Public Information Notice No. 13/29

European Union: IMF Executive Board Concludes 2013 Financial System Stability Assessment

March 15, 2013

On March 8, 2013, the Executive Board of the International Monetary Fund (IMF) discussed the Financial System Stability Assessment (FSSA) with the European Union (EU).

Background

Restoring financial stability in the EU has proven to be a challenge. Following the global financial crisis, the EU’s banking system came under severe pressure. Economic growth has been low and is projected to continue to be weak. This will put bank profitability at risk, limiting an important source of growth and putting solvency in the insurance sector under pressure. In several EU countries, fiscal sustainability is proving difficult to achieve and exposure to weak sovereigns has undermined banks. Market funding has been a challenge with wholesale markets segmented along national borders, requiring banks to rely on central bank support. Recently, however, banks reduced their reliance on central bank funding. Finally, structural forces contribute to deleveraging pressure on banks, leaving some economies with little support from the financial system.

Much has been done to address these challenges. Banks have raised considerable new capital both in the context of European Banking Authority (EBA) recapitalization exercise and national efforts but pockets of weakness in the banking sector remain. After the resolution and winding-down of several institutions, the number of credit institutions fell and a large number of banks have undergone deep restructuring. Still, dependence on wholesale funding remains high, as does exposure to illiquid or impaired assets in some cases. In response, a few countries have set up asset management companies.

The supranational dimension of crisis management has gained importance and significant progress has been made in recent months in laying the groundwork for strengthening the EU financial architecture. Initially problems in EU member states were dealt with primarily at the national level through sovereign support to the financial system, the parameters of which were coordinated at the EU level and subject to the EU competition regulation. However, national fiscal capacity turned out to be insufficient in some cases, triggering the setting up of mutual support mechanism among sovereigns. The European Stability Mechanism became a permanent crisis management facility. The possibility to involve it directly in the recapitalization of euro area banks to help limit the adverse feedback loop between sovereigns and banks is under consideration, and an operational framework should be finalized in the coming months.

To anchor crisis management, major institutional reforms are being implemented. The EU authorities have announced the establishment of a Single Supervisory Mechanism (SSM) at the European Central Bank (ECB), mandatory for EMU members but open to other EU members. It is the first step in the setting up of a banking union, which is proposed to have a single resolution mechanism with appropriate and effective backstop arrangements. Ensuring proper governance and building up supervisory capacity will take time, with the new institutions expected to be fully operational in 2014.

Meanwhile, the financial oversight framework for the single market is being built further. Directives and regulations are under consideration to harmonize capital requirements, resolution frameworks, deposit guarantee systems, and insurance supervision frameworks. A single rulebook for the EU is being built by the European Supervisory Authorities and cross-border supervisory colleges and crisis management groups set up for the large banks. Information sharing among all institutions involved is a challenge and the system remains complex as it covers different groups of countries with different degrees of monetary and supervisory autonomy. Several initiatives are underway to adapt the regulation of financial market infrastructure to the requirements of the single market.

Executive Board Assessment

Executive Directors welcomed the first FSSA for the EU, which, with its focus on supra-national institutions, complements recent national-level assessments for EU member states. They broadly shared the main findings and recommendations in the report.

Directors noted that much has been achieved to restore financial stability: bank capitalization has increased; funding conditions have improved; and countries under stress have been adjusting under programs supported by the EU and the IMF. Nevertheless, risks remain elevated, especially in a context of low growth and fiscal retrenchment. Some financial systems still face pressures from excessive leverage, risky business models, and adverse feedback loops between sovereign and bank balance sheets. Regulatory and policy uncertainty, and gaps in policy frameworks also continue to pose vulnerabilities. Further ambitious steps are thus necessary to rebuild confidence and achieve long-lasting financial stability in the region.

Directors agreed that repair of banks’ balance sheets remains a key priority. This should be complemented by reviews of the quality of banks’ assets, based on harmonized definitions of forbearance and nonperforming loans. Directors supported the announced path toward a banking union, underpinned by robust governance. They welcomed the recent agreement to establish a SSM at the ECB. Directors stressed the need to ensure that the SSM maintains broad oversight over all banks in countries participating in the mechanism and has powers to intervene if necessary, and that its resources are commensurate with this task.

Directors underscored the importance of creating without undue delay a Single Resolution Mechanism. In this context, many saw merit in the staff’s recommendation to develop a time-bound roadmap toward establishing a single resolution authority and a deposit guarantee scheme with common backstops. A few Directors considered that progress on this front depends on greater fiscal integration in the EU. Directors looked forward to early agreement on operational guidelines for bank recapitalization by the European Stability Mechanism.

Directors urged sustained efforts to strengthen the EU framework for financial oversight, including through prompt implementation of the European Commission proposals to harmonize capital requirements, resolution, deposit guarantee schemes, and insurance supervision frameworks. They stressed in particular the importance of full compliance with Basel III on capital requirements, and a trigger for automatic intervention in insolvent banks. Directors also emphasized the need for more effective supervision and resolution for financial institutions with cross-border activities.

Directors commended the European Supervisory Authorities for their achievements in the first two years of existence. They nonetheless saw scope for further improvements in areas such as data transparency, information sharing, and operational independence.

Directors also welcomed the work of the European Systemic Risk Board in developing the macroprudential toolkit, noting that flexible implementation should be allowed in response to different conditions. Close coordination with national supervisors and the SSM would be crucial.

Directors noted ongoing plans to separate banks’ retail activities from those deemed more risky. They noted that while separation could reduce cross-subsidization and facilitate resolvability, it should not substitute for other enhancements in loss-absorption capacity. It is also important to avoid regulatory arbitrage.

Directors took note of the staff’s view that the life insurance and pensions industries would face stricter supervisory requirements under Solvency II. This calls for a refocusing of the regulatory authority’s role toward monitoring, implementing, and enforcing the new standards.

Noting the complexity and potential overlaps of responsibilities, Directors underlined the importance of close collaboration among the various supra-national agencies, as well as with national authorities. In this regard, consideration could be given to establishing a mechanism or committee to integrate crisis-related work and bring to bear an all-inclusive perspective.

Directors welcomed the authorities’ interest in repeating the Financial Sector Assessment Program for the EU regularly every few years.