The European Central Bank's Big Moment

Europe's banking union project has had many doubters since it started to be widely discussed in the spring of 2012. What is not in doubt, however, is its transformative nature. In June 2012, EU leaders chose—in a galloping hurry, as usual—to move towards the centralization of bank supervision across euro area countries, with this authority entrusted to the European Central Bank (ECB). The consequences have only gradually become apparent to most and represent both an opportunity and a risk.

The opportunity is to reestablish trust in European banks, reboot the pan-European interbank market, end dysfunctional credit allocation, and start reversing the vicious circle between bank and sovereign credit. In an optimistic scenario, the ECB's 12-month process of “comprehensive assessment," including an asset quality review (AQR) and stress tests of about 130 credit institutions covering 85 percent of the euro area's banking assets, will trigger the triage, recapitalization, and restructuring that history suggests is a prerequisite for systemic crisis resolution.

The risk is that, if the assessment fails to be consistent and rigorous, the ECB may find its reputation so damaged that the credibility of its monetary policy—and the perception of Europe's ability to get anything done—could be affected. After all, this exercise is unprecedented in scale and scope, which means the ECB has little prior experience. At the same time, the political fallout is potentially poisonous to most of the states concerned.

Thus, much is at stake in the balance sheet review, and the scene is set for an escalating confrontation between the ECB and member states in the months ahead. The ECB has pointedly made clear that it will form an independent judgment on the capital strength of the banks examined, without necessarily following the views of national supervisors.

It has also noted that the AQR can be expected to reveal significant information—which, after all, is the whole point of it. A number of banks that, until now, had been deemed sound by national watchdogs may be found by the ECB to be undercapitalized or even insolvent. In such cases, restructuring will inevitably be painful for the corresponding national governments, both politically and financially, leading them to plead for forbearance. The tension can be expected to generate more market volatility in 2014 than was seen in 2013.

A successful AQR and establishment of the Single Supervisory Mechanism (SSM)—EU jargon for the handover of supervisory authority to the ECB—would have structural consequences. Europe's national and local governments often use their leverage over the publicly-regulated banking industry for industrial policy purposes or to facilitate their own financing, a dynamic known to economists as financial repression.

Furthermore, the combination of national banking policy frameworks with the European Union's integrated single market has created powerful incentives for banking nationalism. It has led to the protection or promotion of domestic banking champions on the pan-European competitive field, both against competing foreign banks and potential new entrants and non-banks. This has often been detrimental to financial stability. The shift of supervisory authority to the ECB can be expected to gradually weaken these links and to hamper the ability of euro area member states to engage in financial repression and banking nationalism. In particular, the “moral suasion" wielded by national authorities to persuade local banks to buy domestic sovereign bonds and ring-fence funding across borders may become considerably less effective under the new regime of ECB supervision.

More generally, and even without rapid completion of a European resolution and deposit insurance framework, one can expect the centralization of bank supervision to foster market integration, cross-border bank consolidation, and the emergence of a more diverse financial sector with a greater variety of banking and non-bank intermediation business models. If the transition is successful, then non-euro countries such as Denmark, Poland, and even Sweden can be expected to join the SSM over a three-year horizon. This will not make the United Kingdom's relationship with the rest of the European Union simpler.

All this, of course, rests on the assumption that a credible AQR and well-handled bank restructuring will allow the ECB to establish itself as a sound, single euro area banking supervisor. This cannot be taken for granted but appears more likely than not. Numerous and powerful interests may work against it, but an even stronger interest will probably prompt the euro area's leaders, starting with those of Germany, to do whatever it takes to help the ECB pass its make-or-break test.