"Europe’s banking trilemma" - a report on Banking Union and bank structure reform

Date published: 5 September 2013

This report on Banking Union and bank reform in the EU, “Europe’s banking trilemma” [click to download], concludes that, despite its intention, Banking Union will fail to prevent European citizens from bearing the losses of failed banks in the event of a systemic banking crisis unless there are meaningful structural and capital reforms to Europe’s largest banks.

Key points from the report include:

  • Bank deposits and payment systems are the lifeblood of our economies. Society relies on bank credit for economic and social order and governments will always step in to protect it.
  • The expectation of bail-out means that banks receive a funding subsidy via government guarantees.
  • There is no reason to subsidise trading activities, in fact this increases systemic risk.
  • In the last 25 years, our largest banks have evolved into “flow monsters” with balance sheets dominated by subsidised trading assets and inter-connected via the derivatives markets.
  • In today’s environment, it is difficult for highly inter-connected banks to undergo “creditor bail-in” without spreading danger throughout the financial system, which undermines the credibility of the bail-in mechanisms proposed.
  • The proposed Resolution Fund and the European Stability Mechanism are too small to withstand a systemic banking crisis on their own.
  • The activities that make banks too-big, too-complex and too-connected-to-fail also make them too-big, too-complex and too-connected-to-resolve in the normal way.
  • When resolution mechanisms are not credible, investors charge a lower risk premium, encouraging the very activities that make resolution difficult. 
  • Without structural reforms and credible loss-absorbency mechanisms on banks’ liabilities, Banking Union risks becoming a paper tiger: a mechanism that appears to help but which delays meaningful bank reform and lacks teeth when the next systemic crisis strikes.

 Policy recommendations in the report include:

  • A strong legislative proposal in the current European Commission mandate to separate commercial banking from investment banking and trading activities, including market making, as recommended by the High-level Expert Group led by Erkki Liikanen.
  • Significantly higher loss-absorbing capacity for banks, including equity requirements through the adoption of strict leverage caps by 2015.
  • Stronger powers for supervisors to intervene to ensure that recovery and resolution plans are realistic.