## _cr1375 — EU Financial Sector Assessment Program (FSAP) Executive Summary and Key Findings

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### Executive summary — overview and remaining vulnerabilities
- Much has been achieved to address the recent financial crisis in Europe, but vulnerabilities remain, and intensified efforts are needed across a wide front.
- Major challenges and structural weaknesses:
  - Restoring financial stability was handicapped by absence of robust national, EU-wide and EA-wide crisis management frameworks.
  - In a low-growth environment, several EU countries still struggle to regain competitiveness, fiscal sustainability, and sound private sector balance sheets.
  - Financial systems face funding pressures from excessive leverage, risky business models, and an adverse feedback loop with sovereigns and the real economy.
- Progress made:
  - Banks have boosted their capital adequacy ratios, although partly through deleveraging.
  - Unconventional monetary operations have enhanced liquidity and firewalls have been put in place.
  - Bank supervision has been improved.
  - Agreement reached to establish an SSM for the EA open also to non EA members.
  - New tools for addressing financial stability, including coordinated stress tests, have come into play.
  - The newly-established European Supervisory Authorities (ESAs) are making their marks.
- Remaining vulnerabilities (from recent FSAP assessments):
  - Stresses and dislocations in wholesale funding markets.
  - A loss of market confidence in sovereign debt.
  - Further downward movements in asset prices.
  - Downward shocks to growth.
  - Exacerbating factors: high degree of concentration in the banking sector; regulatory and policy uncertainty; major gaps in the policy framework.

### Near-term priorities and recommended actions
- Near-term priorities:
  - Bank balance sheet repair, including addressing impaired assets.
  - Fast and sustained progress toward the Single Supervisory Mechanism (SSM) and the Banking Union (BU).
  - Essential steps toward a stronger EU financial oversight framework.
  - Adapt governance arrangements to have an EU (or BU)-wide perspective and to meet diverse needs of EA members, SSM members not part of the EA, and other EU members.
- Specific high-priority recommendations (authorities and timing preserved):
  - Bank balance sheet repair: Secure strong capital buffers, enhance disclosure, and conduct selective asset quality reviews. Authority: National Authorities, SSM, EBA. Timing: By end–2013. Paragraph: 14.
  - Make SSM operational, providing the ECB with adequate resources, staff of highest professional competence and the authority to directly supervise any bank. Authority: EC, Council, EP. Timing: By June 2013. Paragraph: 14.
  - Initiate preparations for an SRM, to become operational around the same time as the SSM. Authority: EC, Council. Timing: By June 2013. Paragraph: 14.
  - Agree on a time-bound roadmap to full BU, including a single resolution authority, and a common DGS with common backstops. Authority: EC, Council. Timing: By June 2013. Paragraph: 14.
  - Establish modalities and governance arrangements for ESM direct recapitalization of banks. Authority: EC, National Authorities. Timing: Immediate. Paragraph: 14.
  - Prompt passage and implementation of directives and regulations of capital requirements (fully in line with Basel III) and resolution (enhanced from current proposals). Authority: EC, Council, EP. Timing: By June 2013. Paragraphs: 14, Box 1.
  - Modify roles of EBA and ESRB to accommodate SSM. Authority: EC. Timing: By June 2013. Paragraphs: 14, 41, 42, 62.
  - Ensure full coordination of crisis management and financial sector policies among all agencies, possibly through a new committee. Authority: EC, Council, EP. Timing: Immediate. Paragraphs: 14, 22.
  - Modify governance of ESAs to limit national bias. Authority: EC, Council, EP. Timing: By end–2013. Paragraph: 37.
  - Improve access of ESAs to data. Authority: EC, National Authorities. Timing: Immediate. Paragraph: 38.
  - Increase resources of ESAs. Authority: EC. Timing: Immediate. Paragraph: 36.
  - Strengthen supervisory colleges and crisis management groups by enhancing the roles of EBA and EIOPA. Authority: EBA/EIOPA. Timing: Immediate. Paragraphs: 42, 46.
  - DG COMP to continue to improve transparency, and to consider—together with IMF and ECB—methodologies for pricing and deleveraging formulae for banks receiving state aid. Authority: EC, Council. Timing: Immediate. Paragraph: 55.
  - Strengthen macroprudential oversight by enhancing capacity of the ESRB, the SSM, and national authorities; ensure more effective coordination. ECB’s macroprudential tools should go beyond those identified in CRD IV. Authority: ESRB, SSM, National Authorities. Timing: As SSM becomes effective. Paragraphs: 61, 62.
  - Enhance, adopt and implement the EU DGS Directive. Authority: EC, Council, EP. Timing: By June 2013. Paragraph: 30.
  - Adopt and implement Solvency II. Authority: EC, Council, EP. Timing: By January 1, 2014. Paragraph: 31.
  - Plan remedial strategies in advance of possible weakening of pensions and life insurance companies’ positions as Solvency II becomes effective. Authority: ESRB, EIOPA. Timing: By January 1, 2014. Paragraph: 32.
  - Pass EMIR technical standards and CSD Regulation, and an EU framework for recovery and resolution of non-bank financial institutions. Authority: EC, ESMA, ESCB, National Authorities. Timing: Immediate. Paragraph: 70.
  - Place Euroclear Bank and Clearstream Banking Luxembourg under SSM supervision. Authority: National competent authorities of Belgium and Luxembourg. Timing: As SSM becomes effective. Paragraph: 74.
  - Enhance information available to ECB on TARGET2 participants’ liquidity and collateral positions, and strengthen the capacity and competences of the ECB oversight over payment systems. Authority: Eurosystem, ECB. Timing: Immediate. Paragraphs: 75, 76.

### Single Supervisory Mechanism (SSM) and Banking Union (BU) specifics
- Key SSM operational and governance imperatives:
  - SSM must deliver high quality supervision as soon as it becomes effective; ECB must build supervisory expertise and have resources commensurate to tasks.
  - ECB should have powers to maintain general oversight over all banks and to intervene in any bank it deems necessary.
  - Governance must avoid “nationality dominance” and preserve a regional perspective.
- Resolution (SRM) and BU sequencing:
  - SRM should become operational around the same time as the SSM; resolution should aim to minimize costs to taxpayers and deposit insurance and resolution funds, without disrupting financial stability.
  - Agreement on a time-bound roadmap to set up a single resolution authority and a common deposit guarantee scheme (DGS) with common backstops is needed.
  - Guidelines for ESM direct recapitalization of banks need clarification so it becomes operational as soon as the SSM is effective.
- Resolution directive enhancements recommended (exact features preserved):
  - Automatic intervention when a bank’s solvency position falls below a certain trigger level; flexibility for intervention in the event of liquidity or other problems.
  - Widen scope to include systemic insurance companies and financial market infrastructures in line with FSB Key Attributes.
  - Provide authority with flexibility to determine non-viability (including liquidity breaches and other regulatory failings), with provision for mandatory intervention if a specified solvency trigger is crossed.
  - Allow mandatory recapitalization power and asset separation tool on a standalone basis; bail-in safeguards should not prevent departure from pari passu treatment where necessary on grounds of financial stability or to maximize value for creditors as a whole.
  - Establish depositor preference for insured depositors with right of subrogation for the DGS.

### Strengthening EU oversight agencies and governance
- ESAs and ESRB reforms and priorities:
  - Adapt governance arrangements to avoid potential national biases; consider voting rights for Chairs, move to full time boards, delegate more to management boards.
  - EBA should be more assertive in cross-border colleges of supervisors and crisis management groups; ensure national authorities undertake careful and consistent analysis of bank asset quality to ensure credibility of stress tests.
  - ESRB should develop macroprudential toolkit, analyze macroprudential effects on the cyclical downside and ensure consistent application of macroprudential policies across sectors and the EU.
  - Heightened responsibilities warrant increased resources and improved access to data for ESAs.
- EBA stress testing and data integrity (Box 2 highlights):
  - Full transparency about banks’ data should be obtained, preferably through an asset quality review.
  - Standardize definitions of NPLs, loan classifications, provisioning; enhance consistency checks and sensitivity analysis.
  - Incorporate banks’ funding and capitalization plans in stress test projections, including effects of phase out of LTRO.
  - Develop further liquidity stress testing and cross-sector, longer-term simulations (e.g., contingent claims analysis).

### Insurance, financial market infrastructures (FMIs), and TARGET2
- Insurance sector:
  - Weak economic environment threatens life insurance and pensions industries; exposures to banks and sovereigns and stricter Solvency II requirements increase vulnerability.
  - Timely implementation of Solvency II (scheduled for January 2014) is important; plan remedial strategies by January 1, 2014.
- Financial market infrastructures:
  - TARGET2: functioned well in the crisis; enhancements recommended include giving the ECB direct access to participants’ liquidity and collateral positions and centralizing monitoring to enable quick Eurosystem action.
  - Euroclear Bank: daily average settlement value of around €1.1 trillion; provides settlement for securities from 44 markets in 53 currencies; needs further upgrades to risk management and recovery/winding-down readiness.
  - CCPs and CSDs: increasing reliance reduces overall risk, but failure would pose substantial risks; EMIR and CSD Regulation adoption and supervisory centralization are priorities.
- Payments oversight capacity:
  - ECB moving to risk-based oversight; needs access to confidential bank-by-bank data, increased staff, cluster modules, and continuity in critical areas such as interdependencies and stress testing.

### Systemic risk, vulnerabilities, and crisis amplification
- Structural contagion factors:
  - Single market passporting and cross-border branching led to rapid financial integration and sharp increases in cross-border exposure.
  - National approaches to supervision left heterogeneity across systems relative to fiscal capacity.
  - Monetary union removed currency risk and contributed to rising cross-border lending; SGP and market discipline failed to restrain excesses.
  - Financial liberalization in EEEs fostered foreign currency borrowing and credit booms.
- Four intertwined vulnerabilities (exact phrasing preserved):
  - Low growth: real activity in the EA is projected to decline slightly in 2013 while slowing in most other EU countries; low growth will put bank profitability at risk; solvency in the insurance sector under pressure.
  - Fiscal vulnerabilities: lackluster growth will hamper fiscal sustainability; weak confidence in fiscal positions has undermined banks with large sovereign exposures.
  - Funding pressure: wholesale markets segmenting along national borders; many banks reliant on central bank support; withdrawal of central bank support will be challenging.
  - Deleveraging: since 2008, EU banks have deleveraged considerably, mainly across borders; deleveraging driven by structural and cyclical forces and risks weakening growth and balance sheet repair.
- Crisis amplification and policy spillovers:
  - Early national/EU responses sometimes led to adverse spillovers (e.g., blanket guarantees, national break-ups of cross-border institutions).
  - ECB unconventional measures listed (2008–To Date) include fixed rate, full allotment tenders (October 8, 2008), expansion of eligible collateral (October 15, 2008), SMP (May 10, 2010), OMTs (September 6, 2012), and multiple LTROs (December 8, 2011, etc.).

### Banking sector resilience, stress tests, and country vulnerabilities
- FSAP stress test headline:
  - Stress tests suggest capital buffers in EU countries appear mostly adequate to withstand severe macroeconomic shocks but with caveats.
- Persisting concerns and priorities:
  - Legacy assets remain a problem; reported NPLs and provisions could understate losses.
  - Comprehensive asset quality reviews largely absent (exception: Spain).
  - Need for larger and better quality buffers consistent with Basel III.
  - Improve legal framework, supervisory processes, data quality, and macroprudential supervision.
- Selected country-level vulnerabilities (illustrative figures preserved):
  - Spain: Substantial bank refinancing needs in 2012–13; likelihood: medium to high; impact: high. Domestic sovereign exposure amounts to 150 percent of core Tier 1 capital. About one out of four banks in the stress test sample would face severe capital losses.
  - Czech Republic: Extreme tail risk losses in the banking sector could amount to about 6 percent of 2010 GDP: Likelihood: medium and rising.
  - United Kingdom: Extreme tail risk losses in the banking system could be as high as 5 percent of 2010 GDP.
  - Cross-cutting staff assessments (Appendix Table 2):
    - Protracted slow growth in Europe: Likelihood: Medium; Overall Level of Concern: High. Key point: 2013 growth projected to be below 1 percent in the EA and the U.K.
    - Stresses in wholesale funding markets: Likelihood: Medium; Expected Impact: Medium/High.
    - Policy risks: Staff assessment: Medium to High.
    - Operational risk of the SSM: Likelihood: Medium; Expected Impact: Medium/High.
    - Deleveraging risk: Likelihood: Low/Medium; Expected Impact: Medium/High.

### Implementation of the SSM — operational, governance, and resource priorities
- SSM design principles (Basel Core Principles basis preserved):
  - (i) operational independence; (ii) clarity of objectives and mandates; (iii) legal protection of supervisors; (iv) transparent processes, sound governance and adequate resources; and (v) accountability.
- Scope and mandate:
  - ECB to take direct supervisory responsibility for the largest 150 banks, but has authority to directly supervise any bank it deems necessary.
  - Metrics for identifying the set of 150 banks must be clear and capture importance in cross-border activities and domestic/EU significance.
- Governance and accountability measures:
  - Establish a Supervisory Board comprising representatives from all EMU countries and any other EU member states that join the SSM; final decisions by the Governing Council (treaty constraint).
  - Need for transparency, accountability (appearances before European Parliament and national parliaments), and Chinese walls between supervision and monetary policy.
  - Governance risks: decisions by Supervisory Board may reflect national interests; guard against nationality dominance.
- Start-up and resource actions:
  - ECB will initially rely on cross-country teams supplied by national authorities and led by an ECB supervisor.
  - Every effort needed to ensure the ECB has necessary resources by the SSM’s March 2014 postulated starting date; ECB may postpone start date if not ready.
  - Recommendations: build off-site supervisory structure, hire specialist expertise, secondments, cross-country teams led by ECB supervisors, supervisory manual, funding not solely from transfers from national authorities.
- Risk mapping and asset quality assessments:
  - ECB to receive risk assessments and local risk classifications from national supervisors; map banking risks and target supervisory actions.
  - ECB may initiate harmonized asset quality assessments for banks brought under SSM, coordinated with EBA guidance and national supervisors.

### Resolution, ESM recapitalization, and macroprudential oversight
- ESM direct recapitalization:
  - Initiate possibility and agree investment mandate; interpretation of ESM Treaty seen as flexible enough subject to political agreement and unanimous consent.
  - Clarify definition of legacy assets, pricing, role of bail-ins, principle for access, and instrument design.
  - If ESM injects ordinary equity, governance and ownership policies need careful elaboration and disclosure strengthened.
  - Ensure ESM has adequate capital to allay investor concerns and to enable leveraging as a common backstop.
- SRM design and coordination:
  - SRM should seek least cost resolution without disrupting financial stability, protect insured depositors, and ensure shareholders and unsecured, uninsured creditors absorb losses.
  - SRM needs mandate to intervene before insolvency with quantitative and qualitative triggers and a wide range of tools (bail-in, purchase and assumption, asset separation, override shareholder rights, bridge banks, close insolvent banks).
  - Coordination mechanisms with SSM, DG COMP, national resolution authorities, and non-BU jurisdictions required.
- Macroprudential framework:
  - ESRB to continue EU-level macroprudential oversight; ECB to have macroprudential tools beyond those in CRD IV/CRR.
  - National authorities need independence; coordination important given cross-border spillovers and branches.

### Monitoring, follow-up, and timetable
- Key timing references preserved:
  - By end–2013: bank balance sheet repair; modify governance of ESAs.
  - By June 2013: SSM operationalization, SRM preparations, time-bound roadmap to full BU; passage and implementation of CRD IV/CRR and resolution directive.
  - Immediate: ESM modalities for direct recapitalization; ensure full coordination of crisis management; improve ESAs’ access to data; increase ESAs’ resources; strengthen supervisory colleges and crisis management groups; DG COMP actions; pass EMIR technical standards and CSD Regulation; enhance TARGET2 information sharing; strengthen ECB oversight capacity.
  - By January 1, 2014: Adopt and implement Solvency II; plan remedial strategies for pensions and life insurers.
  - FSAP mission period: during the period November 27 to December 13, 2012.
  - Document date: February 22, 2013.
- Follow-up:
  - Authorities expressed interest in repeating the EU FSAP on a regular basis; doing the next assessment within the next three years recommended to assess progress in setting up the BU and revisions planned for 2014.

*Executive Summary of the EU Financial Sector Assessment Program (FSAP), IMF staff report. Source: _cr1375.*

### EXECUTIVE SUMMARY

### EXECUTIVE SUMMARY

### Overview and remaining vulnerabilities
- Much has been achieved to address the recent financial crisis in Europe, but vulnerabilities remain, and intensified efforts are needed across a wide front.
- Restoring financial stability in the EU has been a major challenge: the initial policy response to the crisis was handicapped by the absence of robust national, EU-wide and EA-wide crisis management frameworks.
- In a low-growth environment, several EU countries are still struggling to regain competitiveness, fiscal sustainability, and sound private sector balance sheets.
- Financial systems face funding pressures from excessive leverage, risky business models, and an adverse feedback loop with sovereigns and the real economy.
- Progress made:
  - Banks have boosted their capital adequacy ratios, although partly through deleveraging.
  - Unconventional monetary operations have enhanced liquidity and firewalls have been put in place.
  - Bank supervision has been improved.
  - Agreement reached to establish an SSM for the EA open also to non EA members.
  - New tools for addressing financial stability, including coordinated stress tests, have come into play.
  - The newly-established European Supervisory Authorities (ESAs) are making their marks.
- Remaining vulnerabilities noted in recent FSAP assessments:
  - Stresses and dislocations in wholesale funding markets.
  - A loss of market confidence in sovereign debt.
  - Further downward movements in asset prices.
  - Downward shocks to growth.
  - Exacerbating factors: high degree of concentration in the banking sector; regulatory and policy uncertainty; major gaps in the policy framework.

### Near-term priorities and recommended actions
- Near-term priorities to cement gains and end the crisis:
  - Bank balance sheet repair, including addressing impaired assets.
  - Fast and sustained progress toward the Single Supervisory Mechanism (SSM) and the Banking Union (BU).
  - Essential steps toward a stronger EU financial oversight framework.
  - Adapt governance arrangements to have an EU (or BU)-wide perspective and to meet diverse needs of EA members, SSM members not part of the EA, and other EU members.
- Specific high-priority recommendations (see Table 1 highlights):
  - Bank balance sheet repair: Secure strong capital buffers, enhance disclosure, and conduct selective asset quality reviews. Authority: National Authorities, SSM, EBA. Timing: By end–2013. Paragraph: 14.
  - Make SSM operational, providing the ECB with adequate resources, staff of highest professional competence and the authority to directly supervise any bank. Authority: EC, Council, EP. Timing: By June 2013. Paragraph: 14.
  - Initiate preparations for an SRM, to become operational around the same time as the SSM. Authority: EC, Council. Timing: By June 2013. Paragraph: 14.
  - Agree on a time-bound roadmap to full BU, including a single resolution authority, and a common DGS with common backstops. Authority: EC, Council. Timing: By June 2013. Paragraph: 14.
  - Establish modalities and governance arrangements for ESM direct recapitalization of banks. Authority: EC, National Authorities. Timing: Immediate. Paragraph: 14.
  - Prompt passage and implementation of directives and regulations of capital requirements (fully in line with Basel III) and resolution (enhanced from current proposals). Authority: EC, Council, EP. Timing: By June 2013. Paragraphs: 14, Box 1.
  - Modify roles of EBA and ESRB to accommodate SSM. Authority: EC. Timing: By June 2013. Paragraphs: 14, 41, 42, 62.
  - Ensure full coordination of crisis management and financial sector policies among all agencies, possibly through a new committee. Authority: EC, Council, EP. Timing: Immediate. Paragraphs: 14, 22.
  - Modify governance of ESAs to limit national bias. Authority: EC, Council, EP. Timing: By end–2013. Paragraph: 37.
  - Improve access of ESAs to data. Authority: EC, National Authorities. Timing: Immediate. Paragraph: 38.
  - Increase resources of ESAs. Authority: EC. Timing: Immediate. Paragraph: 36.
  - Strengthen supervisory colleges and crisis management groups by enhancing the roles of EBA and EIOPA. Authority: EBA/EIOPA. Timing: Immediate. Paragraphs: 42, 46.
  - DG COMP to continue to improve transparency, and to consider—together with IMF and ECB—methodologies for pricing and deleveraging formulae for banks receiving state aid. Authority: EC, Council. Timing: Immediate. Paragraph: 55.
  - Strengthen macroprudential oversight by enhancing capacity of the ESRB, the SSM, and national authorities; ensure more effective coordination. ECB’s macroprudential tools should go beyond those identified in CRD IV. Authority: ESRB, SSM, National Authorities. Timing: As SSM becomes effective. Paragraphs: 61, 62.
  - Enhance, adopt and implement the EU DGS Directive. Authority: EC, Council, EP. Timing: By June 2013. Paragraph: 30.
  - Adopt and implement Solvency II. Authority: EC, Council, EP. Timing: By January 1, 2014. Paragraph: 31.
  - Plan remedial strategies in advance of possible weakening of pensions and life insurance companies’ positions as Solvency II becomes effective. Authority: ESRB, EIOPA. Timing: By January 1, 2014. Paragraph: 32.
  - Pass EMIR technical standards and CSD Regulation, and an EU framework for recovery and resolution of non-bank financial institutions. Authority: EC, ESMA, ESCB, National Authorities. Timing: Immediate. Paragraph: 70.
  - Place Euroclear Bank and Clearstream Banking Luxembourg under SSM supervision. Authority: National competent authorities of Belgium and Luxembourg. Timing: As SSM becomes effective. Paragraph: 74.
  - Enhance information available to ECB on TARGET2 participants’ liquidity and collateral positions, and strengthen the capacity and competences of the ECB oversight over payment systems. Authority: Eurosystem, ECB. Timing: Immediate. Paragraphs: 75, 76.

### Single Supervisory Mechanism (SSM) and Banking Union (BU) specifics
- The SSM must deliver high quality supervision as soon as it becomes effective:
  - Operational risk regarding the SSM needs to be guarded against by ensuring that the ECB builds supervisory expertise of the highest quality, and has at its disposal resources commensurate to its supervisory tasks.
  - The ECB’s effectiveness as a supervisor needs to be safeguarded by giving it powers to maintain general oversight over all banks and to intervene in any bank it deems necessary.
  - The ECB’s governance and its “will to act” need to be robust, including through ensuring that the SSM avoids “nationality dominance” and that a regional perspective is consistently maintained.
- The SSM is only one of a number of crucial steps to fill key gaps in the EU’s financial oversight framework.
- As crisis tensions abate, implicit unlimited sovereign guarantees in place should be effectively removed through affirmation and implementation of the principle that institutions with solvency problems must be resolved.
- The Single Resolution Mechanism (SRM) should become operational at around the same time as the SSM becomes effective; resolution should aim to minimize costs to taxpayers and to deposit insurance and resolution funds, without disrupting financial stability.
- Agreement on a time-bound roadmap to set up a single resolution authority, and common deposit guarantee scheme (DGS) with common backstops is needed; eventually providing an explicit legal underpinning for financial stability arrangements of a fully-fledged BU would further strengthen the framework.
- Guidelines for the ESM to directly recapitalize banks need to be clarified as soon as possible so it becomes operational as soon as the SSM is effective.
- Resolution directive enhancements recommended: automatic intervention when a bank’s solvency position falls below a certain trigger level; flexibility for intervention in the event of liquidity or other problems.
- More effective supervision and resolution arrangements needed for financial institutions crossing borders between the SSM and the rest of the EU and beyond.

### Strengthening EU oversight agencies and governance
- The ESAs and the ESRB need further strengthening:
  - Governance arrangements need to be adapted to avoid potential national biases.
  - The EBA can play an important role in ensuring a level playing field between countries inside and outside the SSM; it should be more assertive in cross-border colleges of supervisors and crisis management groups.
  - The EBA should ensure national authorities undertake careful and consistent analysis of the underlying quality of bank assets to ensure credibility of stress tests.
  - The ESRB should develop the macroprudential toolkit, analyze macroprudential effects on the cyclical downside and not just the upside, and ensure consistent application of macroprudential policies across the financial sector and across the EU.
  - The ECB’s macroprudential tools should go beyond those identified in CRD IV.
  - Heightened responsibilities for these agencies warrant increased resources.
- Proposals to separate banks’ retail activities from riskier activities are not panaceas but could reduce cross-subsidization and make resolvability easier; such separation is not a substitute for enhancements in loss absorption capacity (capital surcharges, bail-ins, ex ante deposit insurance funds, common backstops). Care must be taken to avoid regulatory arbitrage.

### Insurance, financial market infrastructure, and coordination
- Insurance sector concerns:
  - A weak economic environment, if it persists, can threaten the financial health of the life insurance and the pensions industries.
  - These industries have been adversely affected by exposures to banks and sovereigns and will need to cope with stricter Solvency II requirements.
- Financial market infrastructure:
  - TARGET2 functioned well in the crisis, although enhanced information sharing with the ECB would be appropriate.
  - The ECB’s capacity and competences should be strengthened as it moves toward a risk-based oversight approach.
  - Increasing reliance on Central Counterparties (CCPs) and Central Securities Depositories (CSDs) reduces overall risk, but failure of a CCP or CSD would pose substantial risks; important work is underway to address them.
- Strong coordination across supranational agencies is critical for smooth decision making and policy consistency. For crisis management, establishing a mechanism or committee that integrates ESAs, ESRB, SSM, the forthcoming resolution authority, DG COMP, and supranational support facilities would be desirable.

### Monitoring, follow-up, and timetable
- High priority recommendations are summarized in Table 1; a Risk Assessment Matrix (RAM) is in Appendix Table 2.
- The authorities expressed interest in repeating the EU FSAP on a regular basis. Doing the next assessment within the next three years would allow a timely assessment of progress in setting up the BU and revisions to the EU financial oversight framework planned for 2014.
- Timing and key dates referenced:
  - By end–2013 (bank balance sheet repair; modify governance of ESAs).
  - By June 2013 (SSM operationalization, SRM preparations, time-bound roadmap to full BU; passage and implementation of CRD IV/CRR and resolution directive).
  - Immediate (ESM modalities for direct recapitalization; ensure full coordination of crisis management; improve ESAs’ access to data; increase ESAs’ resources; strengthen supervisory colleges and crisis management groups; DG COMP actions; pass EMIR technical standards and CSD Regulation; enhance TARGET2 information sharing; strengthen ECB oversight capacity).
  - By January 1, 2014 (Adopt and implement Solvency II; plan remedial strategies for pensions and life insurers).
  - The FSAP mission period: during the period November 27 to December 13, 2012.
  - Document date: February 22, 2013.

_Executive Summary of the EU Financial Sector Assessment Program (FSAP), IMF staff report._

### 1.      The recent financial crises have underscored the need for the EU to take a regional

### _cr1375 - 1.      The recent financial crises have underscored the need for the EU to take a regional

### Systemic risk and vulnerabilities in a cross-border setting
- Key structural factors amplifying EU/EMU contagion:
  - Single market in financial services: passporting and cross-border branching led to rapid financial integration and sharp increases in cross-border exposure (Figure 3).
  - National approach to supervision: countries continued their own supervisory approach and national financial systems varied in size and structure and relative to fiscal capacity (Figures 4).
  - Monetary union: elimination of currency risk and interest rate convergence contributed to rising cross-border lending, including to sovereigns; mechanisms to instill discipline through the Stability and Growth Pact (SGP) and markets failed.
  - Commitment to euro adoption by the emerging economies in the EU (EEE): financial liberalization upon joining the EU led to very large investments in western European banks and fostered foreign currency borrowing, contributing to credit booms (Figures 5 and 6).

- Crisis amplification and policy spillovers:
  - Early national and EU policy responses sometimes led to adverse policy spillovers (Figure 7), e.g., guaranteeing all liabilities of the Irish banking system and breaking up troubled cross-border institutions along national lines.
  - Central banks, notably the ECB, implemented unconventional measures to buy time (see Table 2).
  - Absence of robust cross-border crisis management contributed to negative sovereign-banking loops and financial fragmentation; reversal of cross-border capital flows and reduction of cross-border holdings affected the EA periphery until stemmed by the ECB’s Outright Monetary Transactions (OTM) program (Figure 9).

- Ongoing vulnerabilities highlighted by recent FSAP national assessments:
  - Threats of stresses and dislocations in wholesale funding markets.
  - Deteriorating or high sustained sovereign risk.
  - Further downward movements in asset prices.
  - Macroeconomic risks from a global recession and protracted slow growth in Europe.
  - Regulatory uncertainty and high concentration in banking sectors in some countries (see Appendix I).

- ECB unconventional measures (Table 2: 2007–To Date) — decision dates and measures (exact text preserved):
  - October 8, 2008: Fixed rate, full allotment tenders adopted for weekly main refinancing operations, for as long as needed. Reduction of the corridor between standing facilities to 100 basis points, for as long as needed.
  - October 15, 2008: Expansion of eligible collateral through end–2009. Enhance longer term refinancing operations through end–Q1 2009. Provision of US dollar liquidity through foreign exchange swaps.
  - December 18, 2008: Increase of corridor between standing facilities to 200 basis points.
  - February 5, 2009: Fixed rate, full allotment tenders to continue for as long as needed on all main, special term, supplementary and regular longer term refinancing operations. Supplementary and special term refinancing operations to continue for as long as needed.
  - May 7, 2009: One year long-term refinancing operations introduced. Covered bond purchase program announced.
  - March 4, 2010: Return to variable rate tender for three-month long term refinancing.
  - May 10, 2010: Securities Markets Program (SMP) introduced to intervene in the EA public and private debt securities Markets. Fixed rate, full allotment tenders adopted for regular three-month long-term refinancing, extended through today.
  - August 4, 2011: Supplementary longer term refinancing operation with a maturity of approximately six months, fixed rate and full allotment introduced—subsequently extended through today.
  - October 6, 2011: Two longer-term refinancing operations introduced—one with a maturity of approximately 12 months in October 2011, and another with a maturity of approximately 13 months in December 2011. New covered bond purchase program launched.
  - December 8, 2011: Further non-standard measures introduced, notably: (i) to conduct two longer-term refinancing operations with a maturity of approximately three years; (ii) to increase the availability of collateral; (iii) to reduce the reserve ratio to 1 percent; and (iv) for the time being to discontinue the fine-tuning operations carried out on the last day of each maintenance period.
  - February 9, 2012: Further collateral easing by approving specific national eligibility criteria and risk control measures for the temporary acceptance in a number of countries of additional credit claims as collateral in Eurosystem credit operations.
  - September 6, 2012: OMTs introduced to purchase sovereign bonds in the EA in secondary markets.

- Four intertwined vulnerabilities (exact phrasing preserved):
  - Low growth. Reflecting deep recessions in the EA periphery, real activity in the EA is projected to decline slightly in 2013 while slowing in most other EU countries. Low growth will put bank profitability at risk, removing an important source of capital growth. Solvency in the insurance sector is under pressure from low returns and the stagnant economy (Figure 10).
  - Fiscal vulnerabilities. Lackluster growth will hamper efforts to restore fiscal sustainability where needed. Weak confidence in the fiscal sustainability of many EA members—and fiscal crises in some—has severely undermined banks given their large exposures to sovereigns.
  - Funding pressure. Market funding remains a challenge with wholesale markets segmenting along national borders, and many banks remaining reliant on central bank support. The eventual withdrawal of central bank support operations will be challenging for many banks.
  - Deleveraging. Since 2008, EU banks have deleveraged considerably, mainly across borders, including outside the EU. Bank deleveraging can be explained by structural and cyclical forces (see GFSRs from 2012): adjustment of business models to new regulatory and economic environments; pressures to build capital; reduction in reliance on unstable market funding; and strained financial conditions and weak demand for credit. Tight lending conditions risk weakening growth and the scope for balance sheet repair.

### Overcoming the crisis — the supranational dimension
- Core strategy: move banks and sovereigns jointly to safety via policy combinations that strengthen banks without weakening public sector balance sheets.
  - First set of policies: raise private capital.
  - Second set of policies: minimize taxpayer burden from too-important-to-fail institutions (e.g., bail-ins).
  - If national capacity is insufficient, deploy supranational support: direct support for banks and asset management companies (capital and guarantees); common backstops and safety nets (DGS, resolution funds); borrowing from official sources; further fiscal integration.
  - Many elements facilitated for countries that join the prospective Banking Union (BU).

- Progress and remaining gaps (exact points preserved):
  - Bank recapitalization: Banks have raised considerable new capital, both in the context of the EBA recapitalization exercise and national efforts, but pockets of weak banks remain.
  - Banking system restructuring: During 2007–2012, the number of credit institutions fell by 5 percent: 20 banks were resolved, or are in the process of resolution, and 60 banks have undergone deep restructuring. However, many banks are still excessively dependent on wholesale funding, while others remain exposed to illiquid or impaired assets.
  - Burden sharing with creditors: Recourse to bail-in may be more difficult during periods of stress, and only a handful of banks have so far made progress in raising liabilities subject to bail-in.
  - National sovereign support: Financial system support from sovereigns has been large, which has sometimes triggered an adverse loop between banks and some sovereigns.
  - Sovereign adjustment: Virtually all EU countries have embarked on fiscal adjustment and other reforms to strengthen the sovereign.
  - Supranational support: The EFSF and ESM have provided support to sovereigns in funding difficulties. A decision has been taken in principle to allow the ESM to directly recapitalize banks; this needs to be made operational as soon as possible.
  - Resolution in systemic situation: Common fiscal and monetary backstops are essential, alongside bail-ins and resolvability, to cope in an effective and orderly way.

- Priority actions recommended (exact phrasing preserved):
  - Bank balance sheet repair:
    - Secure progress towards strong capital buffers.
    - Greater disclosure requirements, especially of impaired assets, would buttress credibility in the improvement in banks’ condition.
    - National authorities and the SSM should undertake selective asset quality reviews, coordinated at the EU level to add credibility to stress tests envisaged by the SSM and EBA.
  - Fast and sustained progress toward an effective SSM and BU:
    - Anchor financial stability and ongoing crisis management.
    - Allow the ESM to directly recapitalize banks to weaken the bank-sovereign link.
    - Protect interests of member states not in the EA, both those that join the SSM and those that do not.
  - Further steps toward a stronger EU financial oversight framework:
    - Prompt passage and implementation of capital requirements, resolution directives and regulations, and strong coordination across institutions to achieve policy consistency, including with national policies.
    - With respect to capital requirements (CRD IV/CRR), full consistency with Basel III is essential.
    - Implementation of the resolution directive is essential given weaknesses in national resolution regimes and absence of an EU-wide common resolution framework; enhancements needed to allow strong early intervention powers, a full menu of resolution tools, and safeguards for taxpayers’ money.
    - Realign roles of the EBA and the ESRB to accommodate the SSM; build safeguards for non-SSM members into governance arrangements.
    - Establish coordination mechanisms or a committee integrating crisis work of the ESAs, the ESRB, the SSM, the forthcoming resolution authority, DG COMP and supranational support facilities, especially within the EA.
    - Consider a statutory systemic risk exception to provide clarity, powers, responsibility and accountability during systemic situations; formal vetting procedures to limit moral hazard and protect resolution funds.

- Box 1 — Proposed Resolution Directive: risks and areas for enhancement (exact points preserved):
  - Resolution of banks is undermined by the absence of an effective EU-wide framework to fund resolution. Binding mediation powers for the EBA and mutual borrowing arrangements between national funds face inherent constraints (in particular, the EBA cannot impinge on the fiscal responsibilities of EU member states).
  - Passage of the directive will substantially enhance the range of tools available to resolution agencies in the EU. But the scope of the directive should be widened to include systemic insurance companies and financial market infrastructures in line with the Financial Stability Board (FSB)’s Key Attributes. All banks should be subject to the regime, without the possibility of ordinary corporate insolvency proceedings.
  - The breadth and timing of the triggers for resolution should be enhanced by providing the authority with sufficient flexibility to determine the non-viability of the financial institution (including breaches of liquidity requirements and other serious regulatory failings, not just capital/asset shortfalls). There should be provision for mandatory intervention in the event a specified solvency trigger is crossed.
  - The directive affords less flexibility for using certain resolution powers than the key attributes. For instance, it does not permit exercising the mandatory recapitalization power and the asset separation tool on a standalone basis. Also, bail-in safeguards should not prevent departure from pari passu treatment where necessary on grounds of financial stability or to maximize value for creditors as a whole.
  - Staff also considers that depositor preference should be established for insured depositors with the right of subrogation for the DGS.

### Banking Union — implementation and risk mitigation
- Mission support and caveats:
  - The mission fully supports the objectives of the proposed roadmap to a BU.
  - The BU’s effectiveness will require that the ultimate financial stability framework includes all elements: the SSM, the single resolution authority, and the common financial safety net, underpinned with a strong legal basis.
  - Risks to the design of the SSM and the transition to a BU need to be mitigated.

A. Single Supervisory Mechanism
- Basel Core Principles basis for SSM (key elements preserved):
  - (i) operational independence;
  - (ii) clarity of objectives and mandates;
  - (iii) legal protection of supervisors;
  - (iv) transparent processes, sound governance and adequate resources; and
  - (v) accountability.
- EU Council agreement largely aligns with these pre-requisites, but clarity is required on resources and responsibilities within the SSM.
- December 12 agreement and roadmap:
  - The December 12 agreement on the establishment of the SSM and announced roadmap toward a BU is appropriately ambitious. It calls for giving the utmost priority to adoption of a harmonized regulatory set-up (the CRR/CRD IV), and to reaching agreement on the draft directive for bank recovery and resolution and harmonization of DGS. A proposal for a single resolution mechanism will be put forth by the EC in 2013.
- Governance implications under the existing EU Treaty (exact description preserved):
  - Treaty requirement: all ECB decisions must be made by the Governing Council that comprises only member states in the EA.
  - A newly created Supervisory Board, comprising representatives from all EMU countries and any other EU member states that join the SSM, will undertake planning and execution of the supervisory tasks conferred on the ECB, including the proposal to the Governing Council of draft decisions.
  - The Governing Council of the ECB, which comprises of the Governors of EA national central banks (NCBs) and the members of the ECB Executive Board, must formally have the ultimate decision making power for any tasks carried out by the ECB, including supervision.

*EUROPEAN UNION INTERNATIONAL MONETARY FUND*

### 19.      Risks arising from these governance arrangements will need to be guarded against.

### 19.      Risks arising from these governance arrangements will need to be guarded against.

### Governance risks of the SSM / ECB oversight
- Decisions by the Supervisory Board may not be fully independent from national interests; the ECB functions in a nationality-blind manner, but national interests will be harder to ignore when taking supervisory decisions, particularly at the outset.
- The Governing Council of the ECB will be in charge of both supervisory and monetary policy decisions; the ECB must:
  - establish a comprehensive framework for transparency and accountability for the SSM; and
  - establish Chinese walls between supervision and monetary policy at an operational level.
- The setup should permit synergies between supervision and monetary policy (for instance from data sharing).
- Accountability should be safeguarded through appearances of the ECB leadership before the European Parliament, and where relevant also before national parliaments.
- As non-EMU countries cannot vote on the Council, credibility in maintaining a level playing field for such countries that join the SSM must be achieved through the operation of envisaged special arrangements.

### Scope and mandate of ECB supervision
- The ECB is to take direct supervisory responsibility for the largest 150 banks, but will have authority to directly supervise any bank it deems necessary.
- The narrower mandate is pragmatic given resource and other challenges, but metrics for identifying the set of 150 banks must be clear and capture:
  - importance in cross-border activities, and
  - domestic and EU significance.
- The crisis has shown problems can emerge from smaller banks, especially when confidence is fragile.
- According to the EU Council Agreement:
  - the ECB retains responsibility and scope for oversight over the rest of the banking sector; and
  - the ECB has power to quickly exert direct supervisory authority over any bank, or group of banks, if it deems necessary.
- To ensure consistent supervision and safeguard against forbearance, national supervisory authorities (NSAs), which will continue to supervise most banks in SSM countries, are required to share information among each other and with the ECB.

### Transition risks and start-up arrangements
- Initially, the ECB will need to rely on cross-country teams supplied by national authorities and led by an ECB supervisor.
- Critical risks during start-up:
  - mistakes could cause a loss in credibility that would take much time and effort to reverse.
- Supporting a bank asset quality review coordinated by the EBA would help the SSM avoid early difficulties and better understand banks’ conditions.
- The ECB can postpone the date when the SSM becomes effective if it feels it is not ready; nevertheless:
  - every effort is needed to ensure the ECB has necessary resources in place by the SSM’s March 2014 postulated starting date.

### Resolution (SRM) — rationale and operational features
- It is essential that a SRM for the countries participating in the SSM be established around the same time that the SSM becomes effective.
- Rationale:
  - banks are too interconnected to be effectively supervised at a national level;
  - national resolution regimes would have difficulty handling bigger EU cross-border banks even under harmonized arrangements;
  - incentives among national resolution authorities for least-cost and rapid action could remain limited; and
  - coordination difficulties for large cross-border banks may undermine effectiveness.
- As crisis tensions abate, implicit sovereign bank guarantees should be effectively removed through reaffirmation and implementation of the principle that institutions with solvency problems must be resolved.
- To align with best practices, the resolution authority should:
  - seek least cost resolution without disrupting financial stability;
  - protect insured depositors;
  - ensure shareholders and unsecured, uninsured creditors absorb losses.
- The SRM will need:
  - a mandate to intervene before insolvency using well-defined quantitative and qualitative triggers;
  - strong powers and a range of tools to restructure banks’ assets and liabilities, for example:
    - bail-in subordinated and senior unsecured creditors;
    - transfer assets and liabilities with “purchase and assumption”;
    - separate bad assets by setting up asset management vehicles;
    - override shareholder rights;
    - establish bridge banks to maintain essential financial services; and
    - close insolvent banks.
- Coordination with the SSM should be ensured, particularly when early intervention measures are triggered by the SSM.

### SRM coordination with EU institutions and external authorities
- SRM coordination options:
  - regular formal meetings with the Chair of the supervisory board of the ECB; or
  - SSM Chair could serve on the board of the SRM, together with national representatives and representatives of other EU bodies.
- Coordination with DG COMP is important because, unless and until all EU member states participate in the SRM, interventions may be subject to State Aid rules.
- Most large EA banks have presence outside the BU perimeter; coordination between BU resolution authority and those in the remaining EU states and possibly beyond will be needed.

### SRM legal and institutional evolution
- Use of the existing treaty framework will help determine the structure and operations of the SRM:
  - SRM will use the framework of the resolution directive;
  - rely in the first place on financing from national authorities;
  - have powers such as bail-ins to reduce likely exposures; and
  - have the ESM as financing backstop.
- The ESM itself may be adapted to serve as the single resolution authority of the SRM on this basis.
- In time, a single dedicated resolution authority should be created with:
  - backstop financing, including through a single resolution fund;
  - close coordination with national resolution agencies in member states outside the BU, as well as countries outside the EU.

### Legal basis for the BU and medium-term treaty enhancements
- Article 127(6) of the Treaty on the Functioning of the European Union (TFEU) allows the conferral of specific supervisory tasks to the ECB, and is being used to establish the SSM.
- Certain elements of an effective safety net such as an SRM can be designed through secondary legislation on the basis of the current treaty.
- In the medium term, providing explicit legal underpinning in the treaties could:
  - enhance legal robustness and transparency;
  - enshrine explicit financial stability objectives;
  - enshrine the key institutional set up of supervision and the financial safety net; and
  - enshrine the necessary powers.
- A treaty-based approach would help a single resolution authority stand institutionally at par with the Commission and the ECB, facilitate collaboration and mutual checks and balances, provide for desired allocation of responsibilities between SSM countries and the broader EU, and mitigate legal risks that core aspects of the BU are challenged before the European Court of Justice.

### Strengthening the financial stability framework of the single market
- The EU’s financial oversight framework will remain complex and must address three groups of countries with different governance arrangements:
  - members of the monetary union which will automatically be members of the BU;
  - non-EA countries that opt in to the BU but retain their own monetary policy frameworks; and
  - EU countries that remain outside the BU.
- These groups will retain different degrees of national autonomy while adhering to a single market in financial services.
- Ring-fencing domestic banking from foreign operations occurred as part of crisis response and can contribute to instability by causing disorderly cross-border deleveraging and negative externalities; restoring the single market in financial services could enhance financial stability.
- To restore safe functioning of the single market, continued strengthening of financial oversight is essential, with focus on:
  - remaining regulatory reforms;
  - strengthening and adapting institutions (ESAs and DG COMP);
  - implementing macroprudential policy;
  - addressing structural issues; and
  - securing safe market infrastructure.

### Regulatory reforms — banking, deposit guarantees, insurance, securities, shadow banking
- Banking and deposit guarantees:
  - Implementing the directive to harmonize deposit guarantee schemes (DGS) is a first step toward an EU-wide financial safety net.
  - National DGSs should be aligned in quantities (minimum coverage limits) and in prices, with premiums adjusted for risk as practicable.
  - The length of time to payout should be shortened; prefunding of national DGS will be necessary and may need to be combined with a common backstop should national schemes run out of funds.
  - Agreement is needed on the amount of targeted prefunding and on mutual borrowing agreements across national DGSs; prefunding can be phased in over time with transitional arrangements.
- Insurance:
  - Timely implementation of Solvency II (scheduled for January 2014) would help reduce vulnerabilities; disagreements remain mainly around extending the long-term guarantees package.
  - Delay implies important aspects of supervision, including valuation, disclosure and risk management, would remain non-compliant with IAIS principles in several EU member states.
  - Introducing market-based valuation under Solvency II will likely show insurance companies in a weaker position due to use of a low interest rate discount curve for liabilities; this may call into question traditional insurance and pensions business models and suggest significant refocusing or restructuring may be needed.
- Securities:
  - Approval of the Second Markets in Financial Instruments Directive (MiFID2) and reforms to the Market Abuse Directive (MAD) will be key to fostering market resilience and integrity.
- Consumer and investor protection:
  - Approval of Packaged Retail Investment Products (PRIPs) and reforms to MiFID and the Second Insurance Mediation Directive (IMD2) to ensure cross-sector harmonization in regard to investment-like products are important.
- Shadow banking:
  - Addressing risks from shadow banking should continue to be a priority.
  - CRA3 includes provisions to encourage reducing reliance on ratings.
  - Implementation of the AIFMD should bring further transparency to the hedge fund industry.
  - Further work warranted on (i) money market funds and exchange traded funds (ETFs); and (ii) securities lending and repos.
  - ESMA guidelines on securities lending and repos should be the starting point for reforms to be incorporated in UCITSVI.
  - Feedback from consultation of the EU green paper should provide further input.

### European Supervisory Agencies (ESAs) — performance, resourcing, and governance
- ESAs have undertaken significant work in their first two years, preparing single rulebooks and contributing to implementation of directives and regulations.
- Scope for more work in supervisory convergence, risk identification and consumer protection.
- ESAs need additional resources and better governance arrangements.
- The upcoming review of the ESAs should:
  - be an opportunity to sharpen mandates and strengthen governance;
  - promote a more supranational orientation of decision making;
  - consider providing voting rights to the Chairs of the ESAs, moving to a full time board, or delegating more decisions to the management board.
- Data transparency is a significant handicap to effective supervision and market discipline:
  - lack of direct, easy access to institution-specific data creates inefficiencies and reputational risks;
  - ESAs currently must go through NSAs to obtain detailed supervisory data, causing delays and bureaucratic costs that affect real-time risk analysis and crisis-related work;
  - requiring a vote from NSAs to provide data for particular studies might undermine timeliness of ESA work.

### Banking supervision and EBA role
- EBA has had high visibility from creation and significant achievements, though pace and prioritization have been dictated by the crisis.
- EBA played a crucial role in securing bank recapitalization:
  - the June 2011 stress tests failed to signal some subsequent bank failures;
  - the June 2012 recapitalization exercise was more effective and led to substantial infusions of capital into EU banks, although some banks enhanced capital via risk weight optimization.
- Despite limited resources and a cumbersome governance structure, EBA has progressed in rule making but needs additional resources and independence, and to seek synergies with ESRB (e.g., on cross-sector risk assessment).
- EBA should prioritize strengthening transparency and reliability of data by:
  - enhancing quality assurance processes;
  - coordinating an asset quality review;
  - standardizing NPL definitions, loan classifications and provisioning rules;
  - promoting timely disclosure of granular asset quality information;
  - accelerating convergence on Pillar 2 practices (common methodologies for risk assessment);
  - raising supervisors’ awareness on asset quality issues and issuing guidance for supervisors on best practices for asset quality reviews.

### Lessons and recommendations for EBA stress testing (Box 2)
- Full transparency about banks’ data should be obtained, preferably through an asset quality review.
- A high degree of transparency, including on reference date data and sensitivity to differences in data definitions, would strengthen confidence; conversely, further bank failures after passing a stress test would damage credibility.
- Recommendations:
  - Move to standardize definitions of NPLs, loan classifications, provisioning etc. while initiating a review of input asset quality data; complement this with an enhanced system of consistency checks built into stress testing procedures and sensitivity analysis.
  - Continue to publish a wide range of detailed information on banks.
  - Incorporate banks’ funding and capitalization plans in the 2013 stress test projections, including effects of the phase out of the Long Term Refinancing Operations (LTRO); assess sensitivity of results to likely changes in balance sheet composition.
  - Ensure consistency and quality of tests run by NSAs and the SSM with the SSM’s own tests; run tests on relatively neglected topics such as structural issues and funding vulnerabilities; develop further liquidity stress testing and conduct stress tests and related simulations incorporating longer-term and cross-sector factors (for example, using contingent claims analysis) that relate to structural issues.

### SSM and EBA interaction
- The creation of the SSM will bring new urgency to EBA’s supervisory convergence role.
- The ECB will need to implement supervisory procedures and guidance for the SSM in the established timeframe, which may front run parts of the envisaged European Supervisory Handbook.
- It is important that EBA works closely with the new supervisor so the SSM can build procedures on best available practice.

*Source: _cr1375 - 19.      Risks arising from these governance arrangements will need to be guarded against.*

### 43.      EBA will have a key role to play in supervisory colleges after the establishment of

### _cr1375 - 43.      EBA will have a key role to play in supervisory colleges after the establishment of

### EBA and supervisory colleges; consumer protection
- EBA will have a key role in supervisory colleges after the establishment of the SSM.
- Most large EU banks have activities inside and outside the SSM perimeter; EBA should be assertive in the colleges to:
  - ensure a level playing field, and
  - ensure that practices do not diverge across the two areas.
- EBA can have a major role in the EU’s relationships with the outside world.
- In the area of consumer protection, EBA has EU-wide responsibility.
  - More staff and building of knowledge are needed.
  - Support may be drawn from the other ESAs, which have been more proactive, issuing guidelines, and reports on good practices and consumer trends.

### EIOPA — insurance supervision, Solvency II, and consumer protection
- Achievements and current work:
  - EIOPA has contributed to a common supervisory culture using a soft approach based on peer reviews, training, and frequent engagement in colleges of supervisors.
  - In anticipation of Solvency II, EIOPA has been developing regulations and designing technical standards, guidelines and recommendations.
  - Its work on Solvency II equivalence certification has concluded on three countries, and transitional Equivalence measures for several countries are being evaluated.
  - Mutual recognition work with the United States continues.
  - EIOPA has created a common EU voice in insurance and pension matters on selected international topics.
- Challenges and adjustments needed:
  - Solvency II is scheduled to be implemented in 2014.
  - Shifting from developing technical standards toward monitoring, implementing and enforcement will be necessary.
  - EIOPA will need to prevent delays in Solvency II implementation that could result in regulatory arbitrage.
  - EIOPA’s human resources framework and operational processes will need realignment to new challenges.
- Supervisory colleges:
  - In 2012, colleges of supervisors having at least one actual meeting or teleconference were organized for 69 groups.
  - Developments in colleges included introducing crisis preparedness, testing some aspects, developing confidentiality agreement templates, and presenting best practices on group supervision.
  - Work remains to ensure a harmonized level of group supervision in the EU once the Level 3 legislation is in force.
  - EIOPA’s engagement in colleges should go beyond the EU to encompass larger international groups active in Europe and take a leading role in supervising the largest EU groups.
- Consumer protection:
  - EIOPA has been proactive in promoting transparency, simplicity and fairness in the market for consumer financial products and services across the internal market.
  - EIOPA is engaged in the revision of IMD2 and working with ESMA on MiFID2, where it can highlight particular aspects of insurance products and distribution practices.
- Internal models and stress testing:
  - Approval of internal models is a crucial step in evaluating capital levels; resources need allocation to this effort.
  - The level of expertise and amount of work required is imposing severe strain on the NSAs.
  - EIOPA has agreed a work process for the NSAs and insurers.
  - Consideration should be given to centralizing aspects of internal model approval to make best use of limited highly-qualified resources.
  - EIOPA’s stress tests under a Solvency II regime should focus on EU-wide vulnerabilities and interlinkages.
    - To date, EIOPA’s main effort has been to quantify the effect on assets of single factor shocks and traditional insurance factors such as mortality, lapse and market exposures.
    - Stress tests should complement national stress testing activity with a special focus on identifying EU-wide risks, spillovers to and from other sectors, and medium term resilience related to low profitability in some business lines.
    - EIOPA should coordinate with EBA and the ESRB in assessing risks related to bancassurance.

### ESMA — securities markets, supervisory convergence, and CCP model validation
- ESMA performance and gaps:
  - Within its resource envelope, ESMA has performed well during its first two years, especially on the single rulebook and CRAs supervision.
  - Technical standards, opinions, and advice to the EC were developed.
  - ESMA has built expertise on CRAs and worked on developing a risk framework to anchor its supervisory program.
  - Results are more modest in connection with other functions.
- Areas for stepping up:
  - Supervisory convergence:
    - Reengineering and strengthening peer reviews is essential.
    - Reviews can be made more rigorous by increased onsite work.
    - Outcomes can be enhanced by linking reports to development of best practices and/or guidelines, implementation of which can be monitored; stronger actions should be taken if necessary (for instance, for breach of law).
    - NSAs must take necessary steps to ensure the enforceability of ESMA’s opinions and guidelines in their jurisdictions.
  - Risk identification and crisis management:
    - Ongoing projects should allow ESMA to make a qualitative jump in contribution to financial stability and crisis management.
    - ESMA needs timely and granular data and should coordinate simulation exercises among national supervisors, setting out common assumptions to ensure comparability of results.
  - Investor protection:
    - Emphasis on product monitoring is warranted; effective monitoring of financial innovation should also improve financial stability.
  - CCP model validation:
    - ESMA is encouraged to acquire skills to validate complex risk models of CCPs, including for the clearing of OTC derivatives.
    - The independency of the review of these models should receive attention because model accuracy is essential to safeguard CCPs in extreme market circumstances.

### DG COMP — competition, State aid, and bank restructuring
- Role during the crisis:
  - Competition and State aid policy has served as the de facto coordinating mechanism in bank restructuring during the crisis, as it is the only binding EU framework available for this purpose.
  - DG COMP has the exclusive mandate and power to ensure State aid is compatible with the treaty and to accept State aid in exchange for strict conditionality.
  - Member states provided aid through capital injections, guarantees and asset purchases.
  - Compensatory measures required by DG COMP have included divestments, penalty interest rates, management removals, dividend suspensions and burden sharing (shareholder dilutions, and bail in of subordinated debt).
- Concerns and limitations:
  - Interventions by DG COMP have on occasion heightened macro-financial concerns, notably around speed of decision making, insufficient transparency, and impact of compensatory measures on financial stability and economic growth.
  - DG COMP could only act in response to national State aid proposals; decisions were case-by-case even with system-wide problems.
- Evolution and trade-offs:
  - State aid management is evolving to respond more flexibly to the crisis but faces fundamental challenges.
  - DG COMP must mitigate competitive distortions, preserve financial stability, limit taxpayer costs, and ensure long term viability of aided institutions—designing intervention strategies involves significant trade-offs.
  - Procedures have been accelerated and sector-wide implications taken into account; the Spanish arrangement is cited as taking a broader approach.
  - The Commission’s powers regarding bank resolution have been strengthened: ESM support to bank recapitalization is conditional upon the Commission's approval of those banks' restructuring plans.
    - The new mechanism gave DG COMP greater influence and led to a significant acceleration in approvals; for instance, it took less than six months to approve the restructuring plans of eight Spanish banks, consistent with the timelines of the European program of assistance to Spain.
  - Stronger coordination with other institutions is desirable to achieve the Commission’s objective of “restoring financial stability, ensuring lending to the real economy, and dealing with systemic risk of possible insolvency.”
- Enhancements and recommendations:
  - DG COMP’s practices in systemic cases can be enhanced to ensure consistency with a country’s macro-financial framework.
  - Phasing and composition of bank restructuring is critical to mitigate adverse macroeconomic effects.
  - A pricing policy based on ECB recommendations seeks to limit moral hazard by ensuring burden sharing, although at a level still below market remuneration in the absence of State aid.
  - Increased transparency in pricing and proposed deleveraging would give added credibility to DG COMP’s efforts.
  - An examination, for instance with the IMF and ECB, of its policy for determining remuneration of instruments used for capital support would be appropriate to ensure it does not double-hit fragile institutions or simply delay their demise and thereby undermine financial stability.
  - It would be helpful to reassess the methodology for determining the required degree of bank deleveraging.
- Future role and coordination:
  - DG COMP’s role will change as a dedicated resolution framework for the BU is developed.
  - Challenge: balance the Commission’s competition mandate with institutions charged with overseeing bank resolution and safeguarding financial stability at the EU level.
  - One option: foster a permanent coordination mechanism between DG COMP and financial stability authorities for efficient handling of competition and State aid aspects of future resolution cases.
  - As most large EA banks have presence outside the likely BU perimeter, DG COMP likely will coordinate between the BU resolution authority and those in remaining EU member states using the framework of the prospective resolution directive.

### Macroprudential policies and the ESRB
- Role and instruments:
  - Macroprudential supervision aims to identify and reduce risks to financial stability using instruments to:
    i) limit the buildup of financial imbalances;
    ii) address market failures to assess risk externalities among financial institutions; and
    iii) dampen the procyclicality of the financial system.
  - Macroprudential policy can be applied at cycle peaks (“taking away the punchbowl”) and at troughs to prevent downside procyclicality from blocking recovery.
- Current arrangements and coordination:
  - National authorities in the EU are currently responsible for macroprudential oversight, though adequate frameworks are lacking in some countries.
  - Coordination and internalization of cross-border spillovers is achieved at the EU level by the ESRB through a (non-binding) “act or explain” mechanism for member countries in response to its warnings and recommendations.
  - In December 2011, the ESRB issued recommendations on the macroprudential mandates of national authorities.
  - As national authorities establish institutional arrangements, guidance for establishing common macroprudential toolkits is being developed.
  - Some harmonization of tools is required to facilitate coordination and reciprocity of policies with cross-border effects, while allowing flexibility to tailor responses to local conditions.
- Cross-border issues and ESRB procedures:
  - Coordination of national macroprudential policies is especially important given highly integrated EU markets and EMU constraints on monetary policy.
  - National authorities may lack power over all lending within their territory, including by foreign bank branches.
  - Use of macroprudential instruments over a particular activity could be referred by national authorities to the ESRB for approval so that all EU banks regardless of origin are covered.
  - Such coordination is important to minimize negative spillovers, reduce regulatory arbitrage, and foster policy effectiveness—particularly relevant for EEEs with high cross-border banking activities and direct cross-border lending.
  - The ESRB has announced its intention to establish coordination procedures when considered appropriate.
- Limitations and recommendations for ESRB:
  - The ESRB currently lacks binding legal authority, relying on “soft” power, is handicapped by very limited resources, and has a burdensome governance structure.
  - Nevertheless, it has established itself as an important body.
  - Its first warning, over foreign currency lending in EEE, was effective.
  - The ESRB will achieve further credibility once it issues warnings to major “core” economies and obtains positive responses.
  - Further work on the downside of the cycle—e.g., aggregate effects of deleveraging or asset sales—would be particularly relevant at the present juncture.
    - Note: Recommendations on money market funds and bank funding were approved by the ESRB General Board in February 2013.
- ECB role and interaction:
  - Within SSM countries, the ECB will have a role in macroprudential policy as well as national authorities, as it takes on microprudential responsibilities.
  - Synergies exist with microprudential policies; ECB’s understanding of European financial markets and monetary transmission will help assess macroprudential transmission mechanisms.
  - A key challenge is designing, calibrating, and implementing macroprudential instruments while resisting political interference; ECB’s established independence would help.
  - National macroprudential authorities also need adequate independence.
  - Because monetary union prevents participating member states from having divergent monetary policies, macroprudential instruments may be particularly important.
  - The ECB should cooperate closely with national authorities for local knowledge and with the ESRB for oversight of non-EMU countries and the non-bank financial sector.
  - The ECB should be responsible for a wide range of instruments going beyond those included in CRD IV/CRR.
- ESRB’s continuing role and legal framework:
  - The ESRB will continue to be responsible for macroprudential oversight at the EU level, covering the entire financial system including insurance, occupational pensions, market infrastructure, financial markets and products.
  - The ESRB is well suited for identification, analysis and monitoring of EU-wide systemic risks and for assessing the array of instruments to address them.
  - The ESRB should interact with the ECB on macroprudential toolkits when the ECB takes on macroprudential responsibilities, as it does with national agencies.
  - The ESRB must be able to exercise its powers and issue recommendations to the ECB as it does to any NCB or bank supervisor—this would require:
    - a substantial revision to the ESRB legal framework,
    - a detachment from the ECB “umbrella”, and
    - a clear delineation with the mandate of the latter.

### Structural reforms: Liikanen, Vickers, Volcker comparisons, and resolvability
- High-level reviews:
  - High level working groups chaired by Vickers and Governor Liikanen assessed additional banking reforms to reduce probability and impact of failure, ensure continuation of vital functions in failure, and better protect vulnerable retail clients.
  - One conclusion: the crisis showed no one type of bank performed systematically better or worse.
- Liikanen recommendations:
  - Recommended mandatory separation of investment banking business (deemed riskiest) to limit contagion to core functions (deposit-taking and payments) and reduce taxpayers’ contingent liabilities.
  - Separation would limit cross-subsidization, improve monitoring and risk management, and facilitate resolution.
  - Proposal is in spirit of Volcker Rule (U.S.) and Vickers recommendations for ring-fencing retail banking; differences with Vickers and Volcker are noted.
  - Liikanen allows preservation of the universal banking model; mandates that businesses placed in a stand-alone subsidiary include proprietary trading, market making, and investments in hedge funds and private equity funds.
  - Trading subsidiary and the subsidiary housing deposits and payments would need to meet capital and regulatory requirements on a stand-alone basis.
  - Report argues increased costs from removal of synergies may reflect withdrawal of a hidden taxpayer subsidy.
- Enhancing resolvability:
  - Liikanen proposes enhancing the bank resolution regime, developing a comprehensive system of bail-ins, applying more robust weights in minimum capital determination, more consistent treatment of internal risk models, and governance reforms.
  - It recommends higher loss absorbency requirement for trading subsidiaries engaging in separated businesses via a leverage ratio.
- Limits of separation:
  - Separation would not have addressed some of the crisis’s most serious problems (e.g., Lehman Brothers was not a retail deposit-taking institution).
  - Many difficulties derived from “plain vanilla” banking such as residential real estate lending.
  - Sovereign-bank linkages also caused difficulties for banks invested in their countries’ government bonds.
  - From the perspective of ease of resolution and minimizing contingent fiscal liabilities, separation may not work as intended because trading subsidiaries may remain systemically important, especially as they will house market making operations of the largest banks.

*Source: _cr1375 - 43.      EBA will have a key role to play in supervisory colleges after the establishment of (PDF chapter/section).*

### 69.      Consistency with structural reform proposals in comparable jurisdictions, at least

### 69.      Consistency with structural reform proposals in comparable jurisdictions, at least

### Consistency of structural reform proposals
- Importance: Consistency with structural reform proposals in comparable jurisdictions, at least insofar as application to internationally active banks is concerned, is important.
- Risks and challenges:
  - Major international banks may optimize across different structural constraints by moving operations, changing corporate structures, and redesigning products in ways that could weaken policy effectiveness. This would put further pressure on cross-border supervision and resolution.
  - Differences across proposals must be managed to avoid mutually inconsistent structural constraints on internationally active banks.
  - A level playing field will need to be developed vis-à-vis banks from outside the EU that are competing within the EU.

### Financial Market Infrastructure Regulation (overview)
- Key legislative items:
  - Adoption of the European Market Infrastructure Regulation (EMIR).
  - Legislative work on the draft Central Securities Depositories (CSD) Regulation.
- Expected benefits:
  - Creation of a single market for CCPs and CSDs.
  - Significant reduction of sources of risks related to the cross-border offering of clearing and settlement services.
  - Provision for a level playing field, enhancing fair and efficient competition between CCPs and CSDs.
  - Commission’s intention to further centralize supervisory responsibilities in the medium term is appropriate.

### Cross-border recovery, resolution, and supervisory consistency
- Needs and gaps:
  - Measures needed to ensure recovery and resolution plans for CCPs and CSDs will work across borders in case of large market disruptions.
  - National competent authorities bear primary supervisory responsibilities; framework does not provide safeguards against national interest prevailing over general interest in safe and efficient CCPs and CSDs.
  - Active participation of ESMA in CCP colleges should contribute significantly to supervisory consistency and oversight.
  - Access rights of CCPs and CSDs for other markets and infrastructures should be further developed in line with international standards.
  - A comprehensive framework for cooperation between national supervisors of CSDs is needed given the increased cross-border nature of CSDs.
  - Supervision and oversight of the two international CSDs in the EU should be enhanced in cooperation with the ECB and by participation in the SSM, as competitive pressures may encourage competition on risk management frameworks.

### Regulatory coordination for mandatory clearing obligations
- Regulatory risks:
  - Differences in legal and regulatory frameworks in the EU, the U.S., and elsewhere to handle the mandatory clearing obligation for standardized derivative contracts create regulatory uncertainty and inefficiencies for globally operating OTC derivative CCPs.
- Recommendations:
  - Regulators should continue ongoing joint work to prioritize identification and mitigation of conflicts, inconsistencies and gaps between EMIR and other non-EU frameworks through bilateral and multilateral coordination.
  - The EU has drafted flexible arrangements for identification and recognition of third country CCPs that limit risks of conflicts of laws by ensuring foreign CCPs remain subject to their home regulation.

### Crisis management, notification, and monitoring
- Enhancements needed:
  - EU crisis management procedures for financial market infrastructures should be further developed and tested.
  - A notification regime should be established to allow immediate information sharing between relevant authorities, CCPs, CSDs and other systems and market participants.
  - Central monitoring of potential market wide disruptions should be enforced, for example in relation to the quality of collateral kept by CCPs and international CSDs.

### Euroclear Bank — soundness, systemic role, and needed actions
- Systemic role and scale:
  - Euroclear Bank is a securities settlement system contributing to safety and efficiency of global markets for government bonds and other international securities but also concentrates systemic risk.
  - Daily average settlement value of around €1.1 trillion.
  - Provides settlement services for securities from 44 markets in 53 currencies.
  - Services largest global banks with triparty repo arrangements to secure interbank financing.
- Progress and remaining needs:
  - Important risk measures have been taken to reduce systemic risk, but some risk management frameworks need further improvement to fully observe the recently adopted international standards (CPSS-IOSCO Principles for Financial Market Infrastructures).
  - Euroclear Bank should prepare measures to be operationally ready for implementation of its recovery plans and plans for orderly winding down of its operations.
  - It should upgrade some risk management policies and practices to reduce its (potential unsecured) credit exposures to participants and other linked securities settlement systems.
  - Recent improvements made to its collateral and liquidity management frameworks.
- Regulation, supervision, and cross-border cooperation:
  - Euroclear Bank is subject to effective regulation, supervision and oversight by the NBB and FSMA, but cooperation with Luxembourg authorities should be improved.
  - Legal framework provides Belgian authorities sufficient powers to obtain timely information and induce change.
  - Competition with Clearstream Banking Luxembourg—offering similar settlement and banking services—means close cooperation with Luxembourg authorities is needed to avoid competition on risk management frameworks.
  - Belgian and Luxembourg authorities should evolve toward a cooperative framework allowing common decisions and simultaneous implementation in both entities.
  - Plans to include Euroclear Bank on the list of eligible banks for the SSM may further contribute to a level playing field.

### National securities depositories sharing Euroclear Group IT platform
- Oversight and cooperation:
  - National securities depositories of Belgium, France, and the Netherlands share a common IT platform provided by the Euroclear Group and are subject to effective regulation, supervision, and oversight by Belgian, Dutch, and French authorities despite substantial legal framework differences.
  - Cooperation between authorities is effective and contributes to financial stability in Belgium, France, and the Netherlands.
  - Crisis management frameworks are in place and regularly tested and updated.

### TARGET2 — soundness, efficiency, and enhancements
- Current strengths:
  - TARGET2 displays a high level of observance of international standards.
  - System has a sound, coherent, and transparent legal basis.
  - Adequate risk management framework addressing financial and operational risks.
  - As an RTGS system, credit risk is minimized.
  - Liquidity risk mitigated by participants’ access to central bank intraday liquidity based on adequate collateral and the liquidity saving mechanism offered by the system.
  - TARGET2 business continuity arrangements are well developed and comprehensive.
- Enhancements recommended:
  - Crisis management and risk communication procedures can be enhanced by giving the ECB direct access to information on participants’ liquidity as well as collateral positions.
  - For most large participants, liquidity positions are maintained in several countries; NCBs can only monitor positions maintained on their own account system.
  - Collateralization process and securities holding are decentralized.
  - Centralizing monitoring of participants’ liquidity and, where possible, collateral positions at the level of the ECB is crucial to allow the Eurosystem to act quickly and effectively across the EA in the event of financial distress.

### Eurosystem oversight framework for payments — capacity building
- Transition and tools:
  - ECB is moving from a rule-based to risk-based and forward looking oversight approach.
  - Developing more dynamic oversight tools such as interdependencies analysis, stress testing, and early warning system.
  - ECB oversight team responsibilities: define the Eurosystem’s strategy and policy, develop rules and guidance, coordinate the Eurosystem, and contribute to international fora.
  - ECB will soon participate in several EMIR colleges for CCPs.
- Capacity needs:
  - To implement the new risk-based approach credibly, the ECB needs access to confidential bank-by-bank data (within the remit of the NCBs) and to strengthen the capacity and skill of its staff.
  - ECB oversight staff should be significantly increased and organized in cluster modules focusing on individual entities and specific risks across entities.
  - Staff need the right skills and continuity in running critical areas such as interdependencies and stress testing.

### Appendix I — Risks and vulnerabilities in EU countries (lessons from national FSAPs)
- General assessment:
  - Overstatement of asset quality has been a major cause of the banking crisis in some EU countries.
  - Medium-term financial and macroeconomic risks, common across the region, could further impair asset quality and damage banking sector balance sheets.
  - Stress tests suggest capital buffers appear broadly adequate.
  - Against liquidity shocks, availability of official facilities helps protect the banking system, but central banks in smaller countries may face difficulties shoring up foreign currency shortages, especially in U.S. dollars.
  - Safeguarding against tail risk scenarios requires continuing to build up capital and liquidity buffers to meet the Basel III targets.
  - Enhancing financial sector oversight and macroprudential supervision will help reduce balance sheet risks.
- Key historical lessons:
  - Greece and Portugal: domestic banks suffered substantial losses mainly from domestic sovereign debt holdings.
  - Ireland and Spain: losses triggered by burst of domestic real estate bubbles.
  - Capital buffers and provision regimes, including dynamic provisions (e.g., Spain), were not designed to withstand massive losses from downgrades of risk-free assets to junk status and large downward price corrections when asset price bubbles burst.
  - Market concerns about banks’ creditworthiness led to funding shortages, reducing their ability to fund domestic economies and sovereigns.
- Common risks identified in recent FSAPs:
  - Financial risks: stresses and dislocations in wholesale funding markets leading to adverse liquidity and refinancing conditions; deteriorating or sustained high sovereign risk if the EA crisis intensifies; major further downward correction of asset prices.
  - Macroeconomic risks: scenarios of a global double dip recession and protracted slow growth in Europe.
  - Uncertainty about the regulatory environment and the burden it may place on banks and financial institutions.
  - High concentration in banking sectors in several EU countries creates too-big-to-fail problems that could amplify vulnerability.
- Potential materializations and consequences:
  - Further deterioration of asset quality in banks’ balance sheets, contraction of credit to the real economy, and rising stress in funding markets.
  - Rising sovereign risk could affect banks holding substantial claims on EA periphery sovereigns and corporates, raising funding costs and encouraging further deleveraging.
  - Adverse global macroeconomic scenarios (slow and/or negative growth and rising unemployment) would lead to higher NPLs and declining profits, reducing scope for bank recapitalization without inducing further deleveraging.
  - Banks relying heavily on market funding would face liquidity problems amid declining capital buffers, increasing impaired assets, and weak earnings outlook.
  - Central banks in smaller countries may face difficulties providing liquidity in foreign currency despite ECB measures restoring some normalcy to funding markets.
  - These risks reinforce the bank-sovereign linkage, with banking sector weaknesses contributing to increased sovereign risk, and vice-versa.

*Prepared by Jorge A. Chan-Lau.*

*Internal Monetary Fund staff content from _cr1375 - 69.      Consistency with structural reform proposals in comparable jurisdictions, at least.*

### 84.      Notwithstanding these risks, FSAP stress tests suggest that capital buffers in EU

### _cr1375 - 84.      Notwithstanding these risks, FSAP stress tests suggest that capital buffers in EU

### Banking sector resilience and asset quality
- Main finding: FSAP stress tests suggest that capital buffers in EU countries appear mostly adequate to withstand severe macroeconomic shocks but there are some caveats.
- Sources of resilience:
  - Efforts to repair balance sheets, including the divestment of non-core assets.
  - Earnings recovery for some large internationally diversified banks.
- Persisting concerns:
  - Legacy assets remain a problem in many EU countries.
  - Reported NPLs and provisions could understate losses in some cases.
  - Comprehensive asset quality reviews have not been conducted with the exception of Spain.
  - Absent such reviews, loss estimates may not reflect the underlying quality of banks’ balance sheets.
  - Banking’s leverage magnifies asset losses.
  - Even though capital buffers relative to assets will increase under Basel III, assessing asset quality is a must.

### FSAP recommendations: buffers, oversight, and macroprudential supervision
- Continued priorities:
  - Continue building up buffers and strengthening financial sector oversight and macroprudential supervision.
- Specific emphases:
  - Need for larger and better quality buffers; Basel III provides the roadmap and timelines.
  - Improve the legal framework, enhance review, supervisory and crisis management processes.
  - Improve the quality of the data used to monitor and measure risks.
  - The proposed BU could help anchor oversight and supervision within a macroprudential perspective emphasizing the proper assessment of asset quality.

### Country-level vulnerabilities and illustrative figures (selected from Appendix Table 1)
- France (FSAP Completion Date: July 2012)
  - Stresses in wholesale funding markets: Likelihood: medium; impact: high.
  - Double dip recession: Likelihood: medium; impact: high; NPLs likely to rise.
- Germany (FSAP Completion Date: July 2011)
  - Some banks may face distressed U.S. dollar funding conditions: Likelihood: medium; impact: medium.
  - EA periphery exposures amount to half of the aggregate bank capital in the jurisdiction: Likelihood: high; impact: high.
- Luxembourg (FSAP Completion Date: May 2011)
  - Turbulence in bond and asset markets could lead to large scale fund redemptions: Likelihood: low to medium; impact: medium (domestically), high (globally).
- The Netherlands (FSAP Completion Date: March 2011)
  - Banks reliant on interbank borrowing, securitization and covered bond issuance would be most affected: Likelihood: medium; impact: medium.
- Spain (FSAP Completion Date: May 2012)
  - Substantial bank refinancing needs in 2012–13; likelihood: medium to high; impact: high.
  - Domestic sovereign exposure amounts to 150 percent of core Tier 1 capital: Likelihood: high; impact: high.
  - Real estate exposures large; recapitalization needs will further increase; About one out of four banks in the stress test sample would face severe capital losses.
- Sweden (FSAP Completion Date: July 2011)
  - Falling housing prices would lead to direct and indirect losses: Likelihood: medium; impact: high.
- Czech Republic (FSAP Completion Date: December 2011)
  - Extreme tail risk losses in the banking sector could amount to about 6 percent of 2010 GDP: Likelihood: medium and rising; impact: low (sovereign/EA exposures).
- Slovenia (FSAP Completion Date: October 2012)
  - Further recapitalization needs required for the largest domestic bank: Double dip recession likelihood: high; impact: high.
- United Kingdom (FSAP Completion Date: May 2011)
  - Two large U.K. banks have very large exposures to Asia.
  - Extreme tail risk losses in the banking system could be as high as 5 percent of 2010 GDP.
  - Under Basel III, Core Tier 1 capital reduced by half for six largest banks under new definition; new liquidity requirements affect short-term wholesale funding practices.
- Notes on dates and periods explicitly cited:
  - Bank refinancing needs in 2013–4 are significant and heavily reliant on wholesale funding.
  - Substantial bank refinancing needs in 2012–13 (Spain).

### Cross-cutting risks and staff assessments (from Appendix Table 2)
- Protracted slow growth in Europe
  - Staff assessment: Likelihood: Medium; Overall Level of Concern: High.
  - Key points: 2013 growth is projected to be below 1 percent in the EA and the U.K.; banks’ NPLs are likely to rise; weak growth would reduce fiscal space.
- Stresses in wholesale funding markets
  - Staff assessment: Likelihood: Medium; Expected Impact: Medium/High.
  - Key points: EU banks rely heavily on wholesale funding; OMT announcement reduced tail-risk perceptions but exit from LTROs is uncertain; high asset encumbrance lowers access to secured funding.
- Policy risks
  - Staff assessment: Medium to High.
  - Key points: Lack of agreement on ESM direct recapitalization and delays in completing the BU (single resolution authority and resolution fund with credible backstops) would weaken the EU financial stability framework.
- Operational risk of the SSM
  - Staff assessment: Likelihood: Medium; Expected Impact: Medium/High.
  - Key points: ECB needs capacity and resources to directly supervise “significant” banks; incentives alignment between ECB and NCBs is required; ineffective SSM could undermine market confidence.
- Deleveraging risk
  - Staff assessment: Likelihood: Low/Medium; Expected Impact: Medium/High.
  - Key points: Pressures to deleverage could rise from cyclical and structural factors (Basel III); fragmentation and retrenchment of cross-border lending could hinder monetary transmission and curtail credit supply.

_ _cr1375 - 84.      Notwithstanding these risks, FSAP stress tests suggest that capital buffers in EU_

### Appendix II. Recent Developments and Challenges Facing

### Appendix II. Recent Developments and Challenges Facing EU Banks

### Market pressures, funding, and issuance
- Market pressures on EU banks have eased in recent months, bank bond issuance has picked-up, and customer deposit levels have stabilized.
- Credit default swap spreads have come down from high levels, though they still remain elevated for peripheral EA banks.
- The cost of issuance remains high, keeping financial conditions tight in these economies.
- Issuance by the core EA and other advanced EU banks increased moderately in late 2012 relative to the same months a year before.
- Banks benefited from central bank liquidity support, and bank deleveraging reduced funding needs.
- Chart and data notes: asset-weighted averages shown; bond issuance data exclude self-funded issuance.

### Deposits, capitalization, and capital ratios
- Deposits in Greece, Ireland, Portugal and Spain stabilized in recent months.
- Core Tier 1 ratios are trending up as banks raise capital, shrink balance sheets, reduce risk, and optimize risk models.
- Chart/coverage note: Core Tier 1 ratios based on consolidated data from a sample of around 220 EU banks.
- Chart/coverage note: Customer deposit series exclude repos and deposits greater than two years from other EA financial institutions; Spain data adjusted for the increase in retail debt from October 2011.

### Nonperforming loans, asset quality, and credit growth
- Capital could nonetheless come under pressure from rising nonperforming loans and bank exposure to weak economies.
- Balance sheet pressures have contributed to a deceleration in credit growth, unmet demand from SMEs in some economies in the region and a divergence in interest rates on SME loans.
- The nonperforming loan ratio is defined as the stock of impaired loans to the stock of gross loans; the definition of impaired loans differs across countries.
- Asset quality indicators in the charts use a weighted average of real GDP forecasts for 2012 and 2013, weighted by a bank’s exposure to each economy, with exposures taken from data published by the EBA and updated using BIS consolidated banking data.

### Market indicators and bank buffers
- Individual EU bank market indicators include price-to-book ratios and market capitalization (based on daily data from January 2013) and risk-weighted assets for 2012 Q3.
- Bank buffers are measured as core Tier 1 capital and loan loss reserves as a percentage of loans.
- Charts indicate divergence across countries (Spain, Italy, United Kingdom, France, Germany) in lending trends and market valuations since 2008 Q4 (index: 2008 Q4 =100).

### SME lending: met/unmet demand and interest rates
- SAFE survey-based evidence shows met and unmet demand for bank credit from SMEs, with unmet demand reported in Spain, Italy, France, and Germany.
- Interest rates on new loans to non-financial corporations up to and including €1 million in value show divergence across Spain, Italy, France, and Germany in 2010–2012.
- Chart notes: Unmet demand is the percentage of respondents that applied for a loan and did not get all or most of the loan.

*Source: IMF staff compilation from charts and notes in Appendix II of the IMF document.*

### 96.      As the SSM is put into effect, comprehensive risk mitigation should be a central

### _cr1375 - 96.      As the SSM is put into effect, comprehensive risk mitigation should be a central

### Implementation of the Single Supervisory Mechanism (SSM)
- Swift agreement and adoption of harmonized legislations and transposition into national laws.
- If a fully integrated substantive law across the concerned 17 or more jurisdictions were to be in place, the ECB could exercise its powers under a uniform regime.
- Importance of adopting the CRR/CRD IV and building a uniform single supervisory rule-book in the EU, going beyond harmonization prompted by the CRD IV and the resolution and deposit insurance directives.
- Role of the EBA: ensure harmonization of supervisory practices.

### Governance and accountability
- Governance recommendations:
  - Establish a steering committee to support the work of the Supervisory Board to avoid cumbersome higher-level processes.
  - Establish internal and external monitoring mechanisms or “watchdogs” to enhance checks and balances and incentivize ECB supervision effectiveness.
  - Increase representation of permanent, full-time officials or independent experts at the Supervisory Board not linked to national interests.
  - Consider treaty changes in time, for instance allowing representation of non-EA countries in the Governing Council when deciding supervisory matters.
- Accountability:
  - Draft SSM Regulation provides for additional accountability mechanisms, such as the possibility of reporting to national parliaments in addition to the European Parliament.
  - Clarify respective responsibilities of the ECB and the NCAs to make decentralization incentive compatible given ECB’s ultimate responsibility for SSM effectiveness.

### Resources, capacity building, and organizational design
- Allocate resources to build capacity and expertise at the ECB:
  - Establish the off-site supervisory structure at the ECB as soon as possible.
  - Hire specialist expertise externally and obtain expertise by secondments from national authorities.
  - Put in place cross-country teams led by an ECB supervisor as soon as possible for the most systemic or fragile banks (including those requiring ESM direct recapitalization).
  - Funding of the ECB’s supervisory activities should not be derived only from transfers from national supervisory authorities, but also from additional revenues, in part to minimize potential adverse effects on national supervisory resources.
- Specify roles and cooperation:
  - Prepare clear, precise, and transparent rules defining division of labor between the ECB and national authorities to prevent overlaps, gaps, or conflicts.
  - ECB should prepare a supervisory manual as soon as possible.

### Risk mapping, asset quality assessments, and supervisory targeting
- Risk mapping exercise:
  - ECB should receive from national supervisors the risk assessment and local risk classification of local banks as soon as possible.
  - Based on this information, ECB would map banking risks and target supervisory actions accordingly (for example, require national supervisors to undertake additional due diligence on specific portfolios and capital planning or provide information on availability of additional shareholder resources).
- Asset quality assessment:
  - ECB may initiate asset quality assessments for a set of banks as they are brought under the SSM.
  - Exercises should be conducted with national supervisors and perhaps third parties, following harmonized guidance on conduction of such assessments to be issued by EBA.
  - Coordination with other efforts to review data and relevant definitions (e.g., of nonperforming loans) is required.

### European Stability Mechanism (ESM) recapitalization and investment mandate
- Initiate the possibility of ESM recapitalization and agree its investment mandate to advance restructuring of the banking system:
  - Direct recapitalization of banks by the ESM could relieve pressures on weak sovereigns and provide incentives to address solvency issues.
  - Interpretation of the ESM Treaty: flexible enough to enable direct bank recapitalization—subject to political agreement and unanimous consent of ESM membership.
  - Under Article 19 of the ESM Treaty, the Board of Governors may review and change the range of financial assistance instruments; the Board of Directors may adopt guidelines for implementing financial assistance through recapitalization or loans.
  - Important to agree and clarify ESM’s investment mandate and specifics of ESM recapitalization, including:
    - definition of legacy assets,
    - pricing of assets,
    - role of bail-ins,
    - principle for access,
    - design of instruments.
  - If ESM injects ordinary equity into banks, governance arrangements and ownership policies need careful elaboration; possible conflicts from concurrent significant stakes in competing institutions need to be dealt with and disclosure requirements strengthened.
  - Ensure ESM has adequate capital to allay investor concerns about ESM credit quality and to enable leveraging capital to act as a common backstop for bank recapitalization.

### Resolution, deposit guarantees, and macroprudential oversight
- Define a clear roadmap and steps toward a single resolution authority and common backstops, and meanwhile enhance national mechanisms:
  - Pending an EU-wide resolution framework, update national resolution regimes as a priority.
  - EC should announce steps toward creating a strong single resolution authority with a common backstop and a fully integrated resolution regime.
- Develop ECB’s macroprudential powers and oversight:
  - ECB should identify systemic risks, take early actions, and use macroprudential instruments when necessary, in coordination with national authorities and the ESRB.

### IMF Executive Board assessment and public communication (key points from PIN No. 13/29 and Press Release No. 13/79)
- Context and timing:
  - Public Information Notice (PIN) No. 13/29 — FOR IMMEDIATE RELEASE March 15, 2013.
  - Press Release No. 13/79 — FOR IMMEDIATE RELEASE March 15, 2013.
  - IMF Executive Board discussed the Financial System Stability Assessment (FSSA) with the European Union on March 8, 2013.
- Background findings:
  - EU banking system came under severe pressure after the global financial crisis.
  - Economic growth has been low and is projected to continue to be weak.
  - Banks reduced reliance on central bank funding recently, but dependence on wholesale funding remains high in some cases.
  - Structural forces contribute to deleveraging pressure and limited financial system support to some economies.
  - The European Stability Mechanism became a permanent crisis management facility; possibility to involve it directly in recapitalization of euro area banks is under consideration and an operational framework should be finalized in the coming months.
- Executive Board assessment highlights:
  - Directors welcomed the FSSA for the EU and broadly shared main findings and recommendations.
  - Much achieved: bank capitalization increased; funding conditions improved; stressed countries adjusting under programs supported by the EU and IMF.
  - Risks remain elevated in a context of low growth and fiscal retrenchment; some systems face pressures from excessive leverage, risky business models, and adverse sovereign–bank feedback loops.
  - Repair of banks’ balance sheets remains a key priority, complemented by harmonized reviews of asset quality using harmonized definitions of forbearance and nonperforming loans.
  - Support for announced path toward banking union underpinned by robust governance and need for SSM to maintain broad oversight and intervention powers, with resources commensurate with task.
  - Urged sustained efforts to establish a Single Resolution Mechanism without undue delay; supported staff recommendation to develop a time-bound roadmap toward a single resolution authority and a deposit guarantee scheme with common backstops.
  - Directors looked forward to early agreement on operational guidelines for bank recapitalization by the ESM.
  - Emphasized prompt implementation of European Commission proposals to harmonize capital requirements, resolution, deposit guarantee schemes, and insurance supervision frameworks; stressed full compliance with Basel III on capital requirements and a trigger for automatic intervention in insolvent banks.
  - Called for more effective supervision and resolution for cross-border financial institutions.
  - Welcomed ESAs’ achievements while noting scope for improvements in data transparency, information sharing, and operational independence.
  - Welcomed ESRB work on macroprudential toolkit and need for flexible implementation, with close coordination with national supervisors and the SSM.
  - Noted plans to separate banks’ retail activities from riskier activities, cautioning it should not substitute for other enhancements in loss-absorption capacity and warning against regulatory arbitrage.
  - Noted life insurance and pensions industries will face stricter supervisory requirements under Solvency II, implying a refocusing of regulatory authorities’ roles.
  - Recommended close collaboration among supra-national agencies and national authorities; consideration of a mechanism or committee to integrate crisis-related work.
  - Directors welcomed authorities’ interest in repeating the FSAP for the EU regularly every few years.

*Source: _cr1375 - 96.      As the SSM is put into effect, comprehensive risk mitigation should be a central (PDF chapter/section).*

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