EU Banking Union At Risk From Uneven Regulation

by: Global Risk Insights

By Antonio Timoner

After years of painful adjustment, Western European banks now hope to enter a period of relative calm. Yet, their exposure to uneven regulation and financial instability in the Balkans and elsewhere threatens an effective EU banking union.

The institutional reform agenda, giving birth to the so-called European Banking Union, should be the ultimate tool to address a long-overdue necessity: the overhauling of the lending capacity of Eurozone banks to reignite the credit-starved continental economy.

The banking union seeks to provide a robust institutional edifice for banks and markets to function under the principle of plausible certainty: a pre-established set of rules and institutional mandates to reduce the likelihood of sporadic bank failure as well as trigger predetermined and standard policy responses to financial distress.

This is understandable. Markets and banks essentially abhor tail risks and feel comfortable with conceivable scenarios, for which they can anticipate a known range of outcomes (and make profit thereof). Western Europe’s largest banks are expected to be the main beneficiaries from living in this new “wonderland,” which certainly will require a great deal of finishing to resemble its intended design.

However, pan-continental banking groups do not operate only in the realm of the Eurozone’s banking union. Due to the EU’s logic of economic integration, they have also built up substantial business presence in Emerging Europe, with a great share of their balance-sheet located in this region.

In fact, top Austrian, Italian, Greek, and even French and Spanish banks maintain a (sometimes vast) network of subsidiaries in Central Europe and the Balkans, where they hold leading market positions and generate significant volume of earnings. Expansion into Emerging Europe was attractive for many years. The region used to be a promising land of business growth and profitability. But it is now the land of unknown perils, especially the Balkans.

While the Eurozone is levelling the playing field for a uniform supervisory landscape for financial services, banking sectors in Eastern European countries show persistently uneven and generally low levels of regulatory adequacy and supervisory strength as well as high financial volatility. Furthermore, they are subject to multiple pockets of underlying risk in the form of deposit concentration, lack of lending diversification, poor credit risk management, oligarch-style corporate governance, and recurrent political interference.

This results in highly dissimilar degrees of financial stability and great uncertainty of outcomes when banking systems have to confront financial shocks, economic displacement, and unexpected stand-alone bank failure.

The latest example of this was the unforeseen deposit run and near collapse in June of the systemically important Corporate Commercial Bank (Corpbank) in Bulgaria. The collapse fell short to cause a system-wide banking crisis in the Balkan country, but financial contagion to other lenders was averted. Nonetheless, the fact that the rehabilitation of the bank has since remained unaddressed due to political deadlock continues to dent market confidence and question authorities’ ultimate ability to deal with bank failure as well as detect growing distress with effective oversight.

Other countries in the region have also given unpleasant surprises: Hungary has announced repressive regulation that threatens to cause large-scale losses to some of the largest Western European banking groups. Romania, Serbia, and Croatia present stubbornly high levels of toxic assets that burden the financial position of Western banking groups which might have chosen long ago to exit these markets if this would have not posed a serious reputational risk and the recognition of full losses.

Western banking groups have had to deal with this more aggressive environment in the past few years either by withstanding the distress ascetically or retrenching when it was possible. Meanwhile, the stance of financial authorities in these countries has been a mix of conscious negligence, actual powerlessness, and real frustration due to political incompetence.

Past Eurozone ailments managed to divert attention from the need of bank reform in Eastern Europe, just postponing the inevitable. Some progress was made with the passing of the EU mandatory regulation such as CRD IV but little else was accomplished at the domestic level. However, now that the banking union is about to become a fulfilled promise of market discipline and financial stability in the Western half of the continent, the time has come for Eastern half to address their institutional shortcomings that had so long passed unnoticed and now will become more visible.

The first encouraging moves have been the official requests by Romania in July and Bulgaria in June to join banking union membership despite not being Eurozone countries. In Bulgaria, the consensus following the Corpbank collapse was that weak bank supervision failed to prevent the deposit run and reputation had been tainted due to the poor policy response. In Romania, it was the realization that only external bank supervision could introduce some order and transparency in the banks’ balance sheet and highly toxic loan portfolios.

Surrendering supervisory powers to a supranational authority would constitute a loss of economic sovereignty but this has been the price that many Eurozone members have happily paid without question. In many instances, the benefits of having domestic banking sectors under European watch largely exceed the advantages of discretionary domestic policy-making, especially if the latter is frequently flawed or blatantly passive and torpid.

The dividend may not be reaped immediately, but eventually allowing the ECB and the EBA to exert more credible financial oversight over the Balkans could lay the grounds for a more stable business environment for the European banking industry operating in the region. Even if it means having to deal with a two-speed banking union, the extension of Single Supervisory Mechanism and ECB macroprudential supervision to the East could ultimately help to generate the so-needed certainty of policy responses to unforeseen bank distress and consequently ease lingering bank deleveraging pressures in Central and Eastern Europe.

Disclosure: None