© Walter Vorjohann

In the next few weeks, the ECB will undertake a comprehensive assessment of banks in order to create transparency prior to the launch of the Single Supervisory Mechanism (SSM). This European-level supervisory mechanism is part of a project designed to avert the dangers to financial stability that can be caused by distress in national financial systems: the European banking union.

Numerous European countries were forced to prop up some of their domestic banks with substantial financial assistance. These experiences have set the ball rolling for a major project: the European banking union. If properly designed, this union will be able to counter threats to financial stability stemming from troubled national financial systems.

The project has several components. The first is a Single Supervisory Mechanism (SSM) for banks from the 17 euro-area countries based at the European Central Bank (ECB) in Frankfurt am Main. EU member states which have not yet introduced the euro are likewise eligible to join the SSM. The creation of a central supervisory mechanism is to be a precondition for granting failing banks direct financial assistance from the European Stability Mechanism (ESM), the euro area's crisis resolution fund. Until now, it has been left to the individual states to decide whether or not to request ESM assistance in order to prop up their national banking industries. The second component of the project is a European recovery and resolution mechanism, the Single Resolution Mechanism (SRM), for systemically important banks. A third component, a European bank deposit insurance scheme, is also considered to be part of the banking union. However, many elements of this last step are still under discussion.

The Single Supervisory Mechanism (SSM)

Banking supervisors are tasked with overseeing credit institutions' business activities, countering adverse situations and developments in the banking industry and boosting investor confidence. Fulfilling these duties is an essential precondition for ensuring a stable financial system. In Europe, banking supervision currently falls under the remit of national institutions. These duties are carried out in Germany by the Federal Financial Supervisory Authority (BaFin) and the Deutsche Bundesbank. In most of the other countries, the national central banks bear sole responsibility for banking supervision.

During the financial crisis, the close links between sovereigns and banks caused major problems: distressed banks were bailed out by the state, placing a burden on public finances. This, in turn, affected credit institutions via a number of different channels, eg because banks held, and in some cases still hold, large amounts of their own government's debt, mostly in the form of securities. Problems in the banking sector lead to public finance difficulties – and vice versa. One of the goals of establishing a Single Supervisory Mechanism is to sever the close links between nation-states and their domestic banking sectors. In addition, a European-level supervisory authority will have access to more comprehensive information than national supervisors. It is hoped that greater transparency extending across national borders will allow earlier and better detection of threats to, or stemming from, the banking system. Finally, joint supervision will ensure that the same high standards are applied in all participating member states. The varying strictness of national supervisory regimes was a significant factor in the outbreak of the financial crisis.

Banking supervision led by the ECB

At a summit held in late 2012, the leaders of the euro-area countries decided to confer major supervisory powers on the ECB. The Governing Council of the ECB, as the ultimate decision-making body, and the Supervisory Board, as the preparatory body, will be tasked with setting the overall framework for the supervisory practices applicable to all credit institutions. These two bodies will also be responsible for case-by-case decisions affecting the 124 largest and most interconnected banking groups (128 banks) in the euro area.

Around 24 banks in Germany will be covered by this new supervisory mechanism, which will probably be definitively launched in November 2014. Until that time, the ECB and the national supervisors will supervise banks jointly, with the ECB laying out the fundamental methodology of supervision. The ECB will be supported by the national competent authorities in supervising the 124 large banking groups. The Bundesbank's Deputy President Sabine Lautenschläger sees this type of cooperation as a major opportunity: "The ECB will be able to take the best of each country's supervisory approach and will thus also have the opportunity to achieve greater convergence in European supervisory practices. In addition, the global supervisory culture will forestall the possibility that supervisors might favour domestic credit institutions." Non-systemically important institutions will continue to be supervised on a routine basis by the national supervisory authorities. However, in individual cases the ECB can also intervene in the supervision of these banks should this become necessary.

ECB has launched comprehensive assessments

The SSM, which will be based at the ECB, will probably be launched in November 2014. Until then, all SSM banks will be subjected to a comprehensive assessment, which is designed to ensure clarity about the involved banks' risks and legacy problems before the ECB takes over supervisory responsibilities. "That is the only way to rebuild confidence in banks among market participants. The institutions will benefit as well: a strict, three-pillar supervisory regime will take the wind out of the sails of those who would have you believe that all banks' balance sheets are distressed", Lautenschläger explains.

The assessment, which will probably take 12 months to complete, comprises three elements. The first is a risk assessment, which is comparable to the supervisory review process in Germany and will cover all key bank risks. The second element is an asset quality review (AQR) of bank balance sheets, which will focus first and foremost on the quality and valuation of assets but also on the valuation of loan collateral and the adequacy of risk provisions. The third element will be a forward-looking stress test which looks at banks' resilience under tougher market conditions and in a difficult market environment. The ECB will coordinate this last step very closely with the London-based European Banking Authority (EBA).

German banks are getting ready

German banks are now making intensive preparations for the upcoming assessments. "For German institutions, the three-pillar comprehensive assessment will entail a considerable additional workload. The institutions will have to conduct extensive data retrieval in accordance with, in some cases, new criteria", Lautenschläger explains. She believes that the banks would do well to intensively examine their balance sheets for the 2013 annual accounts already to identify potential flaws, yet is convinced that the tour de force will be worth the effort. She believes the SSM will create an opportunity to get the best out of all euro-area supervisory cultures.

Many matters still have to be clarified before the SSM is launched at the end of next year. First and foremost, there needs to be a clear set of rules governing cooperation between national supervisors and the ECB. In the coming years, supervisors will also need to work intensively on developing a common supervisory approach, establishing appropriate reporting procedures and recruiting staff. Moreover, it is still unclear what relationship the SSM will have with the existing European Banking Authority (EBA), whose supervisory remit covers the 27 EU member states. The EBA has mainly had regulatory tasks up until now; it develops harmonised technical supervisory standards for Europe as a whole and monitors their implementation. However, it is also partly involved in operational oversight, eg resolving differences of opinion among the individual supervisory authorities through mediation.

The Single Resolution Mechanism (SRM)

The aim of establishing a single recovery and resolution mechanism is to allow large banks to be restructured and wound down without harming financial stability. Under this mechanism, losses will be distributed among the banks' owners and investors based on their level of responsibility. Only in exceptional cases can taxpayers in the bank's respective country, or even in other member states, be made to shoulder the costs. A single, well-designed liability regime will not only ensure legal clarity and market confidence but will also help creditors to assess risks appropriately. In order to put such a single European restructuring and resolution regime on a firm legal footing, however, a change to primary EU law will be necessary. "As a European resolution authority will have extensive powers of intervention, its legal basis must be absolutely watertight. Resolution will invariably be followed by lawsuits – that much is certain", according to Ms Lautenschläger.

The future banking union's membership

The SSM's initial membership will comprise all 17 euro-area countries. The 11 non-euro-area countries which are members of the European Union and the single market are free to decide whether they wish to join. One of these countries, the United Kingdom, has already announced that it will not be participating in the ECB-based supervisory mechanism. The decisions taken on 14 and 15 December 2012 give each of the representatives of the 17 countries equal voting rights in the SSM.