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Wednesday, 17 December 2014

What challenges do the spillovers from EU Banking Union pose for emerging economies in Europe?

Alexandra Zeitz (Global Economic Governance Programme, University of Oxford)

What will the recent bold shift in European financial regulation mean for Emerging Europe? In early November, Europe took the first steps towards a new level of integration with the launch of the Banking Union. The first stage of this overarching concept was the introduction of the Single Supervisory Mechanism on November 4, under which the European Central Bank took over direct supervision of the largest banks in the Eurozone, which together hold 82% of the area’s bank assets.

In a PEFM seminar on November 24, Piroska Nagy, Director for Country Strategy and Policy at the European Bank for Reconstruction and Development (EBRD), argued that for the Central and Eastern European states, which are deeply integrated with the European financial system, the European Banking Union holds much promise. Whether that promise will be fulfilled has yet to be seen. 

Contrary to popular expectations about ‘emerging’ or ‘transition’ Europe being at the periphery of European finance, Nagy demonstrated on Monday that these states are in fact tightly financially integrated with ‘advanced’ Europe. In particular, the process of bank privatization in post-Soviet states led to incredibly high foreign bank ownership. In some states (e.g. Serbia or Croatia), Eurozone banks make up almost 100% of the banking sector.
This financial integration was strongly supportive of the great growth surge in Central and Eastern Europe during 2000-08, Nagy argued, enabling the large current account deficits fuelling this growth to be easily financed. Of course, this growth model may have been overly dependent on domestic demand and foreign financing, but it is hard to blame foreign finance entirely for the economic reversals that subsequently occurred.

However, this close financial integration has dramatically outstripped any corresponding regulatory integration, as Europe as a whole remained— until a few weeks ago—fragmented in its financial supervision. The consequences of this fragmentation were made clear in the ad hoc response to the financial crisis as it affected Emerging Europe.

Faced in 2008 with the destabilizing prospect of Eurozone-based parent banks withdrawing capital in droves, the governments of these transition states had no mechanisms with which to coordinate. Responding to this vacuum, the EBRD, IMF, Austrian Ministry of Finance and others devised a response that brought Eurozone banks and host country governments together: the Vienna Initiative. Substantial funds from the EBRD ($33 billion) and host country commitments to EBRD and IMF-sanctioned programmes managed to secure agreement from Eurozone banks not to withdraw liquidity from their subsidiaries. This staved off capital outflows and prevented a devastating coordinated withdrawal.

In this regulatory vacuum, the just-initiated European Banking Union should be brilliant news for Emerging Europe, argued Nagy. But because these countries are mostly outside the Eurozone, and some are outside the EU, they will not all reap the same benefits. Some observers have suggested that European authorities had been insensitive to the sub-region in their planning for the Banking Union.

While transition economies that are Eurozone members (e.g. Slovakia, Latvia) are of course automatically included in the Eurozone’s Banking Union, important EU economies that are closely integrated in Europe’s financial markets but do not have the Euro as their currency (e.g. Poland, the Czech Republic) only have the option to opt-in to the regulatory union, where they would only have observer status. Finally, all non-EU countries will be treated alike, meaning that even those Southern European states whose banking sectors are dominated by Eurozone parent banks will only be able to have the same regulatory exchanges with the ECB as New Zealand or Mexico.

The ECB seems to have been largely unresponsive, thus far, to the concerns of those states that are in the EU but outside of the Eurozone and Banking Union, including Poland, a large and important economy that the ECB would rather see within the Eurozone. Most importantly, it has been unwilling to guarantee access to foreign exchange swap lines to assist these states should they face liquidity crises due to external shocks. Without these guarantees, Poland, Hungary and others have been unwilling to opt-in.

For Europeans to the East, the Banking Union offers the promise that regulatory integration will finally catch up with financial integration. For that to be fulfilled, however, the ECB will need to be sensitive to the needs of their non-Eurozone neighbours, bearing in mind how densely interwoven they already are with those markets now under the single supervisory mechanism.

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