After the financial crisis of 2008, EU leaders decided that the European Central Bank needed supervisory powers over banks. Despite the initial success, not keeping the ECB’s functions separate could lead to a conflict of interests.
In a nutshell
- The ECB's bank supervision powers raise difficult questions
- At first, this supervision helped stabilize the industry
- Some worry that the bank could play politics with its power
Is bank supervision central to central banking? This question, debated more than 20 years ago, notably in the context of the creation of the European Central Bank (ECB), may appear surprising today. It is usually taken for granted that monitoring financial markets is one of the bank’s basic prerogatives.
That has not always been the case. When the ECB was established in 1998, bank supervisory powers were not part of its mission. European Union treaties had entrusted the bank with a limited task: define and implement monetary policy so as to maintain price stability and preserve the single currency’s purchasing power.
At the time, officials considered central bank independence as paramount for it to conduct of monetary policy. They believed a narrow mandate, anchored in a safe and stable institutional setting, was a corollary of such independence.
In 2008, when the bank crisis hit, this early picture evolved considerably. Undue risk-taking, pervasive misconduct and fraudulent practices had become commonplace in large parts of the banking system worldwide without anyone really paying attention until it was too late.
European Union leaders believed the ECB should have better knowledge of what was going on in banks.
Realizing how quickly problems in the financial sector can spread and how powerless national and supranational authorities were to address them, EU leaders believed the ECB’s role had to change. As lender of last resort, it should have had better knowledge of what was going on in banks, which had taken on the bad habit of concealing their true state of health behind smokescreens of business confidentiality.
After the arrival of President Mario Draghi at the helm of the ECB in November 2011, the institution stood out as a key actor in crisis management. It soon became apparent that its involvement should go beyond the crisis. The bank was ready to take on new responsibilities to support long-term financial stability.
The creation in 2014 of the Single Supervisory Mechanism (SSM), chaired and hosted by the ECB, fundamentally altered the bank’s original institutional design. EU legislation conferred specific tasks to the ECB in the supervision of credit and other financial institutions. Today, the SSM is a huge bureaucratic network that oversees the eurozone’s 115 most significant banks directly and all others indirectly. More than 900 supervisory staff at the ECB conduct bank surveillance, in close collaboration with 4,700 supervisors from national authorities all over the euro area.
Putting bank supervisory and monetary policy under the same roof in the ECB raised an important question that legislators did not address: should there be some kind of cooperation or, on the contrary, a strict separation between the two functions? In EU parlance that separation is called a “Chinese wall,” in reference to the Great Wall of China.
In practice, the Chinese wall seems to be the option preferred by the ECB. Nonetheless, there are inevitable interactions between the two areas, such as the SSM leaders’ nominations: the ECB president appoints both the chair and the vice chair of the SSM’s supervisory board. While the first enjoys a great degree of independence, the second has a more complicated position within the ECB, not least because, according to SSM regulations, the vice chair must be selected from the ECB’s six-person executive board, which implements monetary policy in accordance with the decisions made by the Governing Council.
It is fair to say that the SSM vice chair is the only person allowed to sit atop the ECB’s Chinese wall, with one leg in monetary policy and the other in bank supervision.
In its first years of existence, the SSM was piloted by the Franco-German tandem of Daniele Nouy (chair) and Sabine Lautenschlaeger (vice chair). Ms. Nouy, who brought to the job 40 years of experience in national bank supervision, built up the new organization from scratch.
When taking office in January 2014, she reportedly found herself alone on an empty floor of the ECB’s Frankfurt headquarters. A team of four was assigned to her for a start. By the end of the year, another 1,000 employees joined her in what she later described as a monumental challenge: making the eurozone’s banks safe and sound again. In February 2014, Ms. Lautenschlaeger became Ms. Nouy’s deputy.
Undeniably, the duo enhanced the ECB’s reputation for toughness. Conducting onsite inspections to find and expose flaws in bank behavior, cleaning up banks’ balance sheets, bringing down nonperforming loans (NPLs), speeding up insolvency and enforcement proceedings, strengthening bank corporate governance, facilitating bank consolidation – these were just a few of the team’s missions.
No mercy was shown to banks failing to comply with regulations and requirements.
No mercy was shown to banks failing to comply with regulations and capital requirements. “There will be deaths,” Ms. Nouy warned at the beginning of her mandate. Just as it has the authority to grant banking licenses, the SSM also has the authority to withdraw them. It also assesses banks’ acquisitions and disposal of “qualifying holdings” and, as such, influences market structures and business models.
The organization enjoys far-reaching investigative and sanctioning powers that the two iron ladies forcefully employed to sanitize a banking industry on the edge of disaster. Unsurprisingly, they met a lot of resistance from bankers, unnerved by the countless reporting obligations, stress-testing, and other costly compliance measures that were imposed on them and threatened their profitability.
In policy circles, however, the team’s achievements were widely acclaimed. When the chair and vice chair’s mandates ended (in December 2018 and February 2019, respectively), eurozone banks not only had much more capital than in 2014, it was also of higher quality. The ratio of NPLs in EU banks had come down by more than half. Bank liquidity had improved as well.
Against the general consensus on the SSM’s performance, Yves Mersch, the ECB’s most senior executive board member, repeatedly expressed his reservations. First, errors were made. For instance, in 2016 the SSM’s capital shortfall projections of Italian lender Monte dei Paschi di Siena, which suffered a deposit run, proved utterly wrong. In the end, the ECB’s failed rescue operation cost taxpayers a lot of money. “Europe should follow its own rules when it looks at the rescue of Italian banks,” Mr. Mersch argued.
Second, Mr. Mersch worries that any deviations from the ECB’s original price-stability mandate could be politically motivated, thus undermining the institution’s independence. The SSM should therefore face much greater scrutiny, he says.
Confusion over the assignment of responsibility and accountability threatens efficiency and legitimacy, Mr. Mersch warned at an ECB legal conference in 2017. For him, the SSM’s very legality is in question. He insisted that the ECB’s rising powers in bank supervision are hard to reconcile with the principles of democratic legitimacy. He further stressed possible conflicts of interest that can arise from the ECB’s role as guardian of monetary policy and its role as watchdog of the eurozone’s banking industry – crystallized precisely in the bridge function of vice chair of the supervisory board.
There is indeed something contradictory about the position. The two policy arms can end up acting against each other, because they pursue different (sometimes conflicting) goals. Monetary policy, on one hand, may seek to stimulate the economy by encouraging lending through low interest rates and other cheap-credit policies. Bank supervision, on the other, seeks to improve the safety of the banking sector. Imposing constraining rules on banks, however, hampers the latter’s profitability and lending capacity – and, ultimately, investment and growth. How can such conflicting objectives be reconciled?
Perfectly aware of the tensions arising from her dual function, Ms. Lautenschlaeger, during her mandate as vice chair, made clear that, for her, bank supervision was the priority. She was determined to remove the conditions that had led up to the 2008 financial debacle once and for all. Consequently, she was not a supporter of Mr. Draghi’s cheap-money policy, which Ms. Lautenschlaeger, along with many others, believes exacerbates risks and vulnerabilities in the banking sector, fuels asset price bubbles and zombie firms, and overheats economies. With every new round of quantitative easing that Mr. Draghi announced, Ms. Lautenschlaeger made her voice heard. She quit the ECB’s executive board in September 2019 over a final disagreement with her boss, who had decided to reopen the ECB’s net asset purchase program once again.
Mr. Draghi had difficulties replacing Ms. Lautenschlaeger on the supervisory board, as several executive board members’ mandates were ending in 2019. After a lengthy interim period, where he himself took over Ms. Lautenschlaeger’s vacant post, he finally turned to Yves Mersch. In his appointment hearing of September 2019, the SSM-skeptic promised to act within the boundaries of the ECB’s mandate and to “respect the law at all times.” He further pledged to ensure that under his guidance the separation principle between monetary policy and bank supervision would be fully respected.
The new team adopted a strategy of noncommunication that stands in stark contrast with their predecessors’ practices.
The newly appointed vice chair of the supervisory board works with Andrea Enria, former head of the European Banking Authority, who took over Ms. Nouy’s post in January 2019. The new team started out by adopting a strategy of noncommunication that stands in stark contrast with their predecessors’ practices. This could either mean that the SSM’s routine is running smoothly, or that the protagonists believe remaining silent (notably about the way the bridge function is performed and how the chair and vice chair collaborate) is the best policy today.
Back to square one
It is finally the Covid-19 pandemic that could break their reserve. “The current crisis is a wake-up call,” Mr. Enria stated in a recent interview, suggesting that under the exceptional circumstances facing Europe, monetary policy goals should prevail over those of bank supervision. He has signaled that lending must be encouraged by all means. Supervisors should not stand in the way.
A series of relief measures have already been announced by the SSM to ensure that each bank can play its role as a vehicle of public policy. Capital requirements have been lowered temporarily – a red line the SSM had refused to cross until now. Banks are invited to draw on their capital and liquidity buffers to absorb losses, and offer loans to companies and households, regardless of their credit risk. “After all, that’s what buffers are there for,” Mr. Enria said.
Relaxing regulation inevitably will create new risks in the banking industry.
As long as the crisis lasts, banks should not pay out dividends either (these should be retained as capital on their balance sheets), he insisted. Nor should they pay back shares or be too generous on variable remuneration. Furthermore, all unnecessary regulatory obstacles should be removed.
Relaxing regulation will inevitably create new risks in the banking industry, starting with a deterioration of banks’ asset quality and a substantial increase in NPLs over the next several months. As a result, banks might soon be back to where they were five years ago, before the SSM began operating.
Mr. Enria therefore proposes the creation of a “bad bank” to clean up soured loans at the eurozone level. Billions of euros in toxic debts could thus be removed from lenders’ balance sheets, and be assumed by the newly created, joint member-state-backed, entity. For the moment, the idea has far from unanimous support among euro area countries. Germany leads the resistance.
Mr. Mersch is due to retire by the end of 2020. The most likely candidate to replace him as vice chair of the supervisory board is German economist Isabel Schnabel, who was recently appointed to the ECB’s executive board. The renowned expert on financial stability and sovereign risk might give the bridge function new elan by reconsidering the interplay between bank supervision and monetary policy.
There is reason to think Ms. Schnabel, were she to become the next SSM copilot on Mr. Enria’s team, might put cooperation before strict separation of the ECB’s two policy arms. A prolonged post-pandemic crisis could threaten the stability of the financial system, thereby undermining the effectiveness of the ECB’s ultra-accommodative monetary policy and, in particular, its transmission to other parts of the euro area.
Access to detailed information on the banking sector could be valuable to President Christine Lagarde’s ECB. It has committed to buying large amounts of government bonds for “as long as necessary,” to shoulder the tremendous economic and social costs generated by the shock of the coronavirus pandemic.
At the very least, the ECB’s “insider knowledge” would allow monetary policymakers to price government bonds more accurately before buying them, thus reducing the risk that the bank will incur major losses. This would amount to further empowerment of the ECB, raising new questions of democratic legitimacy.