Unintended Consequences of Financial Regulation: Closer look at the European Banking Union (Part I)

Written by Max Dechamps

Throughout the years, more and more regulations have been implemented as a response to the multiple economic and financial crises. The banking sector, positioned at the core of every economy, has often be the main target of regulators. A good illustration of the increasing number of regulations can be observed with the development of the Basel agreements. Basel I, often considered as the foundation for today’s financial regulatory framework, barely consisted of 30 pages (Haldane, 2012). However, as crises emerged, the robustness of Basel I became increasingly questioned. Consequently, a revised accord, Basel II, was published in 2004. The new agreed accord encompasses a wider range of regulations regarding capital adequacy, regulatory supervision and market discipline. Reflecting these changes, Basel II consisted of 347 pages. Thirteen years later, the new Basel III accord was finalised and amounted to no less than 616 pages (Haldane, 2012). The growing length of the Basel rulebook demonstrates the increasing reliance on regulations to safeguard the financial system. With respect to the Eurozone, the main response to the 2007-2009 financial crisis was the introduction of a Single Rulebook (“SR”) (EBA, 2018). The SR, defined as the backbone of the European Banking Union, relies on three pillars and ensures that banks are stronger and better supervised (CEU, 2018). Looking back at the last ten years, there is no doubt that these regulations have greatly contributed to safer banks and increased financial stability in the European Banking sector. However, some regulations may have led to unintended consequences. In this regard, this article aims to identify unintended consequences resulting from the set-up of the European Banking Union. In particular, this article focuses on possible unintended consequences caused by the implementation of each of the three pillars of the Banking Union. The rest of the article is structured as follows: Section II briefly introduces the three pillars of the Banking Union. After that, Section III identifies possible unintended consequences of each pillars and gives concrete recommendations on how to mitigate them. Lastly, Section IV reflects on the findings and provides a conclusion to the paper.

II. Towards a Unified Banking Union

In the wake of the recent financial crisis, the European Commission (“EC”) and the European Central Bank (“ECB”) were under considerable pressure to create a safer and more robust financial sector for the Single Market. This pressure led the EC and the ECB to pursue a vast number of initiatives, which were then translated into a Single Rulebook ("SR") (EC, 2018). The SR essentially aims to provide a single set of harmonized prudential rules which financial institutions throughout the EU must respect (EBA, 2018). Directly derived from the SR, the Banking Union is considered to be an essential complement to the Economic and Monetary Union (EMU) and the internal market (Juncker, 2015).

The European Banking Union relies on three distinct pillars:

i. The Single Supervisory Mechanism (SSM)

ii. The Single Resolution Mechanism (SRM)

iii. The European Deposit Insurance Scheme (EDIS)

Figure 1: The three pillars of the Banking Union

Source: ECB (2018)

Figure 1 provides an illustration of the three pillars. The first pillar, the SSM, aims at shifting banking supervision to the European level. The supervision is carried out through an integrated architecture combining both the ECB and the National Competent Authorities (NCAs). Its principal objective is to ensure an enhanced supervision of Europe’s banking sector (ECB, 2018). The second pillar, the SRM, focuses on ensuring a quick and efficient resolution of European failing banks while minimizing the burden on taxpayers and the real economy (EC, 2018). As illustrated in Figure 1, the third pillar has not been completely finalized yet. Indeed, EDIS, which aims at unifying depositor protection across the EU and prevent panic withdrawals, will complete its third stage and start to be fully operational as of 2024 (EC, 2018).

While the first two pillars are already fully operational, the implementation of EDIS and further progress on risk reduction are seen as the last steps towards a unified Banking Union. However, as indicated by president Juncker on 13 September 2017: “The Banking Union must be completed if it is to deliver its full potential as part of a strong Economic and Monetary Union” (Juncker, 2017). Therefore, evaluating the actual effectiveness of the Banking Union represents a difficult challenge for the moment. Notwithstanding, some unintended consequences originating from its early implementation can already be identified. The next section discusses these consequences as well as the context in which they have emerged.

III. Unintended Consequences of Financial Regulation

1. Single Supervisory Mechanism: Evidence of a credit crunch

Investors and regulators often argue that incomplete regulation and ineffective supervision were two of the main drivers of the 2007-2009 financial crisis. Recognizing the need for stronger supervision, the EC proposed to establish a new body solely responsible for banking supervision in Europe. The proposition gave birth to what is known as the Single Supervisory Mechanism (“SSM”) (ECB, 2018). Effective from November 2014, the SSM remains under the ultimate responsibility of the European Central Bank. To ensure efficient supervision, the supervisory roles and responsibilities of the ECB and national competent authorities (NCAs) are allocated on the basis of the significance of the supervised entities. The following structure allows for strong and consistent supervision of all entities across the euro area, while still benefiting from the strong expertise of national supervisors.

In total, 118 significant institutions (SIs) fall under the direct responsibility of the ECB. The remaining less significant institutions (LSIs) are, for their part, directly supervised by the NCAs, subject to the oversight of the ECB (ECB, 2018). By working together, the ECB and the NCAs aim at contributing to the safety and soundness of the banking system as well as the stability of the financial system. However, even though the need for a stronger regulatory framework was clearly recognized in the wake of the financial crisis, regulators were concerned that supervision of European banks on two different levels would bring complexities to an already sophisticated regulatory system. Eventually, these complexities could produce regulatory arbitrage conditions. Thus, even though the SSM was initially designed to reduce the discrepancies in the implementation of policies by the NCAs, one cannot assume that the SSM will eliminate all the inconsistencies in supervision between the ECB and the different NCAs.

In their research, Argawal, Lucca, Seru and Trebbi (2012) studied the inconsistencies between regulators in the United States banking market. In the US, chartered commercial banks are alternately supervised by state and federal regulators. This means that each bank is supervised by one or several regulators for a fixed time period. While analyzing the differences between regulators, the authors found that federal regulators are significantly less lenient, downgrading supervisory ratings almost twice as frequently as state regulators. There is also evidence that banks report higher nonperforming loans, higher capital ratios and lower Return on Assets (“ROA”) under federal supervisors. In fact, the research goes further by proving that US banks actually anticipate these differences and adjust their loan quality and leverage ratios accordingly (Argawal et al., 2012).

Following the same reasoning, one could expect euro area banks to regard NCAs as more lenient than their ECB counterpart in terms of supervision, leading them to adjust their lending behaviour in the course of the SSM implementation. In the remaining part of this section, the paper investigates the difference in lending activities between the SIs that fell under the direct supervision of the ECB and the LSIs that remained under the direct supervision of the NCAs at the time of the SSM implementation. This section particularly looks into the lending behaviour of banks as it was part of the initial comprehensive assessment of October 2013 conducted by the ECB (ECB, 2013).

In particular, asset quality review was one of the three complementary pillars, covering all asset classes such as non-performing loans, restructured loans and sovereign exposures. The rationale behind the assessment was to evaluate the soundness of significant banks. Therefore, one could expect SIs to have modified their lending behaviour in order to reduce the scope of the ECB comprehensive assessment and decrease their probability of financial distress during the SSM launch period. Not surprisingly, due to the relatively young age of the SSM, almost no research can be found on the impact of the SSM on bank’s activities. However, a research conducted by Fiordelisi, Ricci and Lopes (2017) examined the consequences of the launch of the SSM. The study shows that SIs under the supervision of the ECB did indeed decrease their lending activities compared to LSIs in the course of the implementation of the SSM. More precisely, the announcement of the comprehensive assessment reduced the supply of loans by 4,63% to 5.03% (Fiordelisi et al., 2017). This finding confirms the expectation that banks directly changed their lending behaviours as soon as they realized that they qualified as SIs and fell under the stricter supervision of the ECB. By dividing total loans into net loans and reserves for loan losses, the authors also found that SIs decreased both the amount of loans provided as well as the reserve to cover expected credit losses to high–quality borrowers compared to LSIs. Altogether, these findings suggest that a non-negligible credit crunch was an unintended consequence of the launch of the SSM. As mentioned in the study, a plausible reason for the reduction in bank lending is that SIs were concerned about potential capital shortfall in response to the stricter ECB’s requirement. Therefore, banks were pressured to quickly raise their capital ratios, which is often conducted by shrinking the asset size. The results indicate that SIs increased their capital ratios by 0,72% after the introduction of the SSM (Fiordelisi et al., 2017).

All in all, the results of the study suggest that the resulting higher capital ratios were directly caused by a reduction in the balance sheets’ size of the significant institutions. One interesting approach to tackle this problem originates from a paper on macro-prudential approach to financial regulation (Hanson, Kashyap and Stein, 2011). As banks most commonly restore their capital ratios by shrinking their balance sheet, the authors argued that financial regulators need to incentivize banks to raise incremental dollars of new capital. The proposed solution consists of a capital ratio requirement that refers to the maximum of current and lagged assets. Consequently, banks cannot avoid sanctions (imposed due to low capital ratio) simply by shrinking their asset size. Referring back to our original credit crunch, regulators could impose the same requirements on banks several months before conducting a comprehensive assessments or other forms of stress tests. In this way, banks would have to maintain a relatively low share of non-performing loan while being restricted to reduce their lending activities. This would ensure the continuous provision of loans, which is vital to the smooth running of the European economy.

The first section of this article aimed at introducing the European Banking Union and the objectives behind its implementation. While there is no doubt that the introduced regulations have already greatly contributed to safer banks and an increased level of financial stability in the European Banking sector, we have documented evidence in the last section that these very same regulations can lead to unintended consequences. In particular, the implementation of the SSM was accompanied by a temporary, yet significant, credit crunch. In the next section of this article, we dig deeper into the introduction of the second and third pillar, and attempt to identify possible unintended consequences resulting from their implementation.