An asymmetric banking union and European power politics by Antall József Tudásközpont

ANTALL JÓZSEF RESEARCH CENTRE

AN ASYMMETRIC BANKING UNION AND EUROPEAN POWER POLITICS

KRISZTINA ISZÁK

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ANTALL JÓZSEF RESEARCH CENTRE

AJRC-Analyses Series of the Antall József Knowledge Centre

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AN ASYMMETRIC BANKING UNION AND EUROPEAN POWER POLITICS KRISZTINA ISZÁK

INTRODUCTION Amidst the heights of the eurozone debt crisis, the European Union (EU) announced the creation of a banking union with the main goal of eliminating the interdependence between banks and their sovereigns. The banking union counted as a major response to the emerging sovereign debt crisis. Contrarily to the originally envisaged structure,1 a three-pillar framework was negotiated with eventually only two pillars implemented. Main elements of banking supervision and resolution were moved to the supranational level expanding EU competences in the financial system. On the one hand, this represented a remarkable step towards deeper integration in the Economic and Monetary Union (EMU).2 On the other hand, both the scope of supervision and resolution turned out to be limited compared to the plans in the “Four Presidents Report.”3 Furthermore, neither a deposit insurance scheme nor a common fiscal backstop was agreed. Despite these, the banking union contributed to greater financial stability and healthier bank systems while also enhanced financial integration in the EU. The downside is, however, that this incomplete structure created asymmetries across the eurozone.4 Adding to its complexity, the already multi-layered system of financial regulation was complemented with a new eurozone level both in supervision and resolution.5 Moreover, the framework further deepened the North-South divide with significant disadvantages for Southern Member States (MS). Up to this day, the banking union remains unfinished with negotiations on its third pillar reaching a standoff. Additionally, in spring 2020, the COVID-19 pandemic hit the bloc of 27 and it is still ongoing creating economic difficulties on multiple levels. Due to these the eurozone bank systems experience a déjà vu especially in Southern MS. Therefore, this paper aims to understand why the banking union functions asymmetrically in the eurozone. By taking a realist institutionalist approach, it will be argued that this asymmetric functioning flows from an incomplete banking system set

Herman Van Rompuy: Towards a genuine Economic and Monetary Union. renesmits.eu. 5 December 2012. <http://renesmits.eu/Van%20Rompuy%20Report%2006-12-12.pdf > Accessed: 8 January 2021. 1

2 Marius Skuodis: Playing the creation of the European banking union: what union for which Member States? Journal of European Integration. 2018/1. 99-114.

Herman Van Rompuy.

Lucia Quaglia: The politics of an ‘incomplete’ Banking Union and its ‘asymmetric’ effects’. Journal of European Integration. 2019/8. 955-969.

5 Jörn-Carsten Gottwald: The merits of adaptive governance: the regulation of financial services in the European Union, in Hubert Zimmermann and Andreas Dür (eds.). Key Controversies in European integration. London, Palgrave, 2018, 2nd edn. 159-167.

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up through power politics. It is also assumed that future developments of the framework are subject to possible path-dependence for the same reason. Realist institutionalism has long been applied by scholars of international relations. This approach holds that powerful actors aim at setting up an international order which favours their interests while forcing less powerful states to adjust. In the context of the banking union negotiations, this suggests that the functional need for more supranationalism has been ignored— the preferences of financially more powerful countries prevail without adequate fiscal transfers that would restore financial stability. Thus, the outcome of the negotiations is a compromise that results from power politics.6 The eurozone crisis revealed a clear divide between creditor and debtor countries within the eurozone with the latter being in severe financial trouble. Although it is argued that the set-up of EMU has already contributed to this divide, the sovereign debt crisis further worsened the situation of Southern countries. The analysis points out that negotiating a banking union through power politics also resulted in a structure that favours certain MS (especially Germany) over others along the North-South line. The analysis is divided into three parts. The first introduces why the banking union was created and examines its three pillars while looking at latest developments. The second part continues with investigating how the banking union functions. The research shows that due to the inappropriate institutional setting of the eurozone, the lack of fiscal discipline and that of structural reforms at national levels a creditordebtor divide had evolved. Furthermore, asymmetries and imbalances are identified in the functioning of the banking union further contributing to an economically weaker situation of Southern MS. Building on the first two parts, the third section analyses the role of power politics by looking at the way the pillars of the banking union were set up. Contrasting them with their results provides useful insights into their effects on the banking union’s functioning. The assessment of the underlying power relations also contributes to the understanding of possibilities for future reforms and the outcomes in their negotiations. The paper concludes that an incomplete banking union was established through power politics favouring certain countries, such as Germany. The supranationalisation in the banking system is limited and created fragmentations. While the EU level supervision and resolution resulted in positive developments, there is much room for improvement. Relevant risk sharing is still missing and remains mainly at the national level which could ultimately undermine the soundness of the banking system.

BANKING UNION—A SAVIOUR IN THE “DOOM-LOOP”? The idea of banking union emerged in earlier times of EU integration albeit with incremental progress. The question of EU level bank supervision was for example raised as a possible competence when the European Central Bank (ECB) was created, but MS strongly opposed the transfer of such power.7

Shawn Donnelly: Power Politics, Banking Union and EMU – Adjusting Europe to Germany. Routledge, Oxon, 2018.

Skuodis.

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Financial services regulation in the EU took a specific approach following the Lamfalussy process introduced in 2001. While cooperation was strengthened, supervision remained a national competence. After the 2008 global financial crisis (GFC) three institutions were added to stabilise the financial system. Launching the European Financial Stability Facility (EFSF), a temporary rescue fund, and later the European Stability Mechanism (ESM), a permanent agency providing financial assistance, is said to have paved the way for the banking union.8 Moreover, the European System of Financial Supervision (ESFS), has just started providing macroprudential supervision when the eurozone crisis kicked in. This crisis however, revealed the weaknesses of an incomplete EMU. National banking supervision proved to be ill-suited in the otherwise integrated financial system. While the world has started recovering from the GFC, a sovereign debt crisis enfolded in the eurozone with several MS finding themselves in a bank-sovereign doom-loop. In economic terms, this doom-loop refers to a negative spiral between banks and their respective sovereigns. In some cases, the two can be strongly interdependent through sovereign bonds. A high level of interdependence increases the possibility of a scenario where a weak sovereign could bring down a weak bank and vice versa. Figure 1 illustrates this feedback loop and shows how this interdependence between sovereigns and banks could threaten the integrity of a financial system. Figure 1. The feedback loop between banks and their sovereigns

Source: Markus K. Brunnermeier et. al.9

8 Desmond Dinan: The EU as efficient polity, in Hubert Zimmermann and Andreas Dür (eds.). Key Controversies in European integration. London, Palgrave, 2018, 2nd edn. 30-37.

Markus K. Brunnermeier et. al.: The Sovereign-Bank Diabolic Loop and ESBies. American Economic Review: Papers & Proceedings. 2016/5. 508. 9

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The illustration shows that in the event of a financial crisis or economic downturn, the number of non-performing loans increases, leading to lower level of bank lending. This further reduces growth in the real economy and ultimately results in the fallback of sovereign tax revenues. Due to the decreased “income” of the respective sovereign, markets assume higher risk for its bonds. Such event can lead to the downgrading of sovereigns by credit rating agencies further reducing the value of their bonds. However, the upper towards the bank, indicates how downgrading sovereigns affects the value of sovereign debt held by the banks. The result is: reduced solvency and lending capacity of banks. Such scenario increases the risk of having to be bailed out by the sovereign. A bailout further raises the sovereigns’ debt risk thereby creating a vicious circle—a doom-loop.10 In the eurozone, Greece, Ireland, Italy, Spain, and Portugal were specifically exposed to this interdependence, but other MS were also affected. While the roots of the problems differed from country to country from having fiscal, structural and banking issues or a mixture of these, the situation seriously threatened the integrity of the EMU and the internal market should the crisis have become more severe. To break this link between the eurozone banks and their sovereigns, the European Council (EUCO) agreed to establish the banking union. Figure 2 presents the structure of the banking union with its three pillars and the Single Rulebook which is a horizontal instrument aiming to harmonise legislation and create a level playing field for all banks in the EU.11 Figure 2. The structure of the Banking Union

Source: ECB.12

Markus K. Brunnermeier et. al.

European Council: Home/Policies/Banking Union/Single Rulebook. European Council. <https://www. consilium.europa.eu/en/policies/banking-union/single-rulebook/ > Accessed: 25 November 2020.

About Banking Supervision. European Central Bank Banking Supervision. <https://www.bankingsupervision. europa.eu/about/thessm/html/index.en.html > Accessed: 25 November 2020.

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THE SINGLE SUPERVISORY MECHANISM (SSM) The first pillar started operating in 2014 and divided eurozone banking supervision to an EU level and a national level. The new legislation placed the most significant banks in the euro area under ECB supervision. Becoming the single supervisor catapulted the ECB into the centre of the banking union. Although it seems to be a logical step that did not require any treaty change, the move remains controversial as financial supervisors do not necessarily enjoy such independence.13 Besides this, credit institutions considered less significant remained under the supervision of National Competitive Authorities (NCAs). Today, the ECB supervises 113 banks across the eurozone with Joint Supervisory Teams (JSTs) closely involving national authorities.14 However, whether a bank is declared to be resolved or shot down is decided by the ECB. Furthermore, NCAs are ought to follow the ECB as well and asked to provide information under the Single Rulebook. The hierarchy between NCAs and the ECB is compared to that of the European Court of Justice (ECJ) and national courts—strongly vertical with the ECB being on top.15 The aim of the SSM was to create a uniform approach in supervision.16 However, further layering a regulatory system might add to its complexity and create fragmentations in legislative practices. On the one hand, adding an EU level supervision contributed to the process of harmonisation and to the integration of the financial system. It also provides stability and reduces political influence due to the strong independence of the ECB. On the other hand, creating a two-level supervisory structure certainly rendered the system more complicated.17 To ensure consistent supervision strong coordination and close cooperation is required. While the relationship between the ECB and the NCAs are strongly hierarchical with the ECB’s leadership, tensions could remain due to the level of their respective political independence.18

THE SINGLE RESOLUTION MECHANISM (SRM) As the second pillar, the SRM was established to minimise the use of taxpayer’s money in resolving failing banks. It also aimed to harmonise banking resolution processes in the eurozone. The Single Resolution Board (SRB) is the main decision-making body in the mechanism and closely works together with the National Resolution Authorities

Michele Chang: The Constraints of Central Bank Independence: The European Central Bank’s Unconventional Monetary Policy and Incremental Accountability in the Euro Crisis. Journal of Contemporary European Research. 2019/2. 143-161.

List of supervised banks. European Central Bank Banking Supervision. <https://www.bankingsupervision. europa.eu/banking/list/html/index.en.html > Accessed: 27 November 2020.

Donnelley.

Single Supervisory Mechanism. European Central Bank. <https://www.bankingsupervision.europa.eu/about/ thessm/html/index.en.html > Accessed: 27 November 2020.

Keynote speech by Sabine Lautenschläger Member of the Executive Board of the ECB and Vice-Chair of the Supervisory Board of the ECB, at the Workshop of the European Banking Institute (EBI) hosted by the ECB: Single Supervisory Mechanism – Single Supervisory Law?, Frankfurt. 27 January 2016. <https://www.ecb. europa.eu/press/key/date/2016/html/sp160127_2.en.html > Accessed: 1 December 2020.

Luuk van Middelaar: Alarums & Excursions – Improvising Politics on the European Stage. Newcastle, Agenda Publishing, 2019.

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(NRAs). A Single Resolution Fund (SRF) was launched, to finance resolutions, based on private sector contribution to avoid using public money.19 It is worth mentioning however, that only those banks are subject to the common resolution that are under the SSM.20 The SRF’s EUR 55 billion fund is ought to be built up until 2023. The fund received EUR 7.8 billion from 3,186 institutions for the year 2019, bringing the current amount in SRF close to EUR 33 billion. Furthermore, the ESM is becoming a common backstop for the mechanism. The backstop enters into force in 2024 with a maximum of EUR 68 billion ESM loan as an additional to the 2023 target level of SRF.21 This step—and the need for a common backstop—has been widely discussed with questions arising about a much-needed ESM reform. In the autumn of 2020, the ESM reform got on the Eurogroup’s agenda and the Council reached a political agreement in November.22 Although reforming the treaty is necessary for the ESM to become the SRF’s backstop, the efficiency of the current version supported by the Council is debated. Lucas Guttenberg for example strongly argued for a robust reinvention of the mechanism. His suggestion’s main element is to place the ESM within the EU institutional framework under a new name. Furthermore, Guttenberg recommended making the institution the new EU debt agency with all the capital belonging to the EU under the Commission’s control. The new institution would gather all loan support mechanisms (including SURE and NGEU) and would provide a guarantee for them. He argued that this would ultimately recentre eurozone governance with a shift from intergovernmental towards community governance.23 The policy brief also refers to the controversies around ESM support in the current framework. The use of ESM loan—besides adding to a country’s public debt—comes with conditionalities. Using the funds during the eurozone crisis ended with bad sentiment in the Southern countries. Due to this, lending support from the ESM funds during the first wave of the COVID-19 in Spring 2020 proved especially problematic in Italy.24 Now the ESM is trapped in a politically toxic environment with MS reluctant to opt for the crisis management mechanism. Placing the ESM under EU law with the Commission taking over

Dermot Hodson–Uwe Puetter: The Euro Crisis and European Integration, in Michelle Cini and Nieves PérezSolórzano Borragán. European Union Politics. Oxford, Oxford University Press, 2019. 389-405.

Single Resolution Mechanism. European Commission. <https://ec.europa.eu/info/business-economy-euro/ banking-and-finance/banking-union/single-resolution-mechanism_en > Accessed: 27 November 2020.

When will the common backstop be in place?. European Stability Mechanism. retrieved 18 April 2020. <https://www.esm.europa.eu/content/when-will-common-backstop-be-place-0 > Accessed: 11 January 2021. 21

22 Council of the European Union: Statement of the Eurogroup in inclusive format on the ESM reform and the early introduction of the backstop to the Single Resolution Fund. Press release, 30 November 2020. <https://www.consilium.europa.eu/en/press/press-releases/2020/11/30/statement-of-the-eurogroup-ininclusive-format-on-the-esm-reform-and-the-early-introduction-of-the-backstop-to-the-single-resolution-fund/ > Accessed: 12 December 2020.

Lucas Guttenberg: ESM reform: time to come home. Policy Brief. Hertie School Jacques Delors Centre. 12 November 2020. <https://hertieschool-f4e6.kxcdn.com/fileadmin/2_Research/1_About_our_research/2_ Research_centres/6_Jacques_Delors_Centre/Publications/20201112_ESM-Guttenberg.pdf > Accessed: 15 November 2020. 23

Jacopo Barigazzi: Conte’s gamble. Politico. 22 April 2020. <https://www.politico.eu/article/giuseppe-contegamble-coronavirus-european-union-leaders/ > Accessed: 27 November 2020. 24

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the mechanism “would make EU loan support politically and economically viable in the long run.”25 The argument for such a bold reform is rather strong, especially after the political agreement in the EUCO to create a recovery instrument through common borrowing. While this latter has opened the door for moving forward with EU integration, it also increased debates about the future of the block.

THE EUROPEAN DEPOSIT INSURANCE SCHEME (EDIS) The third pillar of banking union was planned to provide a guarantee to individual savers in the euro area.26 Generally, deposit insurance schemes are financed by banks and serve two purposes. Firstly, if a credit institution experiences insolvency issues, deposit insurances are to ensure that savers do not lose their deposits; and secondly, such schemes contribute to the stability of the financial system.27 This latter is specifically important to avoid systemic risks. When a bank faces a liquidity problem, it often falls victim to bank runs as depositors hurry to get their money. A deposit insurance scheme reassures that depositors will get paid and there is no need to withdraw their deposits pushing the troubled bank into bankruptcy.28 In the eurozone, EDIS is to serve as a common risk sharing instrument but the third pillar has not been realised yet. Although EDIS does not exist, it does not mean that depositors are without any kind of protection. The Directive 2014/49/EU on national deposit guarantee schemes (DGS) required all MS to set up at least 1 DGS that all banks of the country must join to. On the one hand, national DGS, completely financed by banks, offer a protection for deposits up to EUR 100,000 and cover depositors of their member’s branches in other EU countries as well. On the other hand, the Directive does not create an EU-level framework for deposit insurance. Instead, it only aims to harmonise certain aspects of national deposit insurance laws, notably the minimum of guarantee and the time for reimbursement. While the third pillar is hanging, calls are often renewed for its implementation. In 2015, the Commission launched a proposal with a gradual approach to EDIS, but negotiations reached a standoff with strong opposition from certain MS. Paschal Donohoe, President of the Eurogroup, recently said that with the ESM agreement done, the question of EDIS is back on the table. This seems positive, but any real progress is far away with language of the statement being rather vague.29 Nevertheless, Donohoe reaffirmed his intentions on advancing the banking union—mainly EDIS, crisis management, cross-market integration

Lucas Guttenberg. 4.

Hodson and Puetter.

Deposit guarantee schemes. European Commission. <https://ec.europa.eu/info/business-economy-euro/ banking-and-finance/financial-supervision-and-risk-management/managing-risks-banks-and-financialinstitutions/deposit-guarantee-schemes_en#:~:text=Deposit%20guarantee%20schemes%20(DGS)%20 reimburse,no%20taxpayer%20funds%20are%20used > Accessed: 1 December 2020. 27

28 Veerle Colaert: Deposit Guarantee Schemes in Europe: Is the Banking Union in Need of a Third Pillar? European Company and Financial Law Review. 2015/12-3. 372-424.

Video conference of the Eurogroup, 30 November 2020. Council of the European Union. <https://www.consilium.europa.eu/en/meetings/eurogroup/2020/11/30/ > Accessed: 6 December 2020. 29

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and the link between banks and their sovereign’s debt.30 Besides these four, the non-performing loans (NPLs) have to be mentioned as well, specifically with regards to the current economic situation due to COVID-19. New rules for capital requirements were adopted by the Council in April 2019 setting specific requirements on additional reserves to deal with future NPLs.31 The Commission also created an action plan to prevent the build-up of NPLs due to COVID-19.32 While this is a great development, both steps and the ESM backstop as well, only apply to future loans raising question about the fate of existing NPLs and their possible negative effects.

SINGLE RULEBOOK This horizontal element was set up to “provide a single set of harmonised prudential rules”33 and contains all financial sector regulations in the EU. While the rulebook is to ensure that consumers enjoy the same level of protection, it also aims to create a level playing field for banks. It has three main pillars corresponding to its three main objectives. First, the Capital Requirements Directive (CRD) and the Capital Requirements Regulation (CRR), to set out capital requirements for credit institutions. Second, the amended Directive on DGSs, to ensure the better protection of depositors. Third, the Bank Recovery and Resolution Directive (BRRD), to prevent and manage bank failures.34 From the above, we can conclude that today’s banking union is more limited than the one originally decided. On the one side, the complexity of the system increased and divisions between MS remained. On the other, however, the banking union certainly constitutes a shift from governing by soft law towards governing by hard law in financial supervision.35 This latter represents a great development in the EMU. The next section looks at the functioning of this incomplete banking union. It zooms in on the growing North-South divide and the doom loop, the banking union was aimed to eliminate.

30 Sam Fleming–Mehreen Khan: Eurozone chief seizes on virus and Brexit to revive banking union. Financial Times. 8 December 2020. <https://www.ft.com/content/9a525f9e-2f03-487c-bf4c-1b6574e790e8 > Accessed: 8 December 2020. 31 Council of the European Union: Council adopts reform of capital requirements for banks' non-performing loans. Press release. 9 April 2019. <https://www.consilium.europa.eu/en/press/press-releases/2019/04/09/counciladopts-reform-of-capital-requirements-for-banks-non-performing-loans/ > Accessed: 30 November 2020. 32 European Commission: Action plan: Tackling non-performing loans (NPLs) in the aftermath of the COVID-19 pandemic. Communication. 16 December 2020. <https://ec.europa.eu/info/publications/201216-nonperforming-loans-action-plan_en > Accessed: 20 December 2020. 33 European Banking Authority: EBA Single rulebook. European Banking Authority. <https://www.eba.europa.eu/ regulation-and-policy/single-rulebook > Accessed: 10 December 2020.

Council of the European Union: Banking union: Single rulebook. Council of the European Union. <https://www.consilium.europa.eu/en/policies/banking-union/single-rulebook/# > Accessed: 12 December 2020. 34

Michele Chang: Economic and Monetary Union. London, Palgrave, 2016.

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TAMING THE SOUTH ASYMMETRIES AND IMBALANCES With joining the Single Market, the EMU and later the single currency, those MS on the periphery had a steady economic growth. Countries like Spain, Portugal, Greece, Ireland and even Italy were catching up with the core. Figure 3 shows the10-year bond yields of France, Germany, Italy and Spain from 1993 to 2020. Figure 3: Eurozone government bond yields 1993-2020

Source: Market Briefing: European Interest Rates.36

During the conversion period,10-year government bond yields closely converged within the eurozone, while competitiveness and productivity only increased at a slower pace or did not increase at all.37 The high growth rate was fuelled mainly by investment and was

Dr.Edward Yardeni–Debbie Johnson–Mali Quintana: Market Briefing: European Interest Rates. Yardeni Research, Inc. 6 January 2021. <https://www.yardeni.com/pub/europeinterestrate.pdf > Accessed: 7 January 2021. 36

37 Elias Papaioannou: Eurozone Original Sin? Nominal rather than institutional convergence. in Richard Baldwin–Francesco Giavazzi: The Eurozone Crisis: A Consensus View of the Causes and a Few Possible Solutions. A VoxEU.org eBook, CEPR Press, 2015. 162-170 <https://voxeu.org/content/eurozone-crisisconsensus-view-causes-and-few-possible-solutions > Accessed: 1 January 2021.

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targeted at financial services. Due to the inappropriate institutional setting of the eurozone, the lack of fiscal discipline and that of structural reforms at national levels, a creditor-debtor divide had evolved.38 Namely, Northern countries with high credit ratings were lending capital to Southern countries resulting in a construction boom and the redirection of labour towards the same sector. As a result of this shift, Southern countries also had to “import” more products from the core countries creating additional trade imbalances. For a long time, the system functioned without problems and both sides got what they wanted. However, Southern countries were running imbalances “underground” with a growing level of foreign borrowing and indebtedness. When the GFC and then the sovereign debt crisis kicked in, it revealed a doom loop between banks and their sovereigns in the eurozone. Southern countries and Ireland turned out most affected. Figure 3 shows how the pre-EMU differences re-emerged by 2009. Thus, the starting point of Southern MS were not advantageous when it came to banking union negotiations. Moreover, they were further weakened by the fact that they received financial assistance. It is also visible on the graph that against several policies, 10-year bond yields have not yet managed to reach the pre-crisis convergence. This implies a certain level of fragmentation in MS credibility within the eurozone while also revealing where the power lines lie.39 The very same power lines were visible during negotiations on possible stimulus packages at the outbreak of COVID-19. Italy and Spain argued for more solidarity and “coronabonds” whilst Germany and several Northern states opposed such level of risk sharing.40

BANK-SOVEREIGN NEXUS The original aim of the banking union was to eliminate the link between banks and their sovereigns. Figure 4 lets us take a glimpse into how the banking union affected the relation between banks and sovereigns. Against positive expectations, the graph shows a sharp increase in the holdings of government bonds in Spanish, Portugal, Italian and even in Belgian banks after creating the banking union. This upsurge, however, also seems to be fuelled by a growing level of NPLs.41

Elias Papaioannou.

van Middelaar.

David Dawkins: Coronabonds And The Eurozone–The Crisis At The Heart Of Europe’s Pandemic Recovery: Explained. Forbes. 7 April 2020. <https://www.forbes.com/sites/daviddawkins/2020/04/07/what-arecoronabonds-and-why-is-nazi-war-debt-back-on-the-eurozones-table/ > Accessed: 14 December 2020. 40

Lars P Feld et.al.: Divergence of liability and control as the source of over-indebtedness and moral hazard in the EMU. in: Richard Baldwin–Francesco Giavazzi (eds.), The Eurozone Crisis - A Consensus View of the Causes and a Few Possible Remedies. A VoxEU.org eBook, CEPR Press, 2015. 185-199. 41

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Figure 4. Government bonds held by their respective banking systems

Source: IMF.42

Although SSM and SRM were aimed at breaking this link, several banks were bailed out by their governments before the banking union. Moreover, numerous credit institutions remain under national supervision due to the limited scope of the SSM. This implies that, in case of failure, their resolution is done through national resolution funds financed by public money.43 Even though having lower level of public debt, countries like Ireland, Spain or Portugal had to absorb losses due to NPLs to maintain their banking systems.44 Additionally, launching the SSM revealed an even higher number of NPLs in several banks in Southern MS. Higher NPL level hinders the landing capacity of banks that hampers economic growth affecting both the recovery and the power of Southern MS.45 This further reinforces the asymmetry in the functioning of the banking union. The first BRRD was adopted in 2015 to address this problem by harmonizing the rules of national level resolution and recovery. A robust empirical analysis suggests that the effects of BRRD I on countries implementing the directive positively weakened the link between

42 International Monetary Fund: Global Financial Stability Report. IMF. April 2019. <https://www.imf.org/ en/Publications/GFSR/Issues/2019/03/27/Global-Financial-Stability-Report-April-2019?intcid=OBannerGFSR041019 > Accessed: 16 November 2020.

Richard Baldwin–Francesco Giavazzi: Introduction. in: Richard Baldwin–Francesco Giavazzi (eds.). The Eurozone Crisis - A Consensus View of the Causes and a Few Possible Remedies. A VoxEU.org eBook, CEPR Press, 2015.18-62.

Lars P. Feld et.al.

Markus K. Brunnermeier et. al.

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sovereigns and their banks, stating that the links are not statistically significant anymore.46 Nevertheless, Figure 5 shows that countries that had the greatest imbalances and weaker financial systems like Spain and Italy remain vulnerable to the doom loop. In 2019 the EU adopted a banking reform package aiming to increase the resilience of the banking system. The reform linked together the requirements for ‘total loss-absorbing capacity’ (TLAC) and for “minimum requirements for own funds and eligible liabilities” (MREL). As the two serve the same purpose—to ensure the appropriate loss-absorbing and recapitalisation capacity— the EU intends to harmonise the standards. Although the deadline for implementation was end of 2020 due to the pandemic the SRB allows for flexibility for the banks under its scope.47 Figure 5: Eurozone banks’ exposure to domestic sovereign debt

Source: ECB.48

46 Giovanni Covi–Ulrich Eydam: End of the sovereign-bank doom loop in the European Union? The Bank Recovery and Resolution Directive. Journal of Evolutionary Economics. 2020/1. 5-30.

Analytics: EU Publishes BRRD II and SRMR II in the Official Journal. Regulatory News. 7 June 2019. <https:// www.moodysanalytics.com/regulatory-news/Jun-07-19-EU-Publishes-BRRD-II-and-SRMR-II-in-the-OfficialJournal > Accessed: 17 December 2020. 47

European Central Bank: Financial Stability Review. ECB. November 2020. <https://www.ecb.europa.eu/pub/ financial-stability/fsr/html/ecb.fsr202011~b7be9ae1f1.en.html#toc1 > Accessed: 26 November 2020.

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Figure 5 also displays recent data on the bank-sovereign interdependence following the start of the COVID-19 pandemic. While domestic banks are not the biggest investors, the link between sovereigns and banks are increasing.49 Expansionary fiscal measures to curb the economic effects of COVID-19 and other policies to support recovery were introduced in many MS.50 Both contribute to the growing level of domestic sovereign debt held by banks. It is also visible on the graph that two Southern countries, Italy and Spain, are specifically vulnerable in this regard. To conclude, we saw how the creditor-debtor divide emerged with Southern MS having a weaker economic stance. The section looked at the imbalances generated by the inappropriate institutional setting and lack of structural reforms. Data also showed that the original aim of banking union to eliminate the bank-sovereign interdependence thereby weakening the threat of doom-loops has not been achieved. Moreover, in certain cases this link has been strengthening with an increasing level of banks’ exposure to domestic sovereign debt. In the following part, the paper addresses how this set up was created by power politics and resulted in favouring certain MS over others.

POWER OF THE PURSE At the start of the analysis the following research question was posed: “Why does the banking union function asymmetrically?”. To answer this question, the paper hypothesised that the asymmetric functioning of the banking union flows from an incomplete banking system set up through power politics. It was also assumed that this structure subjects the system to path-dependence. The first and second sections presented the structure and the functioning of the banking union with recent data, touching upon the effects of COVID-19 as well. Building on these, the last part aims to answer the research question by looking at how the existing two pillars have been negotiated, how this affected their functioning and what does this entail for future developments. Two major underlying questions can be identified that stood in the centre of negotiations. First, the issue of who decides on winding down banks; and second, who pays for it. Disagreements also arose on whether the banking union should take existing problems into considerations or should only be aimed at resolving future issues.51 It is often argued how important ideas and institutions are. This is especially visible in the negotiations as Germany was mainly driven by ordoliberalism52 which on the other hand came in handy for its counterparts to achieve a more beneficial compromise.

ECB: Financial Stability Review. ECB. 2020.

European Commission: European Economic Forecast Autumn 2020. European Economy Institutional Papers. Institutional Paper 136. November 2020. <https://ec.europa.eu/info/sites/info/files/economyfinance/ip136_en.pdf > Accessed: 26 November 2020. 50

Chang. 2016.

Ordoliberalism is the leading economic ideology in Germany. The approach lies between the Keynesian role of state intervention and neoliberalism, by supporting state intervention to enhance economic competitiveness. However, it assigns a less significant role to the state than Keynesianism but a more prominent role than neoliberalism assumes. Read more in Thorsten Beck and Hans-Helmut Kotz eds.: Ordoliberalism: A German oddity? A VoxEU.org eBook, CEPR Press. November 2017. <https://carnegieendowment.org/files/ Ordoliberalism_Nov22.pdf > Accessed: 8 January 2021. 52

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SSM—MAIN QUESTION: DISTRIBUTION OF POWER As countries like Greece, Italy, Portugal, and Spain had a weaker position due to their economic conditions, they were keener to give up sovereignty in return for financial assistance. Joined by France, they advocated for uniform supervision under ECB auspices proposed by the Commission. Opposed to this, Germany showed strong reluctance to give up the supervision of some of its banks.53 Originally, Germany proposed only 25 banks to be supervised by the ECB. It is argued, however, that the ECB had a high degree of independence in identifying the to-be-supervised banks by using its own algorithm.54 Furthermore, the bank also took part in negotiations and provided useful technical expertise.55 In contrast with this, main objections still came from Germany and it managed to keep some of its banks such as local and regional savings banks, Sparkassen or IPEX, a public sector export bank, out of ECB control.56 The very starting point of negotiations was the establishment of the SSM required by Germany to agree into lending ESM support to banks. Correspondingly, the whole SSM project was under strict German coordination.57 This resonates well with the quid pro quo principle prevailing in the EMU: the bigger the financial dependence on EU resources the higher the level of sovereignty to give over to the EU.58 German insistence on using a “one-size fits all” assessment of banks by the ECB echoes the same. Although the European Banking Authority (EBA) became the conductor of stress tests, the ECB launched its own Asset Quality Review (AQR) specifically designed to deal with legacy issues and reveal NPLs.59 This assessment is said to be stricter than other tests carried out previously. I discovered 15% higher level of NPLs, mainly in Southern countries and Ireland. Arguably, the “one size fits all” assessment did not pay attention to financial history either.60 Here again, Germany for example managed to achieve that one of its banks, Landesbanken was exempted from the review.61

Lucia Quaglia.

Donnelley.

Eugénia C. Heldt–Tony Mueller: The (self-)empowerment of the European Central Bank during the sovereign debt crisis. Journal of European Integration. retrieved 18 April 2020. <https://doi.org/10.1080/07036337.2020. 1729145 > Accessed: 8 January 2021. 55

Donnelley.

Henrik Enderlein: Why the euro is a functional necessity in the process of European integration. in: in Hubert Zimmermann and Andreas Dür (eds.). Key Controversies in European integration. London, Palgrave, 2018, 2nd edn. 129-137. 58

Donnelley.

Quaglia.

Donnelley.

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Figure 6: Eurozone domestic government bond holdings and corporate NPL ratios

Source: ECB.62

Although, steps have been taken to solve the problem of NPLs, Figure 6 shows that differences among MS are still vast. Among others, Portugal, Italy and Malta have a high level of NPLs. Moreover, it is also seen that Greece and Cyprus are extremely exposed to this issue. Greece, against the adjustment programmes, departs shockingly from the EU average not just in NPLs, but in stock of debt/GDP and unemployment rate as well which has long term implications on its recovery and future economic growth.63 Both the level of NPLs and scope of SSM were highly connected to the negotiations on SRM.

European Central Bank: Financial Stability Review. ECB.

George Pagoulatos: EMU and the Greek crisis: testing the extreme limits of an asymmetric union. Journal of European Integration. 2020/2. 363-379. 63

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SRM—MAIN QUESTIONS: SCOPE AND DECISION MAKING The question of legacy issues was most debated as Germany pushed for the SRM only to deal with future problems due to fear from moral hazard. The original proposal of the Commission—in line with the SSM proposal—was to cover all eurozone banks. Decisions would have been made by the Commission and a larger SRF would have provided the money.64 This enjoyed the highest support of France, Italy and Spain but was heavily opposed by most of the creditor countries.65 Discussions on establishing the SRM rapidly became an intergovernmental bargaining. Germany pushed for the SRB to be an EU agency with only a EUR 55 billion sized SRF placed outside EU law.66 France was won over by Germany and until 2019, the common backstop for the SRM by the ESM was off the table.67 Additionally, first, the governments of Germany, the Netherlands and Finland took a joint position, then the same opinion emerged within the Eurogroup: legacy debts were ought to be handled by the respective sovereigns.68 The outcome was an intergovernmental decision-making structure in SRM where Germany has a greater say.69 Many banks remained under national supervision and resolution. Adding to this, SRM resolutions involve a lot of politics leaving the system often questionable.70 Although the BRRD I did contribute to breaking the doom loop, the harmonisation of resolution seems to be less successful as different MS apply different solutions in handling ailing banks. Lucia Quaglia addresses various cases to show the differences. In her research, she pointed out, among others, Greece’s Cooperative Bank of Peloponnese. There a bailin took place and deposits were taken over by the National Bank of Greece using Greek resolution funds. In the case of Portugal’s Novo Banco, that failed the ECB test, a limited bail-in took place resulting in legal actions against Portugal authorities. In contrast, HETA in Austria was mainly bailed-in accompanied by an out of court settlement. Italy also had a wide variety of resolutions. In Spain, Bantierra received national financial support while Banco Mare Nostrum was merged into the bigger Bankia; not to mention the case of Banco Popular which was declared to be failing by the ECB and was sold for EUR 1 to Santander with creditors suffering most of the losses.71 These cases certainly reveal an asymmetry as various banks are still subject to national resolution from public money. Besides the problem of public funds, the examples also strengthen the need for stronger harmonisation in bank resolution. Such differences might Communication from the Commission to the European Parliament and the Council:‘ A Roadmap towards a Banking Union. COM/2012/0510 final. retrieved 18 April 2020. <https://eur-lex.europa.eu/legal-content/EN/ TXT/?uri=CELEX%3A52012DC0510 > Accessed: 8 January 2021. 64

Quaglia.

Donnelley.

Quaglia.

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be mitigated in future by the new 2019 banking package, although its implementation seems to be hindered by the pandemic. Following their full application, the efficiency of the reform package and the effects of COVID-19 will remain subject to analysis.

EDIS: NO BAILING OUT OTHER COUNTRIES’ DEPOSITORS Standpoints and diverging opinions culminate in the deadlock on EDIS. The hold of German (and other creditors such as the Netherlands) veto remains persistent. Same battle lines were drawn up when today’s COVID-19 crisis hit the EU and Southern countries like Spain and Italy were asking for financial support and issuing “coronabonds.”72 The COVID-19 crisis renewed the debates about risk-sharing vs. risk-reduction, while the refusal of debt mutualizing caused further pain to Italy.73 This remains problematic on the long run as the EU circles around the completion of the banking union. While the lack of common fiscal backstop is supposed to be remedied by the ESM agreement, problems around its viability can undermine the soundness of the banking system.

CONCLUSION This analysis looked at the functioning of the banking union, one of the biggest steps towards deeper EMU integration in the last decade. Creating a banking union contributed to healthier banking systems and better public finances. However, its incomplete structure further deepened the division between MS. Various eurozone members, mainly Southern countries seem to be economically weaker compared to Northern ones. With the increasingly negative economic effects of COVID-19, Southern MS are experiencing the re-emergence of financial problems. To investigate what causes this asymmetric functioning, the paper looked at the structure of the banking union and how this was negotiated. As a hypothesis, it was assumed, that the asymmetric functioning is a result of an incomplete framework negotiated through power politics. Additionally, it was suggested, that this structure also subjects the system to path-dependence. The first two parts of the analysis examined the structure and the functioning of the banking union. The assessment showed how the doom loop prevails in several MS— mainly Southern ones—keeping them vulnerable. Higher level of NPLs were seen to be another major issue affecting the same group. Although progress has been made in this regard, there is much room for improvement. Research also pointed out, that creating an EU level supervision and resolution had significant positive effects, but their scope remains limited creating fragmentations across the eurozone. The lack of relevant risk sharing and the questionable viability of the ESM reform as a common fiscal backstop hinders the stability of the financial system. Moreover, this incomplete structure of the banking union further contributes to an economically weaker situation of Southern MS.

Coronabonds: no-go zone. Financial Times. 8 April 2020. <https://www.ft.com/content/f440ddfb-feb0-41238724-d49172e96ede > Accessed: 8 January 2021.

73 Caitlin Ostroff: Italian Bond Yields Climb as Eurozone Refuses to Share Coronavirus Debt Burden. Wall Street Journal. 14 April 2020. <https://www.wsj.com/articles/italian-bond-yields-climb-as-eurozone-refuses-to-sharecoronavirus-debt-burden-11586874985 > Accessed: 8 January 2021.

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Followingly, through the lenses of realist institutionalism the third part scrutinised how this incomplete framework was negotiated. It was argued that the main asymmetries resulted from the establishment of an incomplete banking union based on a compromise reached through power politics. The section analysed how the three pillars of banking union were negotiated and how the results affected its functioning. The assessment revealed that the current structure favours certain MS—mainly creditor countries—over others—debtor countries—and it has a very strong German imprint. It also showed that bank supervision and resolution is supranationalised only to a limited extent. While an EU level supervision has been added, risk-sharing remains at national level with domestic deposit guarantee schemes. Finally, it was also presented how power lines between the creditor and debtor countries prevail henceforward resulting in path-dependence when it comes to future negotiations. An unfinished banking union, however, remains vulnerable to shocks. While risk reduction is highly desirable, so is risk sharing to guarantee financial stability and credibility both to MS and to the eurozone as a whole.

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