## _sdn1301

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---

### Executive summary — context, problem, and policy steps
- Crisis dynamics and malfunction:
  - Large intra–euro-area capital flows created sovereign and private imbalances that reversed, producing very sharp contractions and financial market fragmentation.
  - Borrowing costs of sovereigns and national private sectors diverged widely and persistently; cuts in monetary policy rates have had limited or no effects in several economies.
  - Adverse sovereign-bank-real economy dynamics have been prevalent; the monetary union is described as "malfunctioning."
- Policy measures already taken:
  - Adjustment programs; regional firewalls (European Financial Stability Facility (EFSF) and European Stability Mechanism (ESM)); enhancements to fiscal/economic governance (the "Six Pack" and the Treaty on Stability, Coordination, and Governance); ECB liquidity provision; government bond purchases; Outright Monetary Transactions; recycling of capital flight via "Target 2" payments balances.
- Recent milestones and timelines:
  - European Commission presented an SSM plan on September 12, 2012.
  - European Council agreed on December 13–14, 2012, that the SSM would come into operation in March 2014 or one year after the SSM legislation enters into force, whichever is later.
  - Council called for adoption of CRR/CRDIV as "of the utmost priority" and for adoption of the draft Directive for bank recovery and resolution and for harmonization of deposit guarantee schemes (DGS) by June 2013.
  - European Commission will propose a single resolution mechanism in 2013, with the objective of agreement by the summer of 2014.
- Scope of the paper:
  - Discusses benefits and costs (Section II), steady state design (Section III), transition issues (Section IV), and broader EU issues (Section V). Three background technical notes cover: single supervisory framework; single resolution and common safety net; and urgent issues related to ESM direct recapitalization.

### Why a banking union? — core logic and mechanisms
- Fundamental mismatch:
  - Finance is highly cross-border within the euro area but stability architecture (supervision, resolution, safety nets) remains largely national, producing bank-sovereign-real economy links and skewed national incentives.
- Mechanisms by which a banking union helps:
  - Single Supervisory Mechanism (SSM):
    - Facilitates systemic supervision across countries, enforces regulations consistently, reduces national distortions, mitigates cross-border fragmentation, and helps identify/prevent excessive risk concentrations.
    - Discretionary supervisory powers are essential to control undue risk-taking and ensure adequate capitalization.
  - Single resolution mechanism and safety nets:
    - Timely intervention and a single resolution authority with strong powers to close or restructure banks, intervening well ahead of insolvency.
    - Common safety net (deposit insurance and lender-of-last-resort) enhances capacity to cope with shocks and internalizes externalities, decoupling banks’ prospects from weak sovereigns and limiting taxpayer burden (including via "bailing in" creditors).
- Limits:
  - A banking union is not a panacea; it may not have fully prevented the sovereign debt crisis but would likely have weakened sovereign-bank-growth spirals, sustained depositor confidence, and attenuated liquidity/funding freezes.
  - High supervisory quality and effective enforcement are prerequisites.

### Design essentials and sequencing — key recommendations
- Core elements that must progress together:
  - SSM: ultimately supervise all banks, with clarity on duties, powers, accountability, and adequate resources.
  - Single resolution authority: clear ex ante burden-sharing, strong powers to close/restructure banks, obligation to intervene before insolvency.
  - Common resolution/insurance fund: sized to resolve some small to medium bank failures, risk-based, raised over time from the financial sector, combined with access to common backstops for systemic situations.
- Credible backstops and least-cost resolution:
  - Resolution and deposit insurance funds are intended for individual failures; systemic crises require fiscal and monetary backstops.
  - A credible joint backstop with governance safeguards can substantially weaken bank-sovereign links and prevent inefficient national interventions.
  - Resources should be recouped over the medium term and could be raised ex post from the financial sector.
- Transition sequencing and ESM recapitalization:
  - Agreeing at the outset on elements, modalities, and resources is crucial to avoid piecemeal outcomes that worsen the starting position.
  - To delink weak sovereigns from residual banking sector risks, direct recapitalization by the ESM of frail domestically systemic banks should be undertaken as soon as possible, conditioned on an effective SSM.
  - Unviable, non-systemic banks should be wound down at least cost; frail domestically systemic banks should be recapitalized by shareholders, creditors, the sovereign, and the ESM.

### Costs, credibility, and distributional considerations — exact figures and examples
- Costs of delay:
  - Differences over cost-sharing could delay progress; delaying resolution is likely to be far costlier.
  - Some member states remain exposed to potentially large costs, including claims accumulated via Eurosystem exposures.
- Resolution funds and funding design:
  - In steady state, pre-funded resolution and deposit insurance schemes could be fairly small (meant for individual bank failures); funds should be risk-based and raised over time from the financial sector.
- Backstops and fiscal costs – empirical references:
  - Laeven and Valencia (2012) estimate the gross fiscal cost of a median-sized systemic crisis at 7 percent of GDP.
  - For the crisis discussed, gross costs to date have ranged from about 4 percent of GDP in Spain to about 40 percent of GDP for Ireland.
- Fund sizing examples:
  - EC proposal: national resolution funds built over ten years and prefunded to a target ratio of 1 percent of total liabilities excluding own funds.
  - EC proposed harmonized deposit insurance target fund size of 1.5 percent of eligible deposits.
  - Typical target size of resolution and deposit insurance funds could range from about 1–2 percent of total liabilities (excluding equity) in large systems to 4–5 percent in smaller systems, aiming to cover 2–3 mid-sized banks and 4–6 small banks.
- Distributional balance in steady state:
  - Over the steady state, costs and benefits across member states would be symmetric relative to the size of their banking systems; all would benefit from a better-functioning financial system and available insurance for unforeseen problems.

### Institutional design highlights and operational thresholds
- Scope and thresholds for ECB direct supervision:
  - The ECB would directly supervise banks accounting for about 80 percent of euro-area banking assets, including banks with over €30 billion in assets or 20 percent of national GDP, or if otherwise deemed systemic.
  - At least the three largest banks in each member state would be directly supervised; the ECB retains the power to bring any bank under its supervision.
- Delegation and operational model:
  - "Hub and Spokes" delegation: over 6000 banks in the euro area; the 150 largest banks cover some 80 percent of banking system assets, so delegation should depend on the ECB’s supervisory classification and other factors (local knowledge, systemic dimension).

### Resolution authority — powers, burden sharing, and fund mechanics
- Resolution authority powers and tools:
  - Develop resolution and recovery plans, intervene before insolvency, use early intervention measures, restructure assets/liabilities, apply a "bail-in tool" to subordinated and senior unsecured creditors, transfer assets/liabilities ("purchase and assumption"), set up asset management vehicles, override shareholder rights (subject to them being no worse off), establish bridge banks and close banks.
- Burden sharing and creditor hierarchy:
  - Resolution authority should be able to haircut or extinguish unsecured liabilities, starting with equity and potentially extending to senior unsecured debt, with insured depositors given clear priority among unsecured bank liabilities; depositor preference provisions should be included in EU legislation.
- Fund design and use:
  - Resolution and deposit insurance fund built over time through industry levies and prefunded through ex ante premiums; premiums should be risk based.
  - Use of funds complemented by recouping net losses through ex post levies if needed.
  - In systemic stress, common backstops, including temporary funding support from the ECB with safeguards, would ensure adequate liquidity.
- Mixed model and LOLR considerations:
  - Mixed model: common resolution fund administered supranationally while deposit insurance schemes remain national and harmonized—disadvantages include less efficient risk pooling and complexity in cross-border failures.
  - Centralizing all LOLR functions at the ECB in steady state would eliminate bank-sovereign linkages present in the current ELA scheme but would require changes to ECB collateral policy.
  - Until full ECB oversight coverage, ELA sourced through both ECB and national central banks, with adjustments to national ELA limits.

### Sequencing, ESM recapitalization, and operational considerations
- Normal-time sequencing:
  - Gradual harmonization of national regulation, supervision, resolution, and safety nets; development of common institutions; culminate in a full banking union with SSM, single resolution authority, common funds, and backstops.
  - Historical precedent: a decade between the European Council decision in 1989 and the launch of the euro in 1999.
- Crisis-time sequencing and ESM role:
  - ESM direct recapitalization, conditional on an effective SSM, can remove residual risk from sovereign balance sheets and improve bank funding conditions by providing a deep-pocket owner.
  - Council agreed (December 13–14, 2012) that, at the request of the ESM, the ECB may start directly supervising a bank as a precondition for direct recapitalization once the SSM regulation takes effect (i.e., even before March 2014).
  - The Council called for agreement on an operational framework for direct recapitalization, including the definition of legacy assets, by June 2013.
- Principles for ESM recapitalization:
  - ESM should act as a balanced, patient investor; shareholders and creditors should bear expected losses first, then the sovereign, with remaining shortfall covered by the ESM.
  - No first-loss guarantees from the sovereign to the ESM; safeguards against domestic policies that harm bank viability.
  - Exit strategies and incentives for early private investor entry tied to EU-approved restructuring plans.
  - Adequate ESM capital is necessary to limit rating implications and enable its role as backstop.
- Legacy assets:
  - Losses on impaired legacy assets should be recognized through upfront provisioning and proper valuation; not recommended to segregate all impaired assets prior to ESM recapitalization and place them into taxpayer-backed recovery vehicles.

### Transition risks, governance, and the “outs” (non-euro members)
- Transition risks:
  - Incomplete reforms: stopping prematurely at SSM without common backstops could undermine effectiveness; agreement on burden sharing and ESM recapitalization must not be delayed.
  - Supervisory slippages: mobilizing resources and building capacity can produce supervisory drift; clarity on responsibilities and accountability is essential.
  - Governance conflicts: potential conflicts between ECB monetary policy and supervisory responsibilities; strengthened governance and accountability are advisable.
  - Evolving risks: consolidation, new entrants, and strengthened interconnections can increase the number of banks too systemic to fail at the union level; moral hazard may persist.
- Dealing with the “outs”:
  - Proceed first with a euro-area banking union with an option to "opt in" for non-euro-area EU members and governance safeguards for those who stay out.
  - Strengthening the EBA and ESRB roles to protect the interests of non-euro members and coordinate macroprudential oversight with the ECB.
  - Opt-in incentives: improved supervisory quality, reduced compliance costs for cross-border banks, limited regulatory arbitrage, and access to backstops subject to commensurate contributions.
  - Drawbacks for opt-ins: multiple central banks interaction, lender-of-last-resort implications, representation in SSM decisions, and loss of sovereignty.

### Case examples and empirical lessons
- Fortis (September 28, 2008):
  - Multinational rescue effort by Belgium, Luxembourg, and the Netherlands fell apart amid liquidity pressures; breakup along national lines was likely more costly than a joint solution.
- Dexia (failed in 2011):
  - Lost wholesale funding and faced increased collateral demands; breakup segmented along national interests.
  - Remaining troubled assets included a €95 billion bond portfolio; funding guarantees of up to €85 billion provided severally (not jointly) by Belgium, France and Luxembourg; recapitalization of €5.5 billion.
  - At end 2012, the EC approved the resolution plan for Dexia group.

### Policy imperatives and concluding recommendations
- A banking union is necessary for the euro area to address structural flaws in the monetary union’s financial stability architecture.
- All elements of supervision, resolution, and safety nets must progress together; missing elements would produce an incoherent or inferior architecture.
- Early, credible action—including agreement on burden sharing and common backstops, swift establishment of an effective SSM, and timely ESM recapitalization where appropriate—can break sovereign-bank feedback loops, restore monetary transmission, and reverse fragmentation.
- Wrong sequencing or piecemeal approaches risk worsening outcomes and increasing costs reflected in massive payments imbalances and rising Target 2 balances.

*Source: A BANKING UNION FOR THE EURO AREA — Executive Summary and Sections I–II; Boxes 1–3; paragraphs 21, 37, and 47–58 (IMF staff summary of _sdn1301)._*

### EXECUTIVE SUMMARY______________________________________________________________________________4

### EXECUTIVE SUMMARY

### Context and immediate problem
- Crisis dynamics:
  - Large capital flows within the euro area fueled sovereign and private sector imbalances that subsequently reversed, producing very sharp economic contractions and financial market fragmentation.
  - Borrowing costs of sovereigns and national private sectors have diverged widely and persistently; cuts in monetary policy rates have had limited or no effects in several economies; adverse sovereign-bank-real economy dynamics have been prevalent.
  - The monetary union is described as "malfunctioning."
- Policy measures already taken:
  - Adjustment programs, regional firewalls (European Financial Stability Facility (EFSF) and European Stability Mechanism (ESM)), enhancements to fiscal/economic governance (the "Six Pack" and the Treaty on Stability, Coordination, and Governance), ECB liquidity provision, government bond purchases, Outright Monetary Transactions, and recycling of capital flight via "Target 2" payments balances.
- Banking union role:
  - As part of crisis management: reduce fragmentation, enable direct bank recapitalization by the ESM (preconditioned on creation of an effective single supervisory mechanism (SSM)), and support recovery of bank balance sheets.
  - In steady state: a uniformly high standard of enforcement and oversight, removal of national distortions, and mitigation of concentrated risk buildup that compromises systemic stability.
- Recent milestones and timelines:
  - European Commission presented an SSM plan on September 12, 2012.
  - European Council agreed on December 13–14, 2012, that the SSM would come into operation in March 2014 or one year after the SSM legislation enters into force, whichever is later.
  - Council called for adoption of CRR/CRDIV as "of the utmost priority" and for adoption of the draft Directive for bank recovery and resolution and for harmonization of deposit guarantee schemes (DGS) by June 2013.
  - European Commission will propose a single resolution mechanism in 2013, with the objective of agreement by the summer of 2014.
- Scope of the paper:
  - This paper discusses benefits and costs (Section II), steady state design (Section III), transition issues (Section IV), and broader EU issues (Section V). Three background technical notes cover: single supervisory framework; single resolution and common safety net; and urgent issues related to ESM direct recapitalization.

### How would a banking union help? — core logic and mechanisms
- Fundamental mismatch:
  - Finance is highly cross-border within the euro area but stability architecture remains largely national (supervision, resolution, safety nets), producing bank-sovereign-real economy links and skewed national incentives.
- Bank-sovereign-real economy links and consequences:
  - National inability to control local interest rate conditions strengthens the link between a country’s banking/real sectors and public finances.
  - In good times banks may overwhelm national supervisory capacity; in bad times they may overwhelm national fiscal resources.
  - Weak sovereign finances make domestic backstops less credible, increasing bank funding costs and imparting procyclicality, impairing monetary policy transmission, and amplifying fragmentation and volatility.
- Skewed incentives of national authorities:
  - National authorities may favor domestic banks and economies irrespective of cross-border spillovers, delaying resolution and exacerbating costs.
- The logic of a union:
  - Single regulatory and supervisory framework (SSM):
    - Facilitates systemic supervision across all countries, enforces regulations consistently, reduces national distortions, mitigates cross-border fragmentation, and helps identify/prevent excessive risk concentrations.
    - Supervision complements market discipline; discretionary supervisory powers are essential to control undue risk-taking and ensure adequate capitalization.
  - Single resolution mechanism and safety nets:
    - Timely intervention to address weak banks and prevent contagion.
    - A single resolution authority with strong powers to close or restructure banks is needed and should be required to intervene well ahead of insolvency.
    - Common safety net comprising deposit insurance and lender-of-last-resort enhances capacity to cope with shocks that may overwhelm individual economies.
    - Common resolution and safety nets internalize externalities, decouple banks’ prospects from weak sovereigns, protect sovereigns from banking-sector weaknesses, limit taxpayer burden (including via "bailing in" creditors), and reduce incentives for inefficient national resolutions.
- Limits and requirements:
  - A banking union would not be a panacea; it may not have fully prevented the sovereign debt crisis, but would likely have weakened sovereign-bank-growth spirals, sustained depositor confidence, and attenuated liquidity/funding freezes.
  - High supervisory quality is essential; mere reorganization without effective enforcement and standards would not solve systemic risk or too-big-to-fail problems.

### Design essentials and sequencing (key recommendations and requirements)
- All elements must progress together:
  - Single Supervisory Mechanism (SSM): ultimately supervise all banks, with clarity on duties, powers, accountability, and adequate resources.
  - Single resolution authority: clear ex ante burden-sharing mechanisms, strong powers to close/restructure banks, and obligation to intervene well before insolvency.
  - Common resolution/insurance fund: sized to resolve some small to medium bank failures, risk-based, raised over time from the financial sector, and combined with access to common backstops for systemic situations.
- Credible backstops and least-cost resolution:
  - Resolution and deposit insurance funds are intended for individual failures; in systemic crises they would be inadequate, so fiscal and monetary backstops are required.
  - A credible joint backstop with governance safeguards can substantially weaken bank-sovereign links and prevent inefficient national interventions.
  - Resources should be recouped over the medium term and could be raised ex post from the financial sector.
- Transition sequencing:
  - Agreeing at the outset on the elements, modalities, and resources for a banking union is crucial to avoid piecemeal outcomes that worsen the starting position.
  - The December 2012 Council agreement on an ECB-centered SSM is an important step but raises significant challenges.
  - To delink weak sovereigns from residual banking sector risks, direct recapitalization by the ESM of frail domestically systemic banks should be undertaken as soon as possible, conditioned on an effective SSM.
  - Failing non-systemic banks should be wound down at least cost; frail domestically systemic banks should be recapitalized by shareholders, creditors, the sovereign, and the ESM.

### Costs, credibility, and distributional considerations
- Costs of delay:
  - Differences over cost-sharing for resolution and deposit insurance and legacy crisis problems could delay progress, but delaying resolution is likely to be far costlier for everyone.
  - Some member states remain exposed to potentially large costs, including claims accumulated via Eurosystem exposures.
- Resolution funds and funding design:
  - In steady state, pre-funded resolution and deposit insurance schemes could be fairly small (meant for individual bank failures); funds should be risk-based and raised over time from the financial sector.
- Backstops and fiscal costs:
  - In systemic crises, common public resources will be required to restore confidence (fiscal/monetary backstops).
  - Distinguish gross from net fiscal costs: net costs are usually much smaller as asset recoveries reduce net fiscal burden.
  - Laeven and Valencia (2012) estimate the gross fiscal cost of a median-sized systemic crisis at 7 percent of GDP.
  - For the crisis discussed, gross costs to date have ranged from about 4 percent of GDP in Spain to about 40 percent of GDP for Ireland.
- Credibility versus actual use:
  - Existence of common backstops does not imply they will be tapped; credibility itself can deter runs and capital flight.
  - When solvency issues arise, disbursement of resources will be necessary.
- Distributional balance in steady state:
  - Over the steady state, costs and benefits across member states would be symmetric relative to the size of their banking systems; all would benefit from a better-functioning financial system and available insurance for unforeseen problems.

### Strategic considerations and broader EU implications
- Necessary for the euro area:
  - A banking union is deemed necessary for the euro area to address structural flaws in the monetary union’s financial stability architecture.
- Accommodation of non-euro EU members:
  - Addressing concerns of non-euro area EU countries would be helpful for consistency with the EU single market and broader coherence.
- Implementation risks:
  - Sovereign bailouts or failure of a systemic institution early in the new supervisory regime would raise costs and damage the credibility of the new regime.
  - Agreement is needed on burden sharing for future losses; raising resources from the financial sector ex post can help manage transitional costs.

*Source: A BANKING UNION FOR THE EURO AREA — Executive Summary and Sections I–II (as provided).*

### Box 1. European Union: Existing Framework for Financial Stability

### Box 1. European Union: Existing Framework for Financial Stability

### Regulation and supervision
- Regulatory framework
  - Most financial rules in Europe originate from EU Directives and Regulations. A minimum standard has been set in harmonized legislation.
  - In May 2012, the European Council approved the ―Danish compromise‖ of a legislative package—the Capital Requirements Regulation (CRR) and Capital Requirement Directive (CRD IV)—that is currently under consideration by the European Parliament. This package aims to create harmonized prudential rules that would apply to all banks in the EU (it should be made compliant with Basel III).
  - National options and discretion would be the exception, although flexibility is envisaged for financial stability risks that differ across jurisdictions and institutions.
  - National authorities may impose ―systemic risk buffers,‖ without the EC’s pre-approval up to a limit, and with pre-approval above the limit. They may temporarily impose stricter requirements, e.g., in relation to risk weights for certain sectors, large exposure limits, and liquidity requirements. They also retain the flexibility to impose stricter requirements on individual institutions through Pillar 2 reviews.
- National supervision
  - Banking supervision in the EU is the prerogative of national authorities. While EU directives have set minimum internationally-agreed standards, supervisory handbooks and approaches vary across member states.
  - The CRR/CRD IV aims to strengthen elements of supervision (e.g., supervisory planning, on-site inspections, and more robust and intrusive supervisory assessments) and harmonize sanctions.
- Cross-border cooperation
  - Given the high degree of financial integration in the EU, home-host cooperation is essential for effective supervision.
  - Since 2010, there has been guidance on the supervision of cross-border banks, and supervisory colleges provide a forum for discussions, but it is not clear that these are altogether effective.
  - The recent draft EU Directive on bank resolution and recovery clarifies (non-binding) home-host relations and responsibilities in colleges, in particular in relation to the provision of intra-group liquidity provision.

### Resolution
- National regimes
  - Many EU countries have relied on general corporate insolvency proceedings to deal with bank failures, an approach that has resulted in complex and lengthy wind ups or more commonly nationalization, with significant costs for the economy.
  - While some national frameworks have recently been strengthened through special resolution powers to facilitate the quick resolution of failing banks, they remain largely untested and may not, in all cases, be fully in line with international best practice (e.g., the Financial Stability Board Key Attributes).
- Harmonization
  - The EC’s draft Directive on bank recovery and resolution seeks to ensure that national authorities have strong preventative powers, including in relation to recovery planning, early intervention powers (e.g., power to impose capital raising and conservation measures, restrictions on activities, and implementation of recovery plans) and resolution tools (e.g., the possibility to set up bridge banks, perform asset separations, override shareholders rights, replace management, divest non-essential businesses, or write down or ―bail in‖ debt).
  - Member states are also required to set up resolution funds, built over ten years and prefunded to a target ratio of 1 percent of total liabilities excluding own funds.
  - The draft Directive proposes ex post levies, access to a credit line from the central bank, and borrowing arrangements among funds across countries, subject to safeguards.
- Cross-border resolution
  - The draft Directive offers principles for early intervention and resolution of cross-border banks, such as liquidity provision within groups and the creation of resolution colleges to develop non-binding, crisis-planning mechanisms.
  - The absence of binding ex ante burden-sharing agreements leaves unresolved the issue of coordination. It is not clear that least-cost resolution would be achieved quickly and effectively.
  - Implementation of the Directive would set the stage for a more integrated EU resolution framework.

### Safety nets
- Lender of last resort (LOLR)
  - Banks can place deposits and refinance eligible assets with the Eurosystem and, if collateral constraints bind, resort to emergency liquidity assistance (ELA) from their national central banks.
  - While the ECB’s Governing Council has authority to ensure that LOLR activities by national central banks do not interfere with common monetary policy, losses arising on ELA remain the responsibility of the national central banks, which exacerbate sovereign-bank linkages.
- Deposit insurance
  - Existing schemes are national, with varying coverage limits, contributions, and fund sizes. Most schemes are underfunded.
  - The EU Directive on Deposit Guarantee Schemes has set minimum standards on coverage (€100,000 per depositor per bank) and the pay-out period.
  - The European Commission (EC) has proposed harmonizing national schemes (e.g., introduce common standards on financing and set a target fund size of 1.5 percent of eligible deposits) and clarifying responsibilities (e.g., improve insurance payments for cross-border banks), with the possibility of borrowing arrangements across national schemes and with adequate safeguards.

### The European System of Financial Supervisors (ESFS)
- ESFS architecture
  - Following the 2009 de Larosiere Report recommendations, elements of an EU supervisory structure were established in 2011.
  - Regulation remains the prerogative of the EC; technical standards on sectoral microprudential regulation are tasked to the European Supervisory Authorities—the European Banking Authority (EBA), the European Securities and Markets Authority, and the European Insurance and Occupational Pensions Authority—and macroprudential oversight to the European Systemic Risk Board (ESRB).
  - As EU agencies, these new agencies have limited powers (including because of fiscal safeguards) and resources, with ultimate decisions remaining at the national level.
- EBA
  - The EBA is a cooperative body for EU bank supervisors.
  - It is tasked with issuing technical standards in regulatory and supervisory areas (subject to fiscal safeguards).
  - It can organize and conduct peer reviews of competent authorities, including issuing recommendations and identifying best practices, to strengthen consistency in supervisory outcomes, promote supervisory convergence, address breaches of EU law, limit scope for regulatory arbitrage, foster a level playing field, and support consumer protection.
  - It coordinates and ensures consistency of EU-wide stress tests.
- ESRB
  - The ESRB’s role includes establishing macroprudential frameworks and ensuring effective coordination and internalization of cross-border spillovers.
  - Its main instrument is the issuance of non-binding risk warnings and recommendations through a ‖comply or explain‖ mechanism.

### What should the banking union look like? (summary of key considerations)
- Package-level considerations
  - A single supervisory mechanism (SSM) without a common resolution and safety net framework will do little to break the vicious circle between banks and sovereigns and stabilize the euro area.
  - Lack of a credible resolution framework would hamper the effectiveness of the SSM, and impede timely decision making by leaving national authorities to deal with the fiscal consequences of others’ supervisory decisions.
  - Bank recapitalization as well as resolution and deposit insurance mechanisms would lack credibility without the assurance of fiscal backstops and burden-sharing arrangements.
  - Conversely, common safety nets and backstops without effective supervision and resolution would break sovereign-bank links, but risk distorting incentives, reinforcing tendencies for regulatory forbearance, and shifting losses to the euro-area level. Effective control must accompany, or precede, risk or burden sharing.
- Country coverage
  - A banking union is necessary for the euro area, given the financial fragmentation, stresses, and deposit flight from one part of the currency union to another.
  - An EU banking union raises more complex issues, including interaction of multiple central banks and potentially different access to backstops or safety nets (e.g., the ESM that is currently available only to euro area members).
  - It is prudent to proceed first with a euro-area banking union, with an option to ―opt in‖ for non-euro-area EU members and with adequate governance safeguards for those who wish to stay out.
- Institutional coverage
  - Debate over whether all banks should be covered or whether to take a risk-focused approach on systemic banks and those that urgently need or may potentially require recapitalization.
  - The ultimate goal should be to supervise all banks, not just systemic or vulnerable ones, to allow for complete and evenhanded treatment and limit the scope for regulatory arbitrage or capture.
  - A phasing in of coverage, a risk-based use of scarce supervisory resources, and an appropriate level of decentralization would need to be considered, with greater delegation initially to national authorities and subsequent adjustment as capacity at the center is built up.
- Steady state and preconditions
  - Preconditions for sound banking include: (i) the implementation of coherent and sustainable macroeconomic policies; (ii) a clear framework for financial stability policy; (iii) an effective crisis management and resolution framework to deal with bank failures and minimize disruptions; (iv) an adequate safety net to deal with confidence crisis while minimizing distortions; (v) a well-developed public infrastructure; and (vi) effective market discipline.
  - Prerequisites to establish a sound basis for the SSM include: (i) operational independence of the SSM; (ii) clear objectives and mandates; (iii) legal protection of supervisors; (iv) transparent processes, sound governance and adequate resources; and (v) accountability. The EC proposal and EU Council agreement by and large meet these prerequisites, though clarity is required on resources and aspects of governance and legal robustness.
- Responsibilities, powers, and delegation
  - Supervisors at the national and supranational levels must have clear responsibilities and the powers necessary to perform their tasks.
  - The ECB should have the ability to conduct joint inspections and peer reviews and establish cross-country teams of supervisors with an ECB-appointed head.
  - ―Hub and Spokes‖ delegation: with over 6000 banks in the euro area, delegation is necessary. The 150 largest banks cover some 80 percent of banking system assets, so the degree of delegation should depend on the ECB’s supervisory classification of risks for each bank and factors such as the importance of local knowledge, systemic dimension, and discretion required in decision making.

### Box 2. The European Commission Proposal and EU Council Agreement (highlights)
- EU agreement timing and scope
  - The September 12, 2012, EC proposal and December 13-14, 2012, EU Council agreement covered the design of an SSM, the passage of three draft EU legislations, and the role of the EBA.
  - According to the agreement, the ECB would start carrying out supervisory tasks in March 2014 or one year after the SSM legislation takes effect, whichever is later.
  - Banks receiving or requesting public financial assistance would be targeted first; at the ESM’s request and as a precondition for direct recapitalization, the ECB could begin directly supervising these banks, regardless of the starting date of the SSM.
  - The Council called for adoption of the CRR/CRDIV as of the utmost priority, and for adoption by June 2013 of draft EU legislations harmonizing and strengthening national resolution regimes and deposit guarantee schemes.
  - The powers of the EBA were confirmed as the regulatory and supervisory standard-setter and the mediator of cross-border supervision and resolution issues arising in the EU.
- Supervision design
  - The agreement specified a clear mandate for bank safety and soundness to the ECB, and its accountability to the European Parliament and the Eurogroup.
  - The ECB would directly supervise banks accounting for about 80 percent of euro-area banking assets, including banks with over €30 billion in assets or 20 percent of national GDP, or if otherwise deemed systemic (e.g., given cross-border reach).
  - At least the three largest banks in each member state would be directly supervised, with the ECB retaining the power to bring any bank under its supervision if deemed necessary.
  - At the ECB, a supervisory board and a steering committee are being created to prepare and implement decisions and give voice to non euro area members that opt in (as the Governing Council remains ultimately responsible).
- Operational details and roadmap
  - The agreement conferred broad investigatory and supervisory powers to the ECB, responsible for the effective and consistent functioning of the SSM (although national authorities are also responsible for the banks remaining under their direct supervision).
  - Operational arrangements need to be specified to make incentives compatible between national authorities and the ECB, ensure an adequate division of labor, and provide for appropriate information sharing within the SSM.
  - The ECB is to adopt a detailed framework for the practical modalities of supervisory cooperation within the SSM by mid-2013.
  - The Council agreement provided both national authorities and the ECB with powers to make use of macroprudential instruments specified in the relevant EU Directives, although accountability must be clarified.
- Resolution and safety nets roadmap
  - A single resolution mechanism is an indispensible supplement of effective supervision, ideally centered on a single resolution authority, deposit insurance, and common backstops.
  - The Council recognized the importance of a single resolution mechanism with adequate powers and tools. This mechanism is to be based on financial sector contributions and backstop arrangements that recoup taxpayer support over the medium term, and the EC will make a proposal in 2013.
  - Funds raised over time from financial institutions could cover individual small to medium-sized bank failures. Common backstops are essential to handle systemic failures.
  - A time-bound roadmap to common safety nets—needed for depositor confidence and to break sovereign-bank links—would limit the risks of an incomplete banking union.

*Source: IMF staff summary of Box 1, "European Union: Existing Framework for Financial Stability."*

### 21.      Macroprudential oversight. To facilitate identification and action on systemic risks,

### _sdn1301 - 21.      Macroprudential oversight. To facilitate identification and action on systemic risks,

### Macroprudential oversight
- Some shift in macroprudential mandates and tools should be considered, away from member states and toward the ECB.
- The ECB should be given binding powers to be able to use macroprudential instruments if it deems necessary.
- The framework should:
  - Involve national authorities and be sufficiently flexible to tailor solutions to local conditions.
  - Allow national authorities to make use of macroprudential tools within the parameters and guidelines set by the ECB.
  - Include mechanisms to resolve conflicts of interest between national authorities and the ECB.
  - Ensure the ECB coordinates with the ESRB.

### Single resolution mechanism — advantages and best practices
- Advantages of a single authority:
  - Can facilitate timely resolution, including cross-border banks.
  - Provides a mechanism to internalize home-host concerns and reach agreement on resolution and burden sharing.
  - Helps avoid protracted and costly resolutions (examples cited: Fortis and Dexia).
  - Aligns incentives for least cost resolution and avoids mal-incentives to shift residual losses from national taxpayers to those in the euro area.
  - Pooling resolution capacity achieves economies of scale, avoids incoherence and duplication, and accumulates expertise for recovery and resolution plans, particularly for systemic institutions.
- Complexities:
  - If based on national legislation, significant resources may be needed to deal with different legal regimes.
  - A single resolution authority, the preferred approach, would be based on supranational legislation, but any treaty change would require time.
- FSB Key Attributes of Effective Resolution Regimes for Financial Institutions (emerging best practices):
  - Resolution authority should seek to resolve financial institutions without disrupting financial stability, minimize costs to taxpayers, protect insured depositors, and ensure shareholders and unsecured, uninsured creditors absorb losses.
  - Preconditions for effective bank resolution include:
    - (i) a well-established framework for financial stability;
    - (ii) an effective system of supervision, regulation and oversight of financial institutions;
    - (iii) effective safety nets and protection schemes;
    - (iv) a robust accounting, auditing and disclosure regime;
    - (v) a well-developed legal framework.
  - Prerequisites for a strong authority include:
    - (i) operational independence consistent with the statutory responsibilities;
    - (ii) transparent processes;
    - (iii) legal protection;
    - (iv) sound governance, rigorous evaluation and accountability mechanisms;
    - (v) adequate resources.

### Resolution authority: powers and burden sharing
- Mandate and powers:
  - Develop resolution and recovery plans well ahead of, and intervene before, insolvency using well-defined quantitative and qualitative triggers.
  - Strong powers for early intervention measures (e.g., require capital conservation measures or restrictions on activities).
  - Powers to restructure banks’ assets and liabilities, including:
    - Apply a "bail-in tool" to subordinated and senior unsecured creditors.
    - Transfer assets and liabilities—"purchase and assumption"—to a sound acquirer.
    - Separate bad assets by setting up an asset management vehicle.
    - Override shareholder rights (subject to them being no worse off).
    - Establish bridge banks and close banks.
- Burden sharing:
  - Clear ex ante burden-sharing mechanisms are necessary to realize least cost resolution; a systemic risk exception is also needed.
  - Hierarchy:
    - Resolution authority should be able to haircut or extinguish unsecured liabilities, starting with equity and potentially extending to senior unsecured debt, according to a clear creditor priority list.
    - Insured depositors should be given clear priority among unsecured bank liabilities; depositor preference provisions should be included in EU legislation.
  - Contributions:
    - Contributions from the industry—held in a fund—should be used first to finance resolution.
    - If private sector contributions and loss allocation are insufficient in a systemic crisis, a common backstop would need to be tapped.
    - Contributions could follow specific ex ante rules, e.g., based on the ECB or ESM capital keys.

### Fund, deposit insurance, and lender of last resort (LOLR)
- Fund:
  - The resolution and deposit insurance fund would build over time through levies on the industry and be pre-funded through ex ante premiums.
  - Premiums should be risk based to capture national specificities in risk parameters.
  - Use of funds could be complemented by arrangements to recoup net losses through ex post levies on the industry.
  - In the event a systemic institution is under stress, common backstops, including temporary funding support from the ECB, with safeguards, would ensure adequate liquidity.
  - The EU Draft Directive on bank recovery and resolution states that national resolution authorities will have the possibility to borrow from the central bank.
  - The resolution mechanism should specify clear exit strategies that maximize the value of participations acquired and prohibit national preference.
- Size of fund:
  - Typical target size of resolution and deposit insurance funds could range from about 1–2 percent of total liabilities (excluding equity) in large systems (as in the EC proposal, or as in the United States) to 4–5 percent in smaller systems, where the aim is to cover 2–3 mid-sized banks and 4–6 small banks.
  - The target size varies with the quality of the institutional environment and resolution regime, including the presence of prompt corrective actions and early structured intervention mechanisms.
- Mixed model:
  - Create a common resolution fund administered by the single resolution authority, while harmonizing deposit insurance schemes but allowing them to remain at the national level.
  - Under this model, national deposit insurance funds must be available to contribute to resolution, up to the amount available for payout.
  - Disadvantages include: less efficient risk pooling, complexities in cost allocation and implementation in cross-border failures, and duplication of costs and administrative resources.
- Lender of last resort:
  - Centralizing all LOLR functions at the ECB would in the steady state eliminate bank-sovereign linkages present in the current ELA scheme.
  - This would require changes to the ECB’s collateral policy.
  - Until all banks are brought under ECB supervisory oversight, ELA would be sourced through both the ECB (for banks under its purview) and national central banks (for banks that remain under national supervision), with adjustments to national ELA limits.

### Sequencing, recapitalization, and ESM involvement
- Sequencing in normal times:
  - Gradual sequencing: harmonize rules governing national regulation, supervision, resolution, and safety nets; develop new common institutions; culminate in a full banking union with an SSM, a single resolution authority, a common resolution and deposit insurance fund, and common backstops.
  - Historical precedent: a decade between the European Council decision in 1989 and the launch of the euro in 1999.
- Sequencing in crisis:
  - Repair of the financial sector, including bank recapitalization, is critical to break the bank-sovereign dynamic.
  - Raising resources domestically to recapitalize banks may be challenging; shared support raises questions about burden sharing and moral hazard.
- Recapitalization and ESM:
  - In June 2012, euro area leaders affirmed that, when an effective single supervisory mechanism is established, the ESM could, following a regular decision, have the possibility to recapitalize banks directly.
  - The Council agreed on December 13–14, 2012, that, at the request of the ESM, the ECB may start directly supervising a bank as a precondition for direct recapitalization, once the SSM regulation takes effect (i.e., even before March 2014).
  - The Council called for agreement on an operational framework for direct recapitalization, including the definition of legacy assets, by June 2013.
- ESM and crisis resolution objectives:
  - Core purpose of ESM recapitalization of domestically systemic banks undergoing restructuring is to remove residual risk from the balance sheet of a sovereign whose finances are already strained.
  - Unviable, non-systemic banks should be wound down at least cost; systemic banks should be resuscitated by shareholders, creditors, the sovereign, and the ESM as the deep-pocket investor.
  - ESM direct recapitalization would remove future tail risks from the sovereign balance sheet and improve bank funding conditions by providing an owner of unquestioned financial strength.
  - ESM involvement should be conditional upon a determination of systemic risk; a robust mechanism for systemic risk determination is critical.

### Case examples (from Box 3)
- Fortis:
  - Agreement on September 28, 2008, to save the Fortis group with taxpayer support from Belgium, Luxembourg, and the Netherlands fell apart as liquidity pressures mounted.
  - Belgian parent sold shares of the Dutch parts of Fortis to the Netherlands government; Belgium and Luxembourg sought a common solution and eventually sold the banking arm to BNP Paribas.
  - Breakup along national lines was likely more costly than a joint solution.
- Dexia:
  - Failed in 2011 after losing access to wholesale funding and facing increased collateral demands on interest rate derivatives.
  - Breakup segmented along national interests; Belgian operations purchased by the Belgian government; foreign subsidiaries put up for sale; parts of French operations purchased by two French public sector banks.
  - Remaining troubled assets included a €95 billion bond portfolio; funding guarantees of up to €85 billion provided severally but not jointly by Belgium, France and Luxembourg; recapitalization of €5.5 billion.
  - At end 2012, the EC approved the resolution plan for Dexia group.

*A BANKING UNION FOR THE EURO AREA, INTERNATIONAL MONETARY FUND.*

### 37.      Issues. Sequencing the key steps toward a banking union while taking crisis resolution

### 37.      Issues. Sequencing the key steps toward a banking union while taking crisis resolution

### A. Effective supervision
- Defining “effective.”
  - Basel Core Principles.
    - Full supervisory capacity would need to be set up, and the various prerequisites and preconditions met, including establishing an adequate safety net and crisis management and resolution frameworks.
    - The approach demands completeness, and could take years to achieve.
    - The present crisis resolution efforts should be viewed as stepping stones to the longer-term task of building a robust architecture for financial stability.
    - It is the internationally recognized standard for use in the new steady state.
  - Pragmatic approach.
    - The EU Council (December 2012) adopted a more modest near-term approach: as soon as the SSM regulation is adopted, the ECB could, at the request of the ESM, start to directly supervise a bank as a precondition to it receiving ESM direct recapitalization.
    - This approach enables repairing weak systemic banks while ensuring the ECB has the powers and tools needed to supervise these banks.
    - It is critical to: swiftly secure legislative agreement and adoption, establish a single rulebook, and begin preparation for supervision at the ECB and for ESM direct recapitalization (including finding common ground on remaining issues in the first half of 2013).

### B. Sequencing banking union
- First best sequencing.
  - An agreement on burden sharing and common backstops at the outset would both pave the way to a full banking union and facilitate current crisis management.
  - It would set the stage for a single resolution authority coordinating corrective actions with the SSM.
  - Absent centralized resolution, the SSM would need to coordinate with multiple national resolution authorities, risking conflicts over distribution of losses and incentives to shift costs of resolution, delaying action and jeopardizing least-cost resolution.
  - Sequencing the SSM alongside agreement on burden sharing and common backstops would ensure incentive compatibility; subsequently a common resolution fund and deposit guarantee scheme could provide risk-sharing.
- Timeline and key steps.
  - All elements—an SSM, single resolution with common backstops, and common safety nets—are necessary for a successful banking union; missing elements would result in an incoherent banking union or an architecture inferior to the current national-based one.
  - A well-defined timetable at the outset would remove uncertainty, bolster confidence in political willingness, and anchor execution. A possible approach:
    - Harmonized legislation.
      - Adoption of the single rule book—CRR/CRD IV, the recovery and resolution directive, and the deposit insurance directive—needs to proceed urgently.
      - Agreed drafts should be submitted to the EU Parliament as soon as possible, with approval during the first half of 2013 and adoption in national legislations in the course of 2013.
    - Implementing the SSM.
      - A phased rollout could seek to make the SSM "effective" for troubled systemic banks over the course of the year.
      - Emphasis on establishing a strong SSM in which the ECB has formal powers, decision-making processes, and capability to perform essential supervisory tasks in an intrusive delegated monitoring model.
      - The ECB must be able to request and receive all necessary information, conduct offsite diligence, field onsite inspections, and pursue further action on any bank in the euro area.
      - A well-functioning information and evaluation infrastructure must be established quickly so the ECB can serve as a central supervisor.
      - The ECB would need to put in place adequate resources and organizational capacity to commence selected supervisory tasks.
      - Based on information from national authorities on banks’ supervisory histories and risk profiles, the ECB could start offsite stocktaking to prioritize institutions needing deeper diagnostics based on risk.
      - Once essential capacity is in place, the ECB could start, say by mid 2013, actively supervising banks receiving state aid, with an appropriate degree of delegation to national authorities but with key decisions taken at the center.
      - Reaching agreement prior to this date on ESM direct recapitalization would allow direct recapitalization to occur soon thereafter.
    - Scope of supervision.
      - With the largest 150 banks accounting for about 80 percent of banking system assets in the euro area, supervision of most banks could remain the responsibility of national authorities, although the ECB should have the prerogative to step in wherever needed.
      - Initial focus could be on banks at the heart of the current crisis, such as the Spanish cajas.
      - Appropriate delegation to national authorities would be essential, with accountability and governance arrangements, but key decisions taken at the center.
      - Delegation provides flexibility during transition but caution is needed to not lock in an imperfect practice of delegation in the SSM.
      - Adequate early intervention powers for the ECB provide incentives for cooperation and are essential for SSM effectiveness.
    - Implementing single resolution and common safety nets.
      - The European Council should commit to a firm timeline for implementing a single resolution mechanism, including burden-sharing arrangements. The EC is to present a proposal in the course of this year.
      - When agreement on adequate resolution (and deposit insurance) funding and backstops are in place, the single resolution authority could begin operating.
      - Meanwhile, resolutions would be handled by national authorities under strengthened regimes (and, as needed, support from the sovereign with borrowing from the ESM).
- Resolution arrangements.
  - The ECB-centered SSM would have powers of early intervention and would work with national resolution authorities to resolve or restructure weak institutions until a single resolution authority with common backstops is established.
  - There may be merit to establishing a temporary body or an EU agency tasked with coordination of bank crisis management and resolution among national authorities and the ECB.
- Safety nets.
  - Steps toward common safety nets should be taken.
  - A reinsurance scheme could be created from national deposit guarantee schemes, funded at the euro area level through industry levies and contributions from member states.
  - It would pool risk and weaken sovereign-bank links.
  - Ex ante agreement on shares of national and supra-national funding in depositor payouts would limit moral hazard.
  - Over time, the fund would build administrative capacity and could be a step toward a permanent euro area scheme and resolution fund.
- Legal considerations (Box 5).
  - Legal basis of the banking union.
    - Under Article 127(6) of the Treaty, the ECB can take on specific supervisory tasks without treaty change, upon a unanimous decision of the European Council and after consultation with the European Parliament and the ECB.
    - The EU Council agreement vests in the ECB exclusive authority for a wide range of supervisory tasks.
    - The draft SSM regulation attempts to specify the ECB remit, but litigation risks may not be excluded, as any financial institution could bring a case before the European Court of Justice (―ECJ‖) on grounds of lack of competence.
    - In the medium term, providing an explicit legal underpinning for financial stability arrangements in the Treaty would further strengthen legal soundness and allow anchoring financial stability as a key objective and defining roles and powers of safety net players, including a fully fledged resolution authority with a common backstop.
  - Shared competences and responsibilities.
    - Under Article 127(6) and the regulation, supervision will remain a shared competence between the ECB and member states.
    - The ECB will be responsible for certain supervisory measures, while member states retain powers with respect to aspects not covered by the draft SSM Regulation (e.g., AML, consumer protection, and some macroprudential tools).
    - For tasks conferred to it, the ECB would take final decisions vis-à-vis "significant" banks, while national competent authorities (NCAs) will assist with preparation and implementation pursuant to ECB instructions.
    - For other banks, NCAs will formally take supervisory decisions but under ECB instructions.
    - The ECB will be responsible for effective and consistent functioning of the SSM, and both the ECB and NCAs will be subject to a duty of cooperation.
    - The overall division of tasks and responsibilities will need clarification to remove uncertainties about ultimate legal accountability for supervisory decisions.
  - ECB Governance.
    - The Governing Council is the ultimate decision-making body of the ECB, including for supervisory tasks conferred under Article 127(6).
    - Challenges include: the Supervisory Board can only prepare decisions that the Governing Council must formally take, so separation of monetary and supervisory responsibilities can be implemented only at an operational level.
    - Multiple governance layers and inability to delegate decisions to the Supervisory Board may create a burdensome process and legal risks aligning daily supervision with Treaty and SSM regulation requirements.
    - Non-euro area SSM participants cannot be represented on the Governing Council; alternative arrangements (e.g., supervisory board representation, mediation channels) would be required to have their voices heard.
  - EU banking laws.
    - Current approach based on directives implemented in national laws must be replaced by a directly applicable single rule book.
    - Substance weaknesses (e.g., weak fit and proper criteria, absence of restrictions on related party lending) must be remedied.
  - Legal actions at the national level.
    - It is unclear whether the EU Regulation conferring supervisory tasks also requires national legal changes, but national legal amendments seem inevitable to provide legal clarity for smooth SSM functioning.
    - Absent a single, directly applicable rule book, domestic legislative amendments may be necessary to improve national supervisory regimes.

### C. ESM direct recapitalization
- Purpose.
  - Mobilizing the ESM direct bank recapitalization tool in a forceful and timely manner is critical to developing a path out of the current crisis and would complement measures such as the ECB’s Outright Monetary Transactions.
  - Recapitalization of frail, domestically-systemic banks in the euro area, including some migration to the ESM of existing public support to such banks, can help break the vicious circle between banks and sovereigns, reduce financial fragmentation, repair monetary transmission, prepare for banking union and help complete the economic and monetary union.
  - Failing non-systemic banks should be resolved at least cost to national resolution funds and taxpayers.
  - Systemic banks benefiting from ESM support will need effective supervision and reform to return to full viability and private ownership, with state aid rules mandating formal restructuring plans.
  - In some cases, the sovereign itself may need an adjustment program to provide an enabling environment for asset price recovery.
- Approach and principles.
  - Objective: ensure frail, domestically systemic banks have adequate capital, access to funding at reasonable cost, and positive profits—a viable business model.
  - Asset valuations are critical, as are the roles of shareholders, creditors, and the domestic sovereign in bearing costs.
  - Central fiscal provision advantages.
    - In principle, central fiscal authority provision of all capital needed to ensure a systemic bank was adequately capitalized would break the vicious bank-sovereign circle, especially in small jurisdictions or where spillovers must be internalized.
    - Pooling risk provides ex ante protection to all.
  - Practical constraints.
    - The Treaty establishing the ESM provides for the possibility of losses, but such losses are not expected in its financial operations, including bank recapitalization.
    - As a bank investor, the ESM must be careful to take balanced risk positions and likely could not provide capital that a patient investor would not expect to recover over time.
    - Capital needed to bring a systemic bank out of insolvency would first need to be provided by shareholders and creditors, then by the national government, with any remaining shortfall covered by the ESM.
    - There are unlikely to be large, insolvent banks currently in most economies.
  - Balanced, patient-investor approach.
    - The ESM, as a patient, deep-pocket investor, should take a long-term perspective, recognizing that gross upfront crisis outlays tend to dwarf ultimate costs net of recoveries/capital gains and can generate positive financial returns.
  - Asset valuation.
    - Asset values should be neither too high (which would imply mutualization through the back door) nor too low (in which case private sector could buy the assets and official investment would have limited benefit).
    - Assets should be priced considering the positive effect of recapitalization on asset values, including direct effects (more favorable funding costs), recovery, and removal of tail-risk events.
  - Risk sharing.
    - The ESM provides assurance to creditors that potential future capital needs can be met; while it would not take on expected losses, it would shoulder the risk of unexpected losses going forward.
    - This aligns with efficient risk sharing, where the patient investor bears residual risk.
    - Conditional on the ESM standing ready to take material losses in a downside scenario, it would be unlikely to actually incur those losses because the investment would minimize the risk of the adverse scenario.
  - No first loss guarantees.
    - ESM investments should not benefit from loss protection provided by the sovereign to preserve separation of sovereign-bank links.
    - Safeguards for the ESM should exist (e.g., in sales contracts) against domestic policies that could directly harm recipient banks' viability or profitability (e.g., onerous taxes ex post or stiff resolution levies).
  - Exit strategy.
    - There should be incentives for an early ESM exit and private investor entry.
    - Timing would be built around EU-approved restructuring plans.
    - Mandatory sunset clauses should be avoided as they could affect negotiating power ahead of the deadline.
  - Adequate resources.
    - Direct equity injections could absorb significant amounts of ESM capital.
    - Ensuring the ESM has adequate capital is important to allay investor concerns about ESM credit quality, limit rating implications, and enable its role as a common backstop for bank recapitalization.
- Legacy assets.
  - Losses on impaired "legacy" assets should be recognized through upfront provisioning and proper (long-term/post-crisis) valuation.
  - It is not recommended that all impaired assets be segregated prior to ESM direct recapitalization and placed into recovery vehicles ultimately backed by the national taxpayer; that approach would greatly reduce the tool's effectiveness in addressing bank-sovereign links.
  - Bank health should be restored with shareholders, including the sovereign, bearing the expected loss of past excesses by being subjected to an independent valuation exercise consistent with the shared commitment to restore full viability after the restructuring period.

*Source: _sdn1301 - 37. Issues. Sequencing the key steps toward a banking union while taking crisis resolution (IMF PDF).*

### 47.      Further support. To further support balance sheet clean up, certain classes of legacy assets

### 47. Further support

### Asset management and AMC options
- Certain classes of legacy assets could be transferred to asset run-off vehicles such as asset management companies (AMCs) under ESM ownership.
- Expected losses would remain with the sovereign, given the terms of the foregoing recapitalization.
- Consideration could be given to allowing the ESM to set up and own AMCs to limit further contingent fiscal liabilities and harness efficiencies.
- Possible roles for the ECB in supporting AMC operations could be considered, although concerns regarding the prohibition on monetary financing may be raised.
- ECB funding, if possible under its statute, would help smooth over time the warehousing and disposal of hard-to-value and hard-to-sell assets.
- An alternative is for the ECB to support AMC operations indirectly by accepting ESM-guaranteed AMC bonds issued to banks in Eurosystem refinancing operations.

### Risks in transition — incomplete or stalled reforms
- Risk: The move toward a banking union must not stop prematurely with an SSM; coordination of resolution across national authorities without common backstops could undermine effectiveness.
- Critical design aspects must not be deferred; agreement on burden sharing and ESM direct recapitalization must not be delayed to avoid mounting crisis costs.
- Danger: Lack of common backstops could lead to a slower pace of restructuring or resolving problem banks.
- Policy paralysis or backsliding could derail confidence and the recovery.
- Mitigant: Progress under constraints may be better than no progress, provided essential elements of the banking union come together in time.

### Risks in transition — supervisory slippages
- Mobilizing necessary resources, building capacity, and creating incentive-compatible structures will inevitably involve iteration and could produce supervisory drift in the interim.
- Clarity is essential on the responsibilities and accountability of the various supervisory authorities.
- The ECB must move swiftly to put in place cross-country teams for supervision of the most systemic or fragile banks.
- The ECB will need capacity to interact frequently and effectively with national resolution authorities.

### Risks in transition — governance
- Conflicts of interest could arise between the ECB’s monetary policy function and its supervisory responsibilities (e.g., when monetary policy decisions impact bank solvency or when safeguarding financial stability may call for liquidity provision to insolvent banks).
- These risks are exacerbated by the lack of a robust resolution (and early intervention) regime and safety nets.
- Consideration could be given to strengthening governance of the decision-making process and accountability of supervision at the same level as central banking functions.
- The Council agreement on the SSM strengthened governance arrangements relative to the EC proposal.
- Draft decisions by the supervisory board are deemed adopted unless the Governing Council objects within 10 days in normal times and 2 days in stressful times.
- It will be important to balance the representation of national interests and public officials from the ECB in the governance structure of the SSM.

### Risks in transition — evolving risks
- A banking union could change the structure of finance: potential further consolidation of banks, new entrants, and strengthened interconnections across the banking union.
- More banks could become too systemic to fail at the union level; the banking union does not solve the too-big-to-fail problem.
- Moral hazard might persist; the SSM may help contain incentives to grow excessively (e.g., through capital surcharges for SIFIs).
- These developments raise new challenges for financial stability, requiring renewed vigilance and decisive action.
- Some recommendations of the EU High-Level Expert Group on structural bank reforms could prove useful.

### Dealing with the “outs” — spillovers and issues
- A well-functioning euro area banking union generates positive spillovers and enhances the functioning of the EU single market for financial services; non-euro area EU members have a legitimate interest in proper setup.
- A single euro area supervisory mechanism can solve coordination problems for supervision of cross-border banks.
- Issues for the “outs” include:
  - Protecting interests of the “outs” in SSM decisions (e.g., in the EBA and supervisory colleges where the SSM is represented by the ECB).
  - Representing interests of countries that wish to join the banking union but keep their own currency, since they would not have a voice in the ECB Governing Council.
  - Making the banking union attractive to join (for example, facilitating access to backstops and safety nets with commensurate contributions).

### Dealing with the “outs” — EU bodies and voice in the SSM
- Strengthening the EBA provides a way to protect the interests of the “outs” and coordinate action; non-euro area EU members should retain an adequate voice within the EBA.
- The Council agreement modified voting procedures within the EBA Board with double majority voting to balance the interests of the "outs."
- The EBA must be an effective and credible force in the single financial market, including limiting regulatory arbitrage.
- The ESRB’s role as the main macroprudential oversight body in the EU would need to be strengthened and should cooperate closely with the ECB once the ECB takes on greater macroprudential responsibilities.
- The Council agreement seeks to provide an opt-in for non-euro area EU countries through representation and procedures on the supervisory board.
- Draft decisions prepared by the supervisory board are deemed adopted unless the Governing Council objects within 10 days in normal times or 2 days in stressful ones.
- A mediation panel and a steering committee would be created to aid decision making and resolve disagreements, reinforcing cooperation between the ECB and national authorities.
- Importance: Ensure the complexity of the setup does not undermine effective and prompt supervisory decision making.

### Dealing with the “outs” — incentivizing opt-in
- Over time some EU countries may want to join the banking union even if they do not join the euro area.
- A strong banking union offering risk sharing (while avoiding mutualization of legacy issues) and ensuring least-cost bank resolution could be attractive.
- Potential benefits of supervision by the ECB: improved supervisory quality, reduced compliance costs for cross-border banks, limited scope for regulatory arbitrage, elimination of host-home coordination issues, and increased congruence between the market for financial services and the prudential framework.
- A single resolution authority and common safety nets, with backstops, would provide further risk-sharing benefits when in place.
- Drawbacks include interaction of multiple central banks (implications for lender of last resort and macroprudential policies), difficulties ensuring adequate participation of opt-ins in SSM decisions, loss of sovereignty, and less flexibility for country specificities.
- These costs are likely to be less for countries whose currencies are pegged to the euro, have high levels of foreign currency liabilities, or have a sizable presence of euro-area banks.
- If members adopt the euro at the same time as they join the banking union, the benefit would likely outweigh the cost.

### Conclusions and policy imperatives
- The crisis necessitates rethinking institutions to sustain the euro; extending discussion to common fiscal frameworks and institutions in the banking sector is important.
- Banking union is not a panacea but can be pivotal in breaking the vicious loop between sovereign and bank costs and by fixing the broken transmission mechanism from ECB policy rates to final borrowing and lending rates across the euro area.
- A common supervisor, resolution mechanism, and safety net would lay the foundation for long-term stability and reverse fragmentation into sub-zones.
- Critical design aspects must not be deferred; strong zone-wide bank supervision and safety net measures should be implemented quickly.
- The cost of dwindling confidence is accumulating in massive payments imbalances brought on by flight of deposits and capital across the euro area, reflected in the rapid rise in the ECB’s Target 2 balances.
- Early and credible action on banking union can reverse and minimize these potential costs.
- Reformers must be mindful of wrong sequencing and a piecemeal approach, which could worsen outcomes.

*Source: A BANKING UNION FOR THE EURO AREA, paragraphs 47–58, INTERNATIONAL MONETARY FUND.*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/sdn/2013/_sdn1301.pdf_