G roup I nstitutional & R egulatory A ffairs

Group Institutional & Regulatory Affairs The supervision of an integrating European banking sector Zeno Rotondi April 2015

Index • Introduction • Towards a European Banking Union: the new regulatory and supervisory framework • Conclusions

Should there be one or more financial supervisors? (1) Introduction • The financial sector needs much closer supervision and stricter regulation than other economic sectors, because financial institutions are critical to the operation of the economy, and finance is based on public trust. Financial regulation addresses negative externalities by modifying private agents' incentives, constraining their action, and putting mechanisms in place to prevent the most damaging effects of failures, particularly those of banks. Financial supervision is needed to monitor agents' behaviour and to enforce the rules. • Supervision can be grouped into three broad categories: • microprudential supervision: surveillance of the safety and soundness of individual institutions; • macroprudentialsupervision: monitoring the exposure to systemic risk, identifying potential threats to stability arising from macroeconomic or financial market developments, and from market infrastructures; • customer protection: monitoring business conduct and the disclosure of information to customers and other stakeholders. Source: Rossi (2015)

Should there be one or more financial supervisors? (2) Introduction • The financial regulatory and supervisory architecture varies considerably across countries. Tables 1 and 2 show the models chosen by a selection of countries outside and inside the euro area, otherwise referred to as the Euro Zone (EZ). The models are based on data provided in Oreski and Pavcovic (2014) and classified as follows: • In the ‘sectorial’ (‘vertical’) model there is a regulator/supervisor for each main sector within the financial system – banks, insurance companies, non-bank financial intermediaries, securities markets, etc. – which is in charge of all functions: micro, macro, and customer protection. • In the ‘twin-peaks’ model, there is one authority for prudential supervision and another responsible for market conduct and customer protection. Each of them extends its competence over all sectors of the financial system. • The ‘integrated’ model combines the preceding two in a sort of universal authority responsible for both prudential and business conduct regulation/supervision for the entire financial industry. • Any other solution is dubbed ‘hybrid’ when it has elements of more than one model in it. Finally, Tables 1 and 2 distinguish, but only for the ‘integrated’ and ‘hybrid’ frameworks, whether the authorities are, totally or mostly, part of the central bank (CB) or not. Source: Rossi (2015)

Should there be one or more financial supervisors? (3) Introduction • Outside the EZ we find two twin-peaks models (Australia and the UK), one sectorial (USA), and one hybrid (Canada). The four remaining frameworks (Japan, the Russian Federation, Sweden, and Switzerland) are integrated, and only in the case of Russia is the single authority part of the central bank. In the sectorial and twinpeaks cases, the central bank is involved at least partially. • In the EZ, we see two twin-peaks models (Belgium and the Netherlands), one sectorial (Spain), two hybrid (France and Italy, in both cases with a heavy involvement of the central bank), and three integrated (Austria, Finland, and Germany). • Theoretically, all these models have advantages and disadvantages. The merits of one model are always the demerits of another, and vice versa. The main arguments in favour of greater integration are: i) economies of scope, ii) better assessment of risks, iii) effectiveness (better cooperation within one organization than between many agencies), iv) less regulatory arbitrage or supervisory gaps, and v) increased accountability. Source: Rossi (2015)

Should there be one or more financial supervisors? (4) Introduction • In Italy, as I said before when commenting on Table 2, a hybrid model applies. The various authorities involved in regulating and supervising the financial system have mostly sectorial dividing lines: the Bank of Italy for the banking sector, Ivassfor the insurance sector, and Covip for pension funds, all of them involved in both prudential supervision and consumer protection. • But there is also an element of the twin-peaks model, with Consob in charge of market conduct and transparency for all listed intermediaries, and the Antitrust authority in charge of protecting competition in all markets, including the credit and financial ones. Furthermore, Ivass, the insurance regulator, was recently placed under the umbrella of the Bank of Italy, while remaining a separate legal entity. Furthermore, borders between the sectorial authorities are somewhat blurred, and conflicts of competence arise from time to time. Source: Rossi (2015)

Should there be one or more financial supervisors? (5) Introduction Source: Rossi (2015)

Monetary policy and supervision under one roof? (1) Introduction • This specific debate on the benefits and risks of entrusting a central bank with banking supervision is a long standing one. The literature generally concludes that no single pattern of division of supervisory responsibilities between the central bank and other authorities is unquestionably superior. • The most widely cited benefits of having monetary policy and bank supervision residing under one roof are related to: • the exchange of information • shared concern for financial stability Source: Rossi (2015)

Monetary policy and supervision under one roof? (2) Introduction • The first benefit may be well illustrated by the UK experience: the failure of supervisors to head off problems in Northern Rock and prevent the first bank run in more than a century is an outcome widely attributed to imperfect coordination and inadequate information-sharing between the FSA and the Bank of England (Eichengreenand Dincer, 2011). • Bank-specific information is very important for central banks when they act as lenders of last resort. The central bank is the ultimate guarantor of financial stability during a crisis. In performing its LOLR function, the central bank has to assess the liquidity and solvency of its counterparts. More generally, central bank risk management would benefit from better access to information on the financial health of banks to assess the quality of the collateral that these banks provide. Especially in times of tensions, having such information in house increases the timeliness of the information flow. Source: Rossi (2015)

Monetary policy and supervision under one roof? (3) Introduction • Bernanke (2007) underlines that supervisory responsibilities give the central bank access to a wealth of granular on each bank’s organization, management structure, lines of business, financial condition, internal controls, risk-management practices, and operational vulnerabilities. This is beneficial for the conduct of monetary policy because banks play a central role in the transmission of monetary policy impulses. For example, supervisory information on bank capital is useful to assess the contribution of capital constraints to credit developments (Bernanke and Lown, 1991). Similarly, monitoring the portfolio choices of banks is useful to assess the consequences of monetary policy on the accumulation of risks. This information improves the ability of central banks to prevent financial instability. Source: Rossi (2015)

Monetary policy and supervision under one roof? (4) Introduction • The second benefit is related to the common concern for financial stability. Historically financial stability has been a main task for central banks, even without an explicit mandate. In many countries it has been a fundamental factor for their establishment. • Central banks conduct monetary policy to achieve price stability – in most cases their primary goal – and this in turn fosters broader macroeconomic stability and contributes to financial stability. But often central banks have specific responsibilities in the financial stability sphere, as this is a key precondition for price stability. • Central banks with prudential supervisory powers can pursue the objectives of price stability and financial stability with a wider set of instruments, whereas a central bank with monetary policy powers only might end up being overburdened. Source: Rossi (2015)

Monetary policy and supervision under one roof? (5) Introduction • Here it comes a third benefit from having monetary policy and supervision under the common roof of the central bank: it mutually reinforces independence. As recalled by the IMF’s principles, independence is a requirement not only for monetary policy but also for effective supervision. Italy’s historical experience suggests that attributing the supervision of banks to the central bank can not only strengthen the independence of the supervisor: credibility as a tough supervisor can in turn reinforce its reputation and standing in the enactment of monetary policy. • However, we must be aware that the common roof entails the risk of a conflict of interest. The central bank may have an incentive to keep monetary policy too loose to avoid the adverse effects of tighter money conditions on bank earnings and credit quality, 12 and provide liquidity to weak banks to avoid triggering losses. A supervisor that is also a central bank may be tempted to forbearance during a downturn, delaying the closure of problem banks in the hope that macroeconomic conditions improve and the problems in the financial system disappear on their own. Source: Rossi (2015)

Monetary policy and supervision under one roof? (6) Introduction • The potential for conflicts of interest between monetary policy and prudential supervision is debatable. In many instances, such as during the global financial crisis, financial instability can generate deflationary pressures. • There is no clear evidence that central banks with supervisory powers were more or less prone to forbearance than other supervisory agencies. Situations of conflicts of interest between supervisory objectives and monetary policy goals may exist, but attributing the functions to separate authorities. • Having separate authorities would make coordination even more burdensome. Source: Rossi (2015)

Origin and motives of the European Banking Union project (1) European Banking Union • The construction of Europe since the end of WW2 has followed a long and winding road. The Banking Union (BU) is the most recent step. It is still an ongoing process; it has been designed to solve what can be considered the worst crisis ever of the European edifice: the sovereign debt crisis. • We know where the crisis came from. The triggers were local financial crises in two small economies of the EZ, Greece and Cyprus. The response by the European governments and institutions was flawed, and fuelled markets’ suspicion that the euro was not in fact irreversible, as the European rhetoric had claimed until then: a sort of disaffection towards the euro was apparently spreading in important founding countries, particularly in the North of Europe. • Market turmoil receded after the announcement of the Outright Monetary Transactions programme (OMT) by the ECB (‘Whatever it takes’), but meanwhile banks in high-public-debt countries had become the main target of the markets’ concern: they held a considerable amount of public bonds of their respective sovereigns in their balance sheets; the riskiness now attached to the sovereigns was being transmitted to the domestic banks' balance sheets and back to the sovereigns, perceived as the ultimate support to their domestic banking systems, in a vicious circle. Source: Rossi (2015)

Origin and motives of the European Banking Union project (2) European Banking Union • How to sever the sovereign-bank link? The safest way to do it was straightforward: we needed to convince the markets that the EZ banks belong to a common system, so that if one of them fails, or is likely to fail, bailing it out is no more the responsibility of one country, but of all. However, if we wanted all the EZ countries, in particular the low-public-debt ones, to share such a financial responsibility, we had to allow them also to share the ex ante supervision on all banks, not only on the domestic banks of each country. In other terms, we needed to create a Single Supervisory Mechanism (SSM). • The BU project was launched in 2012, and it was conceived as an institutional framework with three pillars: an SSM, a Single Resolution Mechanism (SRM), and a Single Deposit Insurance Scheme (SDIS). The three pillars were originally meant to be concurrent, symmetric and logically connected. The outcome has been different. • The SDIS has been postponed to an indefinite future. On the crucial issue of bank resolution, a long and tiresome negotiation took place, which eventually brought about a reverse approach: it was decided that sharing the cost of a banking crisis among all the EZ countries was not for now; it is foreseen as the final step of a many-year-long process, and in any case it will involve private funds only (the Single Resolution Fund, financed by all the EZ banks). In particular, the use of money from the taxpayers of countries other than the one where the bank’s head office is located has been ruled out – contrary to the original intention. Source: Rossi (2015)

Origin and motives of the European Banking Union project (3) European Banking Union • During the negotiations Italy offered a view consistent with the very motives behind the BU project: the SSM was supposed to be the prerequisite of a common public backstop for distressed banks, with the aims of removing the “tail risk” from the EZ banking system and cutting the link between sovereigns and banks; any moral hazard could be prevented by an effective common supervision. This view, also shared by several other countries, was eventually rejected by the majority. • Meanwhile the SSM was created. The new system has been in place since November 2014. It is centered on the European Central Bank (ECB) and comprises all the national competent authorities (NCAs) of the euro-area countries. • The Single Supervisory Board (SSB), which includes 6 members appointed by the ECB and 19 representatives of the NCAs, is directly responsible for supervision of around 120 ‘significant’ banks. In practice, supervision of each of those banks is conducted by a Joint Supervisory Team (JST) comprising experts from the SSM staff and from the NCAs of the countries where that bank is located. Source: Rossi (2015)

Origin and motives of the European Banking Union project (4) European Banking Union • We now have in Europe a very complicated regulatory and supervisory framework for banks. Regulation is provided by the EBA, an EU-wide entity, while supervision is the responsibility of the SSM, but only for EZ banks. Bank resolution is disciplined by a specific EU Directive and governed by the SRM. The European Systemic Risk Board (ESRB) is in charge of macroprudentialmonitoring. • This is the European layer. The domestic layer, the NCAs, is also fully involved in both regulation and supervision, to various degrees. The two layers coexist, although with different responsibilities: the multinational nature of the Mechanism implies a multiplication of resources dedicated to the various tasks, also because of the need for coordination. It is a costly exercise. Source: Rossi (2015)

The ‘common roof’ choice European Banking Union • A crucial decision was to place the SSM within the ECB. It came after a prolonged discussion, where different lines of thought were confronting. The risk of a conflict of interest between monetary policy and supervisory action was meant to be mitigated by separating the analysis aimed at supervision from the one aimed at monetary policy, and analysis from decisionmaking. • The SSM Regulation actually establishes the separation between the monetary policy function and supervision. The ECB is responsible for carrying out monetary policy functions with a view to maintaining price stability, while the exercise of supervisory tasks has the objective of protecting the safety and soundness of credit institutions and the stability of the financial system. The Regulation thus establishes that monetary policy and supervision should be carried out in full separation, in order to avoid conflicts of interest. Source: Rossi (2015)

The road ahead (1) European Banking Union • Is there a risk that markets will see the BU as a fragile, lopsided creature; that financial market fragmentation will remain untamed; that the BU objectives will be missed? Not necessarily. What we have achieved so far may be not the first best, but it is something. The SSM, the starting point, is valuable per se. • What the NCAs have to do is to build a real single house. We have to bring to this common endeavour the best practices and the most useful experiences. In order to exploit the potential of the SSM, it is essential to harmonize supervisory practices so that the resulting single standard be the highest possible, in terms of both prudence and effectiveness in financing the real economy. Source: Rossi (2015)

The road ahead (2) European Banking Union • In the years preceding the global financial crisis, harshly competing and gigantic intermediaries, mostly in the US, pushed the authorities to lower their regulatory and supervisory standards; on the other hand, shadow banking activities were developed, totally hidden from regulators and supervisors. This latter phenomenon still poses a risk: overburdening banks with ever increasing requests for more capital may be pro-cyclical and counterproductive from the point of view of systemic stability, in that it incentivizes finance to go further into the shadow. • We must let our banks do their job better than they did before the crisis. They must be more stable, more efficient, more competitive, to the benefit of the whole economy. We must dissipate every remaining uncertainty in the markets regarding the irreversibility of the euro, so that the common EZ monetary policy can work fully and correctly. Source: Rossi (2015)

The structure of financial supervision after the crisis (1) European Banking Union • At the EU level, immediately after the 2008 financial crisis, following the proposal presented in February 2009 by a group of experts chaired by Jacques de Larosière (de Larosière Group, 2009), the European Union introduced relevant changes to its architecture for financial supervision. A new EU body for macro-prudential supervision was created, the European Systemic Risk Board (ESRB); three micro-prudential supervisors were created, building up on the previous so-called Level Three (implementing guidelines) Committees, CEBS, CESR and CEIOPS, which became supervisory authorities and were named EBA (European Banking Authority), ESMA (European Securities and Markets Authority) and EIOPA (European Insurance and Occupational Pensions Authority). These new regulators were assigned a number of key tasks including the development of a single rulebook for financial markets in the EU, a mediation role between different national authorities and a coordination role in emergency situations. The three authorities were designed on the basis of a sectoral approach, following the traditional tripartition of financial markets, even though the possibility of a review has already been envisaged. A reciprocal flow of information must be exchanged between ESRB and the ESAs (Figure 1). It should be stressed that the establishment of the ESAs has not been effective at reducing the burden and the activities to be carried out by national authorities, and the related expected cost savings have not been reaped to date. Source: Di Giorgio et al (2015)

The structure of financial supervision after the crisis (2) Introduction Figure 1 - ESRB and ESAs Source: Di Giorgio et al (2015)

The structure of financial supervision after the crisis (3) European Banking Union • The establishment of the Single Supervisory Mechanisms (SSM) at the Eurozone/EU level, which became operational on November 4, 2014, has dramatically innovated the approach and structure of banking supervision in light of the new role of the European Central Bank (ECB) as the direct supervisor of the largest and systemic banking groups in Europe: about 130 European banking groups, accounting for circa 85% of total assets, have fallen under the supervisory umbrella of the ECB. • The ECB is entrusted with direct supervision of systemic banks, defined as those: i) with total assets exceeding € 30 billion; ii) with total assets exceeding 20% of national GDP (unless total assets are below € 5 billion); iii) being among the three most significant credit institutions in a member state; iv) identified by the ECB as significant either following notification by national supervisors or on its own initiative having regard to cross-border relevance; v) having requested or received public financial assistance directly from the EFSF/ESM. • Supervisory tasks are carried out by the Supervisory Board, a new internal body of the ECB, which is separated from the ECB Governing Council and thus from the monetary policy arm in order to minimize potential conflicts between objectives. National supervisors will retain direct supervisory powers on all other banks, but with regard to these banks the ECB shall issue regulations, guidelines and instructions to national supervisors; can intervene directly where necessary to ensure high supervisory standards; can request information and conduct investigations and inspections. Source: Di Giorgio et al (2015)

The structure of financial supervision after the crisis (4) European Banking Union • Therefore, the SSM is a network of supervisors, entailing an allocation and sharing of responsibilities between the ECB and national supervisors. The new system is thus likely to be more complex and articulated, also because at the national level different supervisory structures are still in place across EU countries: in some countries a sectoral approach remains (e.g. Spain, Greece, Portugal); in others, one supervisor is in charge of preserving financial stability, while a separate body oversees conduct of business and must ensure transparency (e.g. Netherlands and, to a large extent, Italy); some countries still rely on a single regulator (e.g. Germany and Ireland). • Table 1 provides an overview of the organizational structure of financial supervision in selected advanced countries and illustrates, at least in part, the overall complexity of the current architectures. It should be noted that supervisory institutional arrangements do not always perfectly mirror a specific theoretical model: hybrid solutions may be identified, combining elements of different models. For example, France has adopted a model by objective, with the Autorité de contrôleprudentiel et de resolution (ACPR) in charge of stability and the Autorité des marchés financiers (AMF) in charge of transparency and investor protection. But the ACPR performs its functions with regard to banks and insurance firms, and it ensures investor protection for the clients of these firms: clearly, the approach by sector and the approach by objective are mixed. In Italy, the dominant approach is based on objectives, but two sectoral authorities oversee the insurance and pension funds sectors (Ivass and Covip, respectively). Source: Di Giorgio et al (2015)

Structure of financial supervision in Europe, as of March 2015 (5) Introduction Table 1 Source: Di Giorgio et al (2015). NOTES: Some specific supervisory functions, e.g. setting regulatory framework, monitoring books, conducting inspections. B=banks, I=insurance, S=securities, P=prudential, C=conduct of business, CB=central banks, G=government, BI,SI,BS=integrated by sector, U = single regulator.

The structure of financial supervision after the crisis (6) European Banking Union • A further element of complexity is related to the scope of application of the SSM (and, more broadly, of the banking union project), since all euro area countries will participate to SSM, while EU non-euro countries may join on a voluntary basis through ‘close cooperation’ agreements with the ECB, but may also choose to stay out (as already done by the United Kingdom). However, vis-à-vis this fragmentation related to supervision, regulatory functions at EU level have been assigned to the EBA for all EU member states, thus creating a complex and interesting asymmetry and geographical mismatch between regulation and supervision. Source: Di Giorgio et al (2015)

The structure of financial supervision after the crisis (7) European Banking Union • More broadly, and quite apart from the issue of the central bank involvement in banking supervision, the 2008 global financial crisis showed that no model of financial supervision was able to perform better than the others: in other words, the key lesson was that no optimal structure of financial supervision exists. The systemic crisis hit banks and financial markets regardless of the institutional arrangements for financial regulation and supervision: it certainly hit the United Kingdom, the country that had had a leading role in the shift to the single regulator model; it hit countries where supervision was organized with a sectoral approach; it hit countries with a model of supervision by objectives; it hit countries where the central bank was in charge of supervision as well as countries where the central bank lacked oversight powers. • In particular, looking at post crisis reforms, the two main lessons drawn from policy-makers seem to be that: 1) the single regulator model is not necessarily the best model; and 2) splitting micro and macro-prudential supervision might be a risky choice, and the two functions should be combined under the central bank umbrella. As a consequence, some countries (e.g. UK and Belgium) have abandoned the single regulator model and reverted to the central bank as the key authority for banking and financial regulation and supervision. But the single regulator is still in place in other countries, like Germany, and in general changes in the institutional arrangements for supervision have been uneven and heterogeneous across countries, leading to a complex web of different national supervisory architectures. Source: Di Giorgio et al (2015)

The structure of financial supervision after the crisis (8) European Banking Union • On top of the complexity of national arrangements, the new European layers of regulation and supervision are likely to make the overall framework even more complex. The approach and the institutional choices on the creation of a EU level of regulation and supervision have been different and, to some extent, conflicting: regulatory functions on all financial market segments (banks, markets, insurance and pension funds) have been assigned to the three ESAs, set up with a sectoral approach, while supervision has been entrusted to the ECB, within the SSM, but just for banks and with a focus on stability. • Moreover, ESMA is also entrusted with supervision of credit rating agencies and trade repositories, adding complexity to institutional arrangements; and, as recalled, EBA is responsible for the single rulebook for all EU countries, while supervision will have a narrower geographic scope only including SSM countries. The assignment to the ECB of banking supervisory powers on stability could not only create room for conflicts between different ECB objectives, but it might also make it more difficult to deal with potential conflicts between stability (ECB) and transparency (ESMA), leading to possible inter-agency conflicts. Source: Di Giorgio et al (2015)

The structure of financial supervision after the crisis (9) European Banking Union • The 2014 review of the ESAs and the European System of Financial Supervision carried out by the European Commission has been very prudent on possible changes to institutional structures: the report mentioned the possibility of moving to a “twin peaks” or a single regulator model and the need to take into account the banking union development, but it fell short of proposing significant changes in the near term, announcing further analysis of the issue with a medium to long term perspective (European Commission 2014a, 2014b). In light of the excessive complexity of current arrangements, the 2014 might be considered as a missed opportunity to rationalize the system and make it simpler, more consistent and more effective. • Finally, the establishment of a banking union might create a further asymmetry, in absence of a broader and more structured financial union. There is a need to rationalize and simplify the legislative framework on financial markets, possibly concentrating all rules in a single rulebook for financial markets in the EU: the current legislative regime is excessively complex and formal compliance with such rules is likely to be excessively burdensome for the financial industry, with a potential to jeopardize compliance with rules from a substantial point of view. Also, supervision should be centralized at the European level, as it has been done for the banking sector, eliminating or minimizing the room for divergent supervisory practices, which currently prevent from the creation of a leveled playing field and may be exploited to reap competitive advantages. Source: Di Giorgio et al (2015)

The structure of financial supervision after the crisis (10) European Banking Union • The capital markets union project recently launched by the European Commission (2015) might play a crucial role in this domain. Though rules disciplining the markets for financial instruments are common to all European countries, financial supervision is still run based on national, and to some extent different, level. Differences among European countries in the development of financial markets, in their financial culture and traditions, as well as, the ESMA’s limited enforcement power provide tremendous obstacles to the centralization process of financial markets supervision. Having a strong European authority in charge of regulation and supervision is essential to actually harmonize supervisory practices and benefit from a concrete institutional simplification. • The complexity of the institutional structures of financial supervision is likely to be particularly burdensome for large European and global cross-border banking and financial groups, which are obliged to deal with a huge number of supervisors in the multiple jurisdictions where they operate: supervisory fragmentation is thus likely to produce a cost for financial institutions. The introduction of new set of rules will make even more difficult the competitive scenario for many financial intermediaries in Europe. In fact, the new revisions of MiFID and IMD directives, as well as the PRIIPs regulation, are expected to set out a wide range of issues and significant changes in market participants’ behavior and in their responsibilities. These changes will inevitably call for a revision in the current supervision and compliance systems. Source: Di Giorgio et al (2015)

The European Banking and Capital Markets Unions – challenges and risks (1) Conclusion • We must not underestimate what has already been accomplished by the BU project. This thorough overhaul of the euro area supervisory architecture took place in – indeed, was motivated by – an environment marked by unsatisfactory economic growth, increasing perceptions of sovereign risk and mounting doubts on the very survival of the euro. The BU project has already helped the stabilization efforts in the Eurozone, which is a prerequisite for economic growth. First, it gave an important signal of the willingness of the member countries to forge ahead with unification. In itself, this provided a potent antidote to the sovereign debt crisis, whose key determinant had been lack of confidence in the single currency project. Second, common supervision and a centralized resolution authority lay the basis for financial stability. • Banking Union, together with other national and European policies – in particular, the monetary policy measures recently decided by the Governing Council of the ECB – is already contributing to the normalization in credit conditions for firms and households. The comprehensive assessment of the balance sheets of the largest euro area banks, which preceded the launch of the (SSM), enhanced transparency and dispelled doubts about the banks’ resilience. Further progress is expected as the SSM brings harmonization of supervisory and business practices, reducing investors’ perception of risks. Although complete normalization in credit conditions will likely require definitive exit from the crisis and a return to stable economic growth, signs of gradual improvement can already be discerned in the surveys conducted by the Eurosystem and in other indicators. Source: Panetta (2015)

The European Banking and Capital Markets Unions – challenges and risks (2) Conclusion • Banking Union has imparted a strong impulse to the efficiency of the financial system by fostering competition across euro area countries. Consider for example the recent decree on the governance of the cooperative banks in Italy. The initiative is the product of a good many years of reflection on the shortcomings of the cooperative structure for listed or very large banks; at the same time, it can be read as part of a broader reform effort to bring the Italian economy up to the best European standards of efficiency. • The important steps already taken need to be followed by further progress, on several fronts. Since the list would be long, I shall mention just one general issue and two specific ones. The overarching issue: further progress towards European integration is essential. We should not forget that the current crisis was provoked, in part, precisely by lack of progress in European integration following the adoption of the single monetary policy. The BU project has gotten the process started again, helping to defuse the crisis. But we must not make the same mistake twice; the integration process cannot be allowed to stall again. Progress in this direction is particularly difficult at present, because national centrifugal forces seem strong. They are visible in various forms: growing support for anti-euro or euro-skeptical political parties in several countries, for one, and the difficulties encountered by European and Eurozone institutions in discussing issues from an area-wide perspective, for another. National interests and perspectives are strong. Take, for instance, the distinction between core and periphery, which has become standard in many discussions and official publications. Source: Panetta (2015)

The European Banking and Capital Markets Unions – challenges and risks (3) Conclusion • If unification is to advance, we must reinforce mutual trust at the international level. This must be achieved over time, through consistent behavior on the part of all parties and recognizing that it is in the interest of every member state to factor in the need to reduce negative spillovers from one economy to the others. If we succeed, it will gradually become clear that there is no conflict between European financial integration and financial stability; indeed, that by favoring the cross-border diversification of risks, financial integration will foster financial stability. Source: Panetta (2015)

The European Banking and Capital Markets Unions – challenges and risks (4) Conclusion • Micro- versus Macroprudentialpolicies: • Throughout 2014 and since the launch of the SSM, the European supervisory authorities have focused mainly on the capital position of banks. This emphasis on strong capitalization was necessary to restore confidence. Now that the comprehensive assessment has shown that the European banking system is solid, it is essential to avoid inducing pro-cyclical behavior by banks, curtailing lending to the economy. • Any bank, taken individually, may have an incentive to strengthen its capital adequacy by curtailing lending. This does not have strong counterindications if other banks have incentives to expand lending. But if all the banks seek to deleverage at the same time, this could trigger a credit crunch, with adverse repercussions on the economy and ultimately on the banking system itself. The crisis drove this simple lesson in externalities home emphatically, prompting the creation of macroprudential authorities in most countries. And as we know, the incentives of micro- and macroprudential authorities are aligned during economic expansions (both policies should be tightened, to strengthen the resilience of single banks and to “lean against the wind” of an aggregate credit boom). However, they tend to diverge during downturns, when, as I just now observed, the macroprudential authority should be wary of imposing stiffer capital requirements. Source: Panetta (2015)

The European Banking and Capital Markets Unions – challenges and risks (5) Conclusion • The present state of the economy in the Eurozone offers a textbook case of the potential tension between micro- and macroprudential policies. There is broad agreement (egwithin the ESRB) that macro risks – low nominal growth in particular – are among the more serious threats to financial stability. In the Eurozone credit growth is negative, and the credit/GDP gap (the main indicator set by the Basel rules to steer the countercyclical capital buffer) is amply negative in most countries. Fully aware that relaunching nominal economic growth in the Eurozone is the paramount objective, the ECB has embarked on a program of quantitative easing. • In this environment, macroprudential policy needs to lean decisively against the wind and act to rekindle credit and economic growth. But in practice it is not doing so. Indeed, most recent macroprudentialactions at national level have further tightened capital requirements, in response to national problems. Coupled with the ongoing micro-level tightening, these measures could ultimately aggravate the risks of persistently low nominal growth. There are certainly good reasons for leaving area-wide macroprudentialinstruments on hold. At the same time, since under the Regulation the SSM has both micro- and macroprudentialresponsibilities. Source: Panetta (2015)

The European Banking and Capital Markets Unions – challenges and risks (6) Conclusion • The complexity of the European system of financial supervision is extraordinary: • This complexity follows from two main factors. First, there are a large number of actors on the stage – at both national and supranational levels, with both micro- and macro-prudential objectives – and in interaction with one another. Legislators, perfectly well aware that the new set of rules that originated the system may need some fine tuning, incorporated the deadlines of a revision process in the rules themselves. Time and experience will tell just how much room there is for simplification. Second, EU member countries are still characterized by different accounting and legal regimes. Convergence is necessary for company, insolvency and taxation law in particular, but a gradual approach will be inevitable. Meanwhile, an effort by all stakeholders will be necessary to get the system to work effectively and to ensure a level playing field. • Heterogeneity is found in the area of supervision as well and the expectation is that the SSM will bring relatively swift convergence in supervisory practices. The preliminary assessment of the functioning of the SSM is positive. The progress achieved in such a short time has been amazing. Nonetheless, we are still at the very first stages, and adjustments may well be necessary. We need to avoid the risks of inefficiency that stem from the complexity of the machinery. A huge number of issues – and of related decisions – are brought to the attention of the Supervisory Board; this threatens to deflect attention from proper reflection on the more important issues. I am sure that we shall be able to flexibly adapt the framework as needs arise. Source: Panetta (2015)

The European Banking and Capital Markets Unions – challenges and risks (7) Conclusion • The Capital Markets Union: • That European firms rely too heavily on banks for external funds has been known for decades, but the crisis has now thrown the dangers of this model into sharp relief, highlighting the need to enhance the role of market funding. The Capital Markets Union (CMU) initiative is directed to this ambitious goal. Further development of non-bank sources of funding seems possible, if we compare the European to the more market-oriented economies. European businesses get the bulk of their financing from banks, while in the US market-based financing is much more highly developed, even for SMEs. • The Commission has set an ambitious agenda in this field, with the aim of channeling funds to Europe’s businesses, particularly SMEs. The agenda includes an effort to revitalize the market for sound (simple) securitizations (which requires work at EU level to design a consistent framework and avoid regulatory arbitrage); harmonization of the market for covered bonds, building on the successful experiences of some European countries in order to generalize best practices; stimulation of crowd-funding initiatives, gradually eliminating significant national differences in legislation and supervisory approaches; enhancement of the small-scale corporate bond markets via mini-bonds; and endorsement of the efforts to identify a common framework for private placement transactions. Source: Panetta (2015)

The European Banking and Capital Markets Unions – challenges and risks (8) Conclusion • The Commission is also working to improve and standardize information on firms, in particular SMEs, and the related disclosure and transparency requirements. The scarcity of such comparable information is a deterrent to cross-border financing, which cuts across the different market segments and types of instruments. • In the medium to long term, the CMU can bring significant benefits: broadening and diversifying the EU financial market, thus improving its resilience, efficiency and competitiveness; eliciting greater long-term financing; and enhancing the supply of equity, to encourage euro-area firms to rely less on bank credit and to rebalance their capital structure. • In the short term, the efforts to enhance market-based sources of funding are part of the policy response to pronounced bank deleveraging within the EU and the attendant anemic credit growth. Some of the items on the Commission’s agenda may be crucial to this end. Indeed, bank deleveraging itself, together with the search for higher yields by institutional investors, may be a powerful catalyst for the development of these alternative sources of external funds. Source: Panetta (2015)

The European Banking and Capital Markets Unions – challenges and risks (9) Conclusion • To conclude, a lot has been achieved but a lot remains to be done in order to create a stable and efficient financial market in the Eurozone. In order to succeed, we must avoid piecemeal policies and work in order to reinforce mutual trust at the international level. A comprehensive view of all the trade-offs entailed in the various policy measures is required in order to safeguard the stability of individual financial institutions, with the key objective of ensuring the availability of resources for investment and economic growth. Source: Panetta (2015)

References • Carmassi, J., Di Giorgio, G., Curcio, D. (2015), "Emerging trends in financial regulation and supervision in the European Union and the costs and benefits of financial supervision" • Oreski, T., and Pavkovic, A. (2014), “Global trends in financial sector supervisory architectures”, in Proceedings of the 5th International Conference on Design and Product Development. • Panetta, F (2015), "The European Banking and Capital Markets Unions challenges and risks", Speech at a conference organized by the Fondazione Italianieuropei and the Foundation for European Progressive • Studies, Rome, 6 February. • Rossi, S. (2015), "Towards a European Banking Union: a euro-area central bank supervisor as a first step", Lecture at the Central Bank of Russia, Moscow, 2 April.

G roup I nstitutional & R egulatory A ffairs