Has the European Central Bank been a success?

21 January 2020

By Kern Alexander 

For the first half of the last decade many people would have said no the European Central Bank (ECB) has not been a success, due to the severe economic slowdown in the euro area along with the fragility of its banking system.  

But the creation of the European Banking Union in response to the eurozone sovereign debt and banking crisis of 2012-2014 has marked a turning point in European financial policy. The ECB embarked on a more ambitious monetary policy involving the use of extraordinary financing tools to support – and prevent the implosion of – the European banking system and to prevent deflation across the eurozone.

When the euro became legal tender in 2002, the ECB was given responsibility for monetary policy across the 12 countries, which are now 19, of the euro area. Although the ECB had broad powers (ie interest rates and open market operations) to ensure price stability, it did not have any direct authority to supervise or oversee individual banks or other financial institutions. 

It was not long before strains and tensions developed between the ECB and the national regulatory authorities in the eurozone, who were in charge of banks and importantly the provision of credit to the eurozone economy. 

Co-ordination problems developed between the ECB and member state authorities and it was difficult for the ECB to meet its monetary policy objective of keeping inflation at two per cent – particularly during the financial crisis when there were strong deflationary pressures. 

The ECB learned during the crisis that banking institutions needed to be sound financially in order to conduct effective monetary policy. Banking regulation, however, is strongly influenced by local political pressures, which worsened the eurozone banking and sovereign debt crisis from 2010 to 2012. As the ECB was largely toothless in regulating the banks it could not fully ensure that its price and financial stability mandates were met. 

It took the crisis to change all that. By 2012 the euro debt crisis had escalated to such an extent that Greece, Italy, Portugal, Cyprus, Ireland and Spain were asking the ECB to bailout their top banks as they didn’t have sufficient funds.

This gave European political leaders, led by EU Council President Herman van Rompuy and German Chancellor Angela Merkel, the leverage to demand that the ECB take over the supervision of eurozone banks. In return the EU would guarantee the liabilities of banks and sovereign debtors through the creation of a state-guaranteed lender – the European Stability Mechanism. 

The European Commission then proposed in June 2012 the creation of a European Banking Union, consisting of three pillars: the Single Supervisory Mechanism (SSM), Single Resolution Mechanism (SRM) and a Deposit Insurance Scheme (EDIS). 

Under the SSM the ECB took over the supervison of credit institutions and certain financial groups, allowing it to impose tighter supervision of banks.

The eurozone could well have broken up in 2012 if it was not for the announcement that a banking Union would be created along with strong backing from the ECB. During this period, the ECB’s extraordinary measures of monetary support for eurozone banks – so-called ‘quantitative easing' – and its new powers of banking supervision contributed significantly to the eurozone banking system becoming more stable.

The ECB has been a tough regulator of banks, who complain more about the ECB as it is not subject to the political influences of national authorities. As a treaty-based institution it has a strong form of independence, separate from political interference, to pursue its objective of price and banking stability. 

Indeed, once Mario Draghi, the then President of the ECB, famously said in July 2012 that the ECB was “ready to do whatever it takes to preserve the euro” stability slowly emerged across the eurozone.

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In Spain, for instance, the country's banking regulations were favouring certain banks which led to the collapse of one of the largest Spanish lenders, Bankia, in 2012. The ECB now has the power to supervise large banks strictly and to ensure that another collapse like that does not happen.

It demands banks recognise losses on their balance sheets, something many were not required to do when loans had become defaults. Before, a lot of banks had loans listed as assets even though they had fallen into arrears. It meant banks were not taking any enforcement action and did not build up enough reserves to write them off.

The ECB scrutinised banks' balance sheets and forced them to declare bad loans, segregating them from the balance sheet and selling them off for a low price to hedge funds and other investors. The banks also have to hold more capital to cover any losses now. If that had not been done we may have had another crisis.

Cynics argue the eurozone would have stabilised itself and the financial markets are cyclical, so we can’t tell if the ECB has done this. Plus, any institution with a lot of power that doesn’t have to answer to politicians can become corrupt itself.

Indeed, some countries believe the ECB has become too powerful. It now takes responsibility for the 132 largest banks in the eurozone with direct supervision of them, so it will go into them, interrogate senior managers and analyse their balance sheets.

The smaller banks - some 8,000 of them - are still overseen by the national regulators, though they have to enforce the same ECB regulations. This can lead to friction because the national regulators are politically in tune and can be pressured by local politicians and banks. It has arguably created a two-tier system of regulation.

This new regulatory framework is rather complex, and encourages medium-sized banks to look for regulatory arbitrage, ie they will try to be overseen by national regulators as they are not as strict as the ECB. Also, the ECB does its supervision in English, which can give the impression that they don’t have a feel for what the bank needs in its own country or understand the local market and culture.

Another weakness of the ECB is that it does not have authority for bank resolution, that is, when a bank is failing and it needs to be restructured or broken up safely so there are no systemic repercussions. This is a big concern for regulators after the US Government let Lehman Brothers go bankrupt in 2008, triggering a severe worsening of the global financial crisis.

Under the second pillar of the Banking Union, bank resolutions are managed by the SRM, which is overseen by a Single Resolution Board (SRB), an EU agency, with more limited powers than the ECB. It must get approval from the resolution authorities of the states in order for a eurozone bank to be taken into resolution.

The SRB consists of representatives from the 19 EU countries that participate in the banking union. Its decision-making process can be influenced more by politics than by economics, thus leading potentially to controversial restructurings of banks that may not have needed it – as is alleged in recent lawsuits concerning the SRB taking the Spanish bank Banco Popular into resolution in May 2017, with accusations of political machinations after it was sold off cheaply to Spain’s largest bank Santander.

Also, there are a number of tools available in resolutions, such as a 'bail-in’ where creditors and bank shareholders are forced to take losses. This can potentially lead to lawsuits as bank bondholders and shareholders have property rights that must be respected according to EU and European human rights law. 

Some argue that the ECB might be more independent and a better resolution arbiter. It has more protection in the EU Treaty with European courts recognising its strong form of independence, which arguably would make it more difficult for investors to file lawsuits against when a bail-in is undertaken. Indeed, recent European Court of Justice cases have recognised the ECB’s independence, but of course it cannot act in a way that violates the EU treaties. 

But member states involved in the SRB do not want to give up their resolution powers and thus influence over decisions to take a bank into resolution. 

Despite these problems and its detractors, it is hard to argue that the ECB hasn’t brought stability to the eurozone – something it badly needed.

 

Find out more about banking regulation on the MSc Global Central Banking and Financial Regulation or download a brochure.

Kern Alexander is Professorial Chair in Law and Finance at the University of Zurich and Lecturer on the MSc Global Central Banking and Financial Regulation.

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