EU Takes Critical Next Step in Banking Union

EU Takes Critical Next Step in Banking Union

The European Union has at last proposed what it calls the “second pillar” of its banking union. The first pillar, unveiled last December, consists of proposals for banking reform, aimed at reducing risk in the financial system. This next step proposes a mechanism should those reforms fail and the authorities have to deal with bank failures. Some, including Michael Barnier, the EU commissioner in charge of regulation, have referred to this proposed Single Resolution Mechanism (SRM) as a “revolution” on a par with the adoption of the euro. That characterization surely overstates, as does use of the word “pillar.” Matters on either proposal are far from settled. Still, there is no denying that Europe has taken significant steps toward financial security.

Both pillars aim to avoid a repeat of the 2008-2009 financial crisis. Like its American equivalent, Dodd-Frank, and national reforms already proposed in the U.K., France and Germany, the bank reform agreed to in December would reduce risk by prescribing how banks can dispose of their assets and insisting on protections for their depositors and their balance sheets. The reforms aim at the union’s 30 largest banks and the large subsidiaries of foreign banks operating in Europe—those that are “systemically important,” in the evolving jargon of financial regulation. Though highly complex, their most dramatic provision would forbid these banks from proprietary trading in securities and commodities. This is far from straightforward. Because the reform allows banks to continue trading on behalf of their customers, banks would have to own securities for periods of time, making it difficult for the regulators to distinguish for whom the bank is trading. Recognizing this, the proposals further insist that trading for clients happen in a separate entity from the banks’ other activities. Aiming at other forms of risk reduction, these proposals would also forbid banks from owning or having large exposures to aggressive investment operations, such as hedge funds.

The proposed SRM, the second “pillar,” constitutes a refreshing recognition that even the best rules and regulations can fail, and markets will need calming when that occurs. The proposals under the second pillar would create a clear procedure for dealing with weakness in any one of Europe’s 130 biggest banks and 200 so-called cross-border banks. The SRM would not concern itself with smaller financial institutions and those largely contained within a member nation, which would come under the control of national bank regulatory authorities. To give the new mechanism the liquidity needed to calm markets in the face of trouble at one of these banks, especially the fear of failure, it would have at its disposal a roughly $76 billion resolution fund, raised from levies on the banks under its supervision. Initially, most of the fund would remain in national compartments. Only 40 percent of it would have a mutual pan-European character, though the whole fund would gradually be mutualized over the next eight years. To further enhance the SRM’s ability to calm market disruptions during a bank resolution, the proposals would give it broad authority to borrow.

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