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The yin and yang of banking market integration – the case of cross-border banks

Speech by Andrea Enria, Chair of the Supervisory Board of the ECB, at the 7th Annual Digital Conference on the Banking Union

Frankfurt am Main, 18 November 2020

For a long time, financial integration was being heralded unequivocally as a driver of prosperity. Not only was it considered a key driver of growth, it was also supposed to distribute risk to those best equipped to bear it. The Single Market for banking services was first introduced in the early 1990s with a view to spurring greater competition in a sector characterised by extreme market segmentation along product and regional lines. The idea that banks could freely open branches and provide services across the EU through a single passport was expected to bring tangible benefits for banking customers, while the implementation of the Basel standards was deemed to ensure that adequate prudential safeguards were put in place. The introduction of the euro further strengthened the process: the disappearance of foreign exchange risk within the euro area and the establishment of a common framework to access central bank liquidity represented a leap forward in banking market integration, especially on the wholesale banking side.

Then, the great financial crisis struck. The distribution of risk turned into a channel of contagion. The search for yield, the overextension of credit and the mispricing of risk had led to the creation of a bubble. Once this bubble burst in the wake of the Lehman crisis, banks abruptly reversed the previous trend. Cross-border loans and sources of liquidity dried up in times of need, and the integrated banking sector served to amplify the shock.[1]

As the safety net for banks had remained completely national, the policy response resulted in banking markets segmenting once more along national lines: cross-border banking groups were broken down and their crises were managed under local regulations, ring-fencing measures were introduced to prevent local establishments from importing risks from other group entities and to ensure they remained viable on a standalone basis, and banks supported by government funds were asked to refocus their business on domestic households and corporates. The drop in cross-border banking within the euro area was the main driver of the fall in financial integration at the global level.

While the excesses of the pre-crisis period required correction, the real, longer-term question facing us is whether or not an integrated, euro area banking sector would become less of a channel of contagion, and instead become an effective mechanism to absorb the shocks that hit one part of the Union.

From channel of contagion to shock absorber

The US experience shows that an integrated banking sector can provide an important element of stability. In the United States, about 20% of an economic shock is smoothed via credit markets.[2] Several mechanisms are at work: banks with assets well diversified across states are better able to withstand idiosyncratic shocks hitting any one of those states, thus offsetting losses in one region with profits earned in others. Furthermore, when banks in one state enter into a crisis because of a local shock, their assets and liabilities can be transferred to buyers from other states, thus minimising the impact on local customers and avoiding a credit crunch that would exacerbate the crisis.

Depending on its features, an integrated banking market can be either a shock absorber or a channel of contagion. With banking union, the aim was to prevent the latter and bring about the former. The key ingredients for such a shift are common, effective and fully unified supervision to prevent an excess build-up of risk and a more integrated response to shocks through the use of a common resolution framework and a more unified safety net. As we all know, we have not yet reached the finishing line as far as the institutional set-up for banking union is concerned. The third pillar thereof, the European deposit insurance scheme, which should complement the Single Supervisory Mechanism and the Single Resolution Mechanism, is not yet in place. In its absence, the legislative framework remains peppered with options and national discretions that prevent cross-border groups from operating seamlessly at the euro area level and from treating the banking union as their domestic market.

The coronavirus (COVID-19) pandemic has proved to be a litmus test for the progress achieved in the area of banking union, and the first results are promising.

While one ECB composite indicator of financial integration pointed towards a significant increase in financial fragmentation after the first wave of the pandemic, its level remained above those witnessed during the great financial crisis and ensuing sovereign debt crisis.

What is remarkable, however, is that the indicator for banking market integration has remained almost completely stable in stark contrast to the steep decline seen during the great financial and sovereign debt crises. This indicator captures the dispersion in comparable bank lending rates across the euro area: the lower the dispersion, the higher the level of integration.

The financial reforms implemented after the great financial crisis have created a stronger and more unified rulebook, leaving little room for competition of laxity. The swift and fully unified supervisory response to the shock caused by the pandemic is an important change compared with the past. The fact that such a response was fully coordinated and consistent with the powerful stimulus provided by the monetary and fiscal measures taken, also at European level, is another sign that a fundamental paradigm shift has occurred.

These findings point to the possibility that banking union is indeed transforming the European banking market from a shock amplifier into a shock absorber. But we are not quite there yet. There is still a risk that in the event of a major systemic shock, European banking groups may be prevented from functioning as shock absorbers since their capital and liquidity remain largely segmented in local pools in individual Member States.

As long as deposit insurance schemes remain at national level only, Member States will have an incentive to ring-fence their banking sectors. Completing the banking union by establishing EDIS would be the most direct route to foster integration, as any argument to justify the remaining regulatory provisions in European and national legislation that trap capital and liquidity within national borders would fade away

A fully-fledged European deposit insurance scheme must continue to be our goal. But it is also clear that it will take some time to materialise. Until then, we as supervisors can take steps to try and counter ring-fencing as much as possible.

The importance of cross-border banking groups

Currently, liquidity requirements applied at the individual bank level may prevent parent companies from efficiently managing their liquidity resources within the group, even within the banking union. To ensure compliance with the liquidity coverage ratio at the individual level, around €200 billion of high-quality liquid assets sitting with the cross-border subsidiaries of significant credit institutions are not transferable. This clearly makes centralised liquidity management less effective; liquidity is not allowed to flow freely. Not only can this can exacerbate a crisis, as funds may not be able to go where they are needed, but it hampers an efficient allocation of resources overall.

But we have to acknowledge that in the absence of a fully integrated deposit guarantee scheme at the European level, there need to be safeguards that prevent parent companies from behaving like free riders and opting to enjoy the benefits of resources generated in local markets in good times but failing to protect local franchises in times of stress. How can we combine both a broader pooling of liquid resources and, ideally, of capital, with safeguards for national stakeholders if and when banks start to see signs of a deterioration in their financial positions?

Linking group financial support agreements to recovery plans

Banking union has eliminated the distinction between a parent company’s home supervisory authority and its subsidiaries’ host supervisory authorities. We now have European supervisory and resolution authorities that take a truly integrated, area-wide approach. For example, let’s look at how prudential requirements are set for entire banking groups: if a local risk is not diversified away or netted out in consolidation, it needs to be captured in group requirements. This might help to limit the risk at the national level and reduce the need for ring-fencing.

We can deal with cross-border banks that encounter difficulties in a similar fashion. For these banks, group recovery and resolution plans should play an essential role. As intended by international standard-setters and European legislators, advance planning by banks under the scrutiny and guidance of their supervisory and resolution authorities should ensure that a cooperative approach prevails when a situation starts to deteriorate or develops into an outright crisis. If we want to strengthen confidence in crisis management at the European level, the best way forward is to strengthen the role of group recovery and resolution plans, as well as their practical implementation. The focus should be on recovery plans, because the options outlined in these plans can potentially be activated at an early stage, and can therefore offer a clear opportunity to act before a crisis actually occurs.

When it comes to the coverage and credibility of banks’ recovery plans, ECB Banking Supervision has already made considerable progress, notably by conducting an annual review and ensuring there is a follow-up supervisory dialogue. We will continue to strengthen the usability of these plans. One additional step would be to offer banking groups the option of having subsidiaries and parent companies formally agree to provide each other with liquidity support, and to link this support to their group recovery plans. This would not only help to explicitly map out how group entities could support each other when difficulties arise, taking into account local needs and restrictions, but it would also enable the setting of appropriate triggers for providing contractually agreed support at an early stage. This would also ensure that supervisors would be involved in the process, since recovery plans are assessed by the relevant competent authority. For significant euro area banking groups, this would be the ECB.

The provision of financial support by the parent entity would therefore be linked to internal recovery indicators at the level of the subsidiary. It would be up to the banking group – in close cooperation with supervisory authorities – to identify the most appropriate liquidity indicators for group support to be activated. These indicators would need to be tailored to the characteristics of each group and be consistent with the group’s internal liquidity management policy.[3] This would also make it possible for group support to be activated early enough for it to be effective. Safeguards could be established and included in recovery plans to also address the concern that subsidiaries could be drained of liquidity in the event of their parent company experiencing difficulties in funding markets. For example, a separate vehicle to manage all pooled liquid resources could be established under the parent company’s responsibility, with the precise rules of engagement outlined in the event of difficulties experienced at any level of the group.

But creating a stronger link between group support and recovery plans would not necessarily mean that the provision of support would be triggered automatically. The bank’s management body could still refrain from taking an action foreseen in its recovery plan if it did not find said action appropriate in the particular circumstances. Once recovery indicators were breached, however, the management body would have to assess the overall situation and decide whether to activate a recovery plan option or refrain from taking action. At the same time, the supervisor would be made aware of the breach of indicators and the management body’s decision about whether or not to activate the group financial support agreement, and could be granted early intervention powers to take action on the basis of the group financial support agreement.

This stronger link with the group recovery plan could provide additional reassurance regarding application of the group financial support agreement, whether at the parent or subsidiary level. And confidence in its application could be strengthened further if EU legislation were to empower the supervisor to enforce the agreement included in the group’s recovery plan.

This solution would be more agile and effective than the group financial support agreements currently envisaged in the Bank Recovery and Resolution Directive. Safeguards would be triggered at an earlier stage and would require less stringent conditions, due to the power of enforcement that could be assigned to the supervisor.

Introducing adequate incentives and safeguards to enter into group financial support agreements

For this proposal to work, we need to give banks adequate incentives to enter into group financial support agreements. This could be achieved, for example, by linking the granting of cross-border liquidity waivers to the inclusion of adequate intragroup financial support agreements in the recovery plans. In addition, the decision to grant a cross-border liquidity waiver could underpin the enforceability of these intragroup agreements. For example, a clear link could be established between the effectiveness of financial support agreements and the granting of the waiver itself. A link of this kind, and the possibility to reassess it, could provide significant incentives for banks to comply with financial support agreements.

Obtaining an independent legal opinion on the enforceability of the group financial support agreement would help to ensure adequate safeguards for a receiving group. This could also be reinforced by encouraging certain group parent entities to issue public statements about their commitment to provide group support in the event of a crisis. In future, the enforceability of group financial support agreements outlined in banking groups’ recovery plans could be enhanced by introducing statutory safeguards in the European legal framework.

This move towards greater cross-border integration would ideally be combined with a broader harmonisation of the European crisis management framework. In particular, the mechanisms suggested here do not aim for or require any substantial change in national laws relating to insolvency, corporate or contract law, as they build only on what is a generally recognised principle in the European legal system: that a parent company may have a legitimate interest in providing support to a subsidiary to facilitate its operations and possibly benefit from the recognition of that support by the supervisor. Similarly, subsidiaries, as separate legal entities, have a legitimate interest in protecting their creditors and ensuring the timely payment of their obligations in times of stress, and should have their claims on the common pool of liquid assets safeguarded within an overall, commonly agreed group policy.

A pragmatic approach to the integration of the operations of cross-border groups within the banking union could also remove existing – or perceived – obstacles to consolidation across Member States. Moreover the possibility now offered by the Capital Requirements Directive (CRD5) to treat the banking union as a single geographical area in the G-SII buffer methodology removed an important disincentive to cross-border consolidation: while in the past the increase in international business could have led to higher buffer requirements, a cross-border merger within the banking union would now have exactly the same impact as a domestic one.


Let me conclude.

Through banking union, we have made great strides towards transforming the European banking sector from a shock amplifier into a shock absorber. Unlike in previous crises, lending rates have not diverged substantially across the euro area since the outbreak of the pandemic. But for the banking union to be a truly domestic market, we need a European deposit insurance scheme. While we are working towards this, we can take steps in our role as supervisor to improve the cross-border integration of banking groups to not only bolster their ability to deploy their resources in a flexible and efficient manner in response to shocks, but also to improve the overall allocation of resources, and in this way contribute to an efficient financing of the European economy.

  1. Cimadomo, J., Furtuna, O. and Giuliodori, M. (2018), “Private and public risk sharing in the euro area”, Working Paper Series, No 2148, European Central Bank, Frankfurt am Main, May.
  2. ibid.
  3. To preserve resolvability, these agreements should be implemented in accordance with the banking group’s resolution strategy.

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