Financial crises always challenge conventional assumptions about financial systems. Europe is no exception. Before 2007, most Europeans thought that their system, which was dominated by banks supervised by national authorities, provided them the safe and efficient financial services they needed. But the crisis has revealed unsuspected fragilities in Europe's banks, and the consequences are still unfolding. The year 2015 will see new steps in the resulting transformation of European finance.
The most important policy initiative so far has been the inception of a banking union in 2012. This refers to the decision to endow the European Central Bank (ECB) with central authority over banking supervision in the euro area, and to create a new European agency to handle future cross-border banking crises. The ECB duly took on its supervisory responsibility in November, and the bank resolution agency will be operational in a year's time. In July, the new president of the European Commission in Brussels, Jean-Claude Juncker, announced another financial reform effort, which he called a capital markets union. He presented it as a push to develop non-bank financing of the European economy. A debate has started on the capital markets union's exact ambition, timing and content.
The economic reasoning behind all this is sound. Contrary to pre-crisis consensus, Europe's overdependence on banks has meant fragility not strength. When banks need to repair and reduce their balance sheets following financial turmoil, as is now the case, there is no "spare tire" to keep providing credit to the economy. This stands in contrast with the more diverse U.S. financial system, where bank restructuring in 2009-10 did not have contractionary impact because alternative channels of financing were available. It thus makes sense for Europe to develop larger, more integrated capital markets. The European commissioner in charge of financial services legislation, Jonathan Hill, can safely move his teams' attention from banks to capital markets, while his predecessor, Michel Barnier, had to concentrate most of his focus on banking laws that are now enacted.
However, EU policymakers should have no illusion about the pace of change in the structures of the financial system. Strong, vibrant capital markets will take many years to develop. In the meantime, banks will remain the mainstay of European finance, and banking policy will still have much more economic impact than new capital markets legislation.
Thus, in the short-to-medium term, the central role in addressing Europe's financial challenges will be played by the ECB, not the European Commission. The ECB has a heavy agenda in its new role as Europe's banking supervisor. First, it should enforce a more harmonized and rigorous definition of capital. Second, it should put an end to the constraints imposed by national regulators, which prevent pan-European banks from shifting capital and liquidity across borders within the euro area, and thus lead to harmful financial fragmentation. Third, it should force banks that hold excessive amounts of sovereign debt issued by their home country to rebalance their debt portfolios and reduce their home-country sovereign exposure to at least below one-quarter of regulatory capital. Fourth, it should adopt a consistent policy framework for groups of small banks that support each other, such as Germany's savings banks, to ensure they do not result in hidden systemic risk. Fifth, the ECB should dramatically enhance the transparency of supervisory and risk information that it provides about banks, and that banks provide about themselves. This would build on the numerous disclosures made last October at the close of the ECB's initial assessment of the euro area's 130 largest banks, but making these disclosures regular time series rather than a one-off observation.
Most importantly, the ECB must finish the job that has been started with that comprehensive assessment. The massive exercise of asset quality review and stress testing was a significant step in the right direction, but has not yet restored confidence in Europe's battered banking sector. The ECB must reassure the doubters. It should ask all banks it supervises, including those whose shares are not publicly listed, to disclose their capital ratio under a definition truly compliant with the global Basel III standard. All the discrepancies between that standard and the EU's Capital Requirements Regulation, as listed in a recent report from the Basel Committee, should be corrected in such calculations, except possibly the zero-risk-weighting of EU sovereign debt, as long as the euro area does not have a sustainable fiscal framework. The ECB should mercilessly wield its supervisory authority to impose higher capital requirements on all banks it considers unviable and trigger a resolution process if those requirements are not met. In other words, kill the zombies and heal the wounded. This thankless work should be essentially completed by the end of 2015. Waiting beyond that date would make it much more difficult, as the ECB will be held responsible for its own supervisory shortcomings in the meantime.
By contrast, the capital markets union agenda is entirely about the long term. Trying to boost its short-term impact, with public subsidies or regulatory shortcuts, will only result in harmful distortions that will defeat the initiative's purpose. The level of ambition should be correspondingly high. Rather than tinkering at the edges of securities regulation, the European Commission should aim at substantially harmonized frameworks for insolvency law and the taxation of savings; an integrated supervisory and resolution system for key markets infrastructure firms; fully consistent financial disclosures, accounting and auditing practices across EU countries; and an asset management industry that better serves the interests of European investors and savers.
The EU has many problems. Its growth is anaemic, and unemployment too high. Some of its member states are still living beyond their means. Its citizens are increasingly resentful of political elites and institutions. But in financial services policy, it may belatedly be moving in the right direction. The ECB's banking policy actions in the short term, and the European Commission's capital markets legislation in the long term, have the potential to make Europe's financial system more stable, more diverse and more efficient, to better serve the needs of European households and companies. This opportunity must not be missed.