring confidence in European credit institutions and the single currency. The integrated financial framework, or banking union as it has come to be known, was identified as a key component for delivering a stable and prosperous EMU in the report from the Four Presidents[2].
In Sept 2012 Commissioner Barnier published his proposal for the Single Supervisory Mechanism (SSM), which included a roadmap setting out how the elements of the Banking Union were to be established. The SSM will ensure that the EU’s policy relating to the prudential supervision of credit institutions, as set out in the CRD IV package, is implemented in a coherent and effective manner. It also seeks to ensure that the single rulebook for financial services is applied in the same manner to banks in all Member States concerned, and that those banks are subject to supervision of the highest quality, unfettered by other non-prudential considerations.
Under the SSM, responsibility for the supervision of all Euro-area credit institutions will transfer to the ECB in November 2014. The ECB, acting jointly with the national supervisors, will directly supervise the most significant institutions. For the less significant institutions, national authorities will be responsible. However, the ECB retains the power to intervene at any time to exercise supervision directly over any institution which it deems necessary to maintain financial stability. In order to ensure consistency of practice, the ECB will issue instructions, regulations and guidelines to the national supervisors for tasks performed by them as part of the SSM. It is important to point out that while euro area Member States are required to be members of the SSM, it is open to all Member States and it is hoped that some non-euro Member States will participate.
Under the Irish Presidency of the Council agreement was reached on the Capital Requirements package of legislation which will enhance financial stability, and strengthen the effectiveness of the regulation of credit institutions and investment firms in the EU. The Capital Requirements Directive and Regulation will ensure that European banks hold enough good quality capital to withstand future economic and financial shocks. A further objective is to contain the pro-cyclicality of the financial system which, in turn, will ensure a high level of protection for investors and depositors. The ECB, will apply the CRD package for the SSM institutions for which it has direct supervisory responsibility.
As you are aware political agreement was also reached on SSM under the Irish Presidency and the proposal was formally adopted last month and it has now entered into force. Over the next 12 months the ECB will carry out an asset quality review and stress tests for the most significant banks in the euro area. This is seen as an important exercise by the ECB, as they want basically a “clean bill of health” for the banking sector in advance of them taking control of supervision.
Banking union with just supervision is not enough
A complete banking union requires common supervision, deposit insurance and a common resolution framework, with an appropriate fiscal backstop. Following the adoption of the Single Supervisory Mechanism the European Council called for the creation of a Single Resolution Mechanism for banks covered by the SSM. This is consistent with the principle underpinning the banking union that where supervision is centralised, resolution should also be exercised at the same level of authority. If supervision was exercised at the central level but resolution remained at a national level, tensions could emerge between the EU level supervisor and the national resolution authority over how to deal with a failing bank.
The toolkit underpinning the Single
Resolution Mechanism is provided for in the bank recovery and resolution proposal (BRR) which was agreed last June in Council under the Irish Presidency. The proposal provides a common framework of rules and powers to help EU countries manage arrangements to deal with failing banks at national level as well as cross-border banks, whilst preserving essential bank operations and minimising taxpayers' exposure to losses.
There are three pillars to the BRR framework to facilitate a range of appropriate actions by authorities: –
Preparatory and preventative measures including reinforced supervision and robust recovery and resolution planning for major institutions;
Early intervention which would include supervisory powers, implementing recovery plans and appointing a special manager; and
Resolution tools including sale of business, bridge bank and asset separation tools and also the use of bail-in mechanisms.
It is fair to say that if these recovery and resolution measures were in place and rigorously followed and monitored, a significant amount of bailouts which have occurred over the last five years or so could have been avoided.
Funding
While the BRRD may provide the tool-kit, to be effective, the SRM requires adequate financial resources to support resolution. Key to this is an adequately funded Single Resolution Fund financed by the banking sector in the participating Member States. As you are aware the Commission proposal provides for a target funding level of 1% of the amount of covered deposits of all credit institutions authorised in the participating Member States. And it provides for a period of 10 years to achieve this level with contributions spread out as evenly as possible over this period.
In relation to scope I believe it is essential that all banks contribute to the fund as it has been demonstrated that the size of a bank is not necessarily an accurate indicator of its systemic impact in a crisis situation. Furthermore all banks will benefit from the financial stability that the SRM will provide. The last thing we want is a two tier system which treats different banks in different ways.
An important issue for Ireland in the SRM debate is to ensure adequate resources in the early years of the new regime when the Single Resolution Fund is building up its funding levels. Our concern is that if there is a significant call upon the Fund in its early years this could have financial implications for Member States unless sufficient monies are available in the Fund. The proposal does try to limit the exposure of Member States in Article 6.4 where it states that “No decision of the Board or the Commission shall require Member States to provide extraordinary public financial support”. However the practical reality is that, in the absence of a backstop to the SRM, Member States may be forced be to make significant contributions to resolution.
Consequently, we believe that there needs to be agreement on the establishment of a backstop to the SRM which would provide certainty that an alternative source of financing is available, should there be any shortfall in the Single Resolution Fund. In our view, the most appropriate means of achieving this objective is to have a credit line available from the ESM in such circumstances. Not all Member States necessarily agree on the backstop issue and in particular on how it should be funded. However in my view, the backstop is necessary to achieve the central objective of the SRM – that is – to break the link between the sovereign and the banking sector. Therefore this issue will continue to be one that I will focus on as part of the on-going negotiations on SRM and as part of the broader ESM discussions at Ecofin.
Completing the Banking Union and next steps
To conclude negotiations on banking union, we are working to the deadline set by the European Council. This requires us to reach agreement on the SRM by the end of the legislative term in the early part of 2014. We will discuss the SRM in ECOFIN next week where it is hoped that final agreement in Council will be reached. While there are still some hurdles to be overcome, I believe the Lithuanian Presidency is moving in the right direction and that agreement in Council by the end of the year is possible.
In parallel it should also be kept in mind that the Presidency is also aiming for final agreement with the European Parliament on BRR and DGS so that agreement on the main elements of banking union can be reached by the end of the year.
Benefits of banking union
While a core objective of the Banking Union is to break the bank sovereign nexus, there should be knock-on benefits which ought to deliver significant benefits to the real economy.
The major benefit, as I see it, is that the cost of bank finance to SMEs and households should converge to the euro area average. In other words a small business should be able to borrow at the same rate as its equivalent in other euro area countries, assuming they both have the same level of credit risk, simply because the country risk has been eliminated. This is particularly important for a country such as Ireland where our cost of funding has been consistently higher than the core euro area countries over the last number of years. Banking union is an important step in removing this competitive disadvantage and should contribute to strengthening the domestic economy.
Exiting the bail-out
Before I conclude, I would like to make some remarks about our exit from the EU-IMF programme.
The successful implementation of our programme has paved the way to exit in mid-December. We have delivered over 260 actions under the programme, undergone 12 quarterly reviews and upon conclusion we will have drawn down €67.5 billion in funds. We have demonstrated our commitment to getting our country back on track.
Most significantly, we have returned successfully to the financial markets. We now have substantial cash reserves, in excess of €20 billion, which can be called on as a domestic backstop. Domestic and international economic conditions are improving, monetary policy decisions are conducive to exit and confidence and sentiment towards Ireland has improved considerably in recent months. Like most other sovereign euro area countries, from 2014 we will be in a position to fund ourselves normally on the markets.
Our financial sector has also undergone significant restructuring and has been stabilised. This restructuring included deleveraging undertaken as part of the Financial Measures Programme and the merger of Allied Irish Banks with the EBS. Exceptional Liquidity Assistance has been removed from the system following the liquidation of IBRC. NAMA has maintained a strong financial position, generating considerable cash, leaving it on track to redeem €7.5 billion of bonds by the end of this year. Private capital has been brought into the banking system through the sale of Bank of Ireland equity in 2011 and contingent capital notes this year, and also by the sale of Irish Life this year.
Confidence in the Irish banks is beginning to return and this has helped reduce their reliance on Eurosystem funding, which is now a fraction of what it was at the beginning of the programme. This is further evidenced by the successful conclusion of significant funding transactions by both AIB and PTSB in the international debt markets, raising a combined total of €1 billion of long term funding. Both transactions, which were heavily oversubscribed, represent another significant step forward in the rehabilitation of the Irish Banking system.
Recent indicators are showing the continuation of the recovery. Employment grew robustly at over 3 per cent year-on-year in Q3, property prices have begun to grow again and household debt (although high) is on a downward trajectory. Trading partner growth has also resumed and, while challenges and risks remain, external prospects are at their most benign for Ireland for a number of years.
Concluding remarks
In conclusion then, I would like to thank you once again for the opportunity to speak on this very important matter. In my view Banking Union is in many respects the most critical issue which is currently facing the EU and which we need to get right if we are to re-invigorate both our own economy and the rest of Europe. It is also an essential pillar of economic and monetary union. I think we are moving in the right direction; however the next number of weeks is going to be particularly important as we work on laying the ground with final agreements on BRR, and DGS as well as obtaining a General Council approach on SRM.