Main recommendation of the European Financial Congress "If and when the countries outside the euro area should join the Banking Union?

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1 Main recommendation of the European Financial Congress "If and when the countries outside the euro area should join the Banking Union?" General recommendations 1. The Banking Union is not a closed project, therefore the final decision on whether to accede to it should not be taken until the project is completed, and benefits and risks associated with it are known. The key issue is to transfer to the supranational level not only supervisory competences and decision-making powers but also financial responsibility (the European resolution fund, the European Deposit Guarantee Scheme). Transfer of the decision-making powers to the supranational level may not be accompanied by responsibility left at the local level since doing so could involve a risk of the economic and political disintegration of the European Unions, which is contrary to the intentions of its creators. 2. Countries outside the euro area which are in a similar situation as Poland, should demonstrate their willingness to accede to the Banking Union and actively participate in development of final solutions. 3. If costs of accession to the Banking Union under principles of the so called "close cooperation" outweigh benefits in this respect, countries from outside the euro zone will face a difficult choice. Should, however, the final design of the Banking Union prove to be a successful step in the further economic and political integration, then the most important conclusion for these countries would be to step up their efforts aimed at accelerating their membership in the euro zone as staying outside the euro area will in fact become more and more irrational. It is then worth synchronising the moment of accession to the Banking Union with joining the ERM II system. Specific recommendations Countries outside the euro area that are considering their accession to the Banking Union under the "close cooperation" principles should in particular strive to: 1. develop such solutions with regard to the procedures for restructuring and an orderly liquidation of banks that will not create the risk of transferring stability of financial systems from host to home countries. From the practical point of view, this means a ban or a very severe restriction on the free movement of assets between companies within the cross-border banking groups. The free transfer of assets of public companies with minority shareholders should be categorically prohibited;

2 2. determine appropriate rules of financing the resolution fund and the European Union Deposit Guarantee Scheme (DGS); 3. leave macro-prudential policy and supervision within the national competences; 4. extend the European Stability Mechanism (ESM) to all countries of the single supervisory system SSM (Single Supervisory Mechanism); 5. ensure the ECB liquidity support to all banks directly supervised by the ECB; 6. develop principles for financing the current needs with regard to covering actual losses and to separate them from the issues related to the costs of financing future financial safety network in the European Union and insurance against the risk of destabilizing the European financial system in the future; 7. define a clear mechanism for resolving the host - home conflicts (host countries - home countries) in a new format that includes the EBA (European Banking Authority), the ECB and the national supervision; 8. optimize relationships between the ECB and the national supervisory authorities in order to avoid undue centralization and transferring too many executive supervisory functions to the ECB level. Justification and refinement I. Concept of the Banking Union The European Union politicians are determined to implement concept of the Banking Union. It is one of the most important steps on the path to further political and economic integration of Europe. The idea of the Banking Union is not a new one. It, in fact, means a transfer to the supranational level of both supervision over the banking sector and fiscal responsibility. These issues were extensively discussed in the course of creation of the single financial market. The Banking Union is to be based on three pillars: a single framework for the banking supervision (SSM); a mechanism for restructuring and orderly liquidation of banks, that is a so-called resolution mechanism financed by the industry itself and not by the taxpayers; a common system of deposit guarantees. By now, principles of common supervision have been established, but the other two pillars have not been agreed upon. They are crucial in order to fully assess the Banking Union, its effectiveness and impact on individual countries.

3 It is believed that a well-designed and implemented Banking Union in Europe would help both in preventing and mitigating the crisis by, inter alia: breaking the feedback between insolvent banks and insolvent countries; early identification of risks in the banking sector for the countries of the Banking Union; reducing the moral hazard created by the banks that are "too big to fall"; the resolution mechanism would lead to the restructuring and orderly liquidation of the banks instead of their saving at the expense of the taxpayers; reducing fragmentation of the financial markets, which is a barrier limiting the increase in lending and economic growth; increasing the confidence of depositors through the harmonization of deposit guarantee schemes; relative reduction in the size of banks in relation to the GDP (previously to the national GDP, now the European Union one). Therefore, it seems justified to assume that a well-designed and implemented Banking Union would actually have a positive impact on the prevention and mitigation of the crisis in the euro area. Furthermore, it would reduce costs of financing economies of the countries affected by the crisis and thus contribute to the return on the path of economic growth in euro zone. II. Poland: benefits, costs and risks of participating or remaining outside the Banking Union Is it reasonable for non-euro countries which are not members of the monetary union to join the Banking Union? When looking at this issue from a purely professional point of view, one can give only one answer: we should join the Banking Union if the expected benefits of the membership exceed potential costs and related challenges. The account must be in particular taken of the costs of risk associated with joining the Banking Union and the price of risk resulting from remaining outside the Banking Union. II.1. Strategic risk (staying outside processes of further political integration of the European Union) Benefits and costs should be analysed in the long term and may not be limited exclusively to the economic issues. The risk of disintegration of the European Union is not only a real threat to the idea of the single financial market and the benefits associated with it, but also weakens the political power of the entire group and individual countries. Poland's geopolitical situation implies analysis of a scenario in which we do not participate in the process of further political integration of the European Union. Risks resulting from this scenario would be higher than the possible negative balance of economic costs and benefits stemming from Poland's joining the Banking Union. Poland may face a political dilemma of choosing the lesser evil. The Banking Union project leads to a political extension of the euro zone by countries staying outside the euro area which established a close cooperation with the ECB. Undoubtedly, there is a political and market risk linked with staying outside the Banking Union. It poses a threat of the "two-speed Europe" split. Markets outside the Banking Union may be exposed to risks associated with a lesser confidence of depositors and investors and a limitation

4 of cross-border activities of the banks' from the euro zone. In the end, this may result in the establishment of two financial sector areas within the European Union. Those countries and banks that will be outside the Banking Union may find themselves in a worse position. As the euro zone will enjoy a special confidence placed by markets (which translates, inter alia, into the profitability of national debentures), banks operating under joint supervision may be seen as safer than banks beyond control. There is a risk that those countries outside the euro area that do not establish a close cooperation within the framework of the Banking Union can be marginalized and seen as "second rate" EU member states. Voice of Poland, a country which is both outside the monetary union and the Banking Union, can weigh a lot less than it does today in taking many important decisions within the European Union. With so many dynamic changes taking place in the euro area, there is a risk that we will find ourselves on the road running in a direction more and more diverting from the integration process. II.2. Risk of insufficient sensitivity to the interests of countries outside the euro area in decisionmaking processes There was a concern that the ECB's decision-making process in the context of the single supervisory mechanism will not sufficiently take into account position of the countries outside the euro area. Today, however, the above-mentioned risk appears to be minimized according to the finally negotiated decision-making principles, interests of the countries outside the euro area should be well protected within the boundaries of the existing treaty conditions. Yet, the risk associated with the non-membership in the Banking Union is the fact that decisions taken within the framework of the single ECB supervision may have an indirect impact on the countries that have chosen not to join the Union. It is a real risk because half of the Polish banking sector assets are subsidiaries of institutions operating in the euro area that are subject to the supervision exercised by the ECB. In the case of participation in the SSM, our country will gain influence on the shape of these decisions. II.3. Risk of discrimination of host countries as compared to home ones Before 2006, the entity subject to the supervision was just a single bank. Under the CRD II regime, the supervised entity became a banking group consisting of individual banks. The final say on the issue of granting individual banks permissions to use advanced methods was given to the supervisory college, and in the absence of unanimity the consolidating supervisor. This led to a situation in which a local bank may obtain this permission despite a negative opinion of the local supervisor, and even despite objections raised by that supervisor. CRD IV introduced group rules governing decision-making with respect to practically all the essential supervisory matters. On the other hand, the SSM, while respecting the principle of the group decision making, is guided by another philosophy, which is shown in Appendix 1 (available at

5 These rules are in general more favourable for the host countries than CRD IV principles. CRD IV has clearly defined method of exercising supervision over banking groups. The SSM provides for a similar procedure, yet it introduces another mode of decision-making which again is, as a rule, more favourable for the national supervisors. Differences in the procedures of taking corresponding decisions under the CRD IV and SSM regimes are shown in Appendix 1. The essential difference between the CRD IV and the SSM regimes relates to the method of dealing with disputable issues. CRD IV provides that in the event of a dispute an arbitrary decision is made by the consolidating supervisor while the country that is not satisfied with this decision may apply to the EBA with a request for a legally binding mediation. This would lead to a change of the already taken decision, which is always difficult. In the case of a dispute within the framework of the SSM, decision is taken by the majority already at the stage of developing this decision, and in an extremely disadvantageous situation a country outside the euro area may immediately withdraw from the SSM. II.4. Risk of not having access to the ESM fund and the ECB subsidies A decision taken by a consolidating supervisor or a board (of supervisors or presidents) which is unfavourable for the country exposes that country to potentially adverse consequences. Banks in the euro area may rely on the ECB liquidity support, as well as on the ESM capital support. However, current solutions do not provide the same support for banks from countries outside the euro area. Still, the issue of unequal treatment of countries outside the euro area is consistently raised during the works on the SSM, which does not mean, however, that it will have a positive outcome. We can draw the following conclusion from the above: in the course of discussion on the possible accession (or non-accession) to the SSM, the most important question is access of all countries within the SSM system to safety mechanisms that are currently available only to the euro zone members. Linking this decision to the date of joining the euro area is less important. It seems that currently it is particularly possible to demand establishment of mechanisms to protect countries outside the euro area against adverse effects of decisions taken against their standpoints. An extremely unfavourable situation for the host countries would arise if new regulations could allow a free transfer of assets within cross-border banking groups. That would mean: a risk of transfer of liquidity from the subsidiary companies and destabilising financial markets in the host countries; a risk of value migration for the minority shareholders of banks being subsidiary companies that are publicly traded. II.5. Risk of burdens assumed in order to ensure stability of the euro zone that are inadequate to benefits A significant factor is the price we would have to pay as a result of the accession to the Banking Union.

6 Of course, those who generate greater systemic risk should pay more. However, there is no economic justification for the common "stability" EU fund (regardless of whether it is a supranational deposit guarantee fund or a resolution fund) to be fed by those who do not generate systemic risk or those who will not use resources there accumulated. Problem of the scale of financing the Banking Union costs by individual states may determine reasonableness of its membership for the non-euro countries. It may also become a factor delaying consensus among the euro zone countries. At some point in time Poland will join the euro area and the Banking Union (provided it has not joined the latter at an earlier stage). Therefore, the problem of funding must already be our priority and we should actively participate in the discussion on this topic. Regardless of whether Poland decides to join the Banking Union now or at a later stage, simultaneously with the accession to the euro zone, the question of our participation in the fees for the resolution fund requires preparation of a clear position and arguments, as well as finding allies, already today. It is worth noting that the resolution fund amounts to several hundred billion euros. When preparing the Polish position on the contributions to the resolution fund, one should pay attention to the following issues: the simplest solution out of those suggested by the European Commission is the contribution contingent upon the size of the banks' assets. It is favourable for countries with relatively low bank assets as compared to the GDP (for instance Poland), and disadvantageous for countries in which these assets are high, mostly for the United Kingdom; however, the United Kingdom will not become a member of the Banking Union; it would be reasonable to propose progressive fees, contingent upon the size of the bank; it would hinder growth of the largest banks, systemic risk and moral hazard; progression rates would be dependent on the relationship of bank (banking group) assets to the GDP of the country where the parent company is established; the "taxation" base, on the other hand, could be diminished by the amount of the first category equity (so called Tier 1). This would be consistent with the regulations aimed at deleveraging banks, and could be an alternative for different ideas of risk weighting of assets and making the contribution dependent on of the risk generated by individual banks, which is theoretically correct but quite difficult to implement from the practical point of view. The above ideas may pose a number of problems associated with the correct measurement of risk, which can be very conflicting and will no doubt extend discussions; an important qualitative argument is the fact that methods of the group management are important in terms of the level of risk generated by a subsidiary bank - if the bank is independent, the risk is generated at the level of the subsidiary bank, if it is generated at the level of the parent company, the risk originates from the home country. Therefore, the following should be suggested:

7 total bank assets minus equity (Tier 1) should be taken as the basis for calculating contributions for the resolution fund, which would be "rewarding" for more reliable institutions; a progressive rate of charges, which would hinder the process of monopolisation and rebirth of banks "too big to fall"; if we choose to support the proposal of the International Monetary Fund, that is to take the level of liabilities as the basis for the "taxation" of the banks, it would also require introduction of a progressive rate and diminishing the taxation base by shareholders' equity (Tier 1). III. Risk of the unfinished project of the Banking Union There can be two basic approaches to an orderly bankruptcy of cross-border holdings: SPE (single point of entry) and MPE (multiple points of entry). The SPE involves intervention at the level of the holding from the point of view of the host country. It requires cooperation between individual supervisors, and is dependent in the context of the Banking Union on the financial support at the EU level. The MPE approach assumes intervention at the level of holding's national operating units and a greater role of the national financing, which in practice could result in some restrictions on the freedom of movement of capital and the adoption of the "single domestic market" principle for attracting deposits and lending activities. The current stage of discussions on the directive establishing a framework for the orderly liquidation of banks provides only for establishment of national resolution funds (which in ten years are supposed to reach 0.8% of the financial sector deposits in individual countries). Transfer (borrowing) of financial resources between national funds should be possible on a voluntary basis. It is assumed that the European Parliament will approve the above-mentioned directive by the end of The risk of failure to reach the agreement by that date seems to be quite high. It seems that in the case of lack of the agreement as to the financial mechanism supporting the single mechanism for restructuring and controlled insolvency of the banks (Banking Recovery and Resolution Plan), approach of the countries outside the euro zone to the resolution issue and/or possible financial support will to a large extent depend on the mechanisms of financial support at the national level. In practice, it seems important to: develop and agree upon ex-ante rules of conduct and cooperation between supervisors in the case of local and/or global problems experienced by cross-border holdings, with particular emphasis on the elements linked to the financial support; implement in the cross-border holdings, both at the central level and at the level of major subsidiary companies (sub-holdings), detailed plans for operational schemes to be followed in the case of the need to launch resolution procedure. In practice, this means that there is a high risk of leaving the Banking Union project unfinished in the part related to the transfer of fiscal responsibility to the supranational level. A highly probable scenario of the Banking Union project will be limited to the centralization of supervisory and regulatory competences at the supranational level, while the issue of financial responsibility for defective supervision, faulty regulations and decisions will remain at the national level. In other words, there is a high risk that the European Union member states will not be able to come to an agreement on the resolution fund, which means they will not be able

8 to agree as to who will pay, and how much, for the fund intended to handle civilized bankruptcies of the banks of the systemic importance, that is banks that are "too big to fall". This would de facto mean a construction of the Banking Union which would result in the transfer of moral hazard on the supranational level and adjourning of the risk of disaster, but on a much larger scale. If we were to keep at the supranational level only the European Stability Mechanism (ESM), whose mission is not to allow bankruptcy but - on the contrary - to support banks that create (generate) systemic risk, instead of the resolution fund, then construction of the Banking Union would duplicate failures of the central planning system and in the short term would replace the market economy by a system based on official prices. Without going into details, we are currently facing a growing risk of erroneous construction of the financial safety network that is being built. This does not allow us to be optimistic about the further economic development of the euro zone. On the other hand, processes of economic and political integration have been intensified. When joining the Banking Union, Poland would find itself in a paradoxical situation: it would transfer supervisory powers to the supranational level but would not have any access to supranational funds in the case of a crisis, perhaps caused by incompetence of supranational regulatory bodies. The supranational funds (ESM, ECB subsidies) would foster the short- and medium-term credibility of the banking system in the euro zone, but not in member states of the European Union remaining outside the euro area. In the long run, lack of solutions restoring market discipline, for instance, mechanisms such as resolution funds, will result in the decline of the euro zone credibility, and the rate of economic growth will be similar to that of Japan's in the past twenty years, that is oscillating around zero. Belief of the European politicians in replacement of the market discipline by administrative bans today seems unassailable. IV. Summary In a situation in which accession to the euro area (and the prior participation in the ERM II system) has not yet been decided, accession of a member state to the Banking Union will be justified if the sum of benefits exceeds its costs. Benefits and costs should be analyzed over a long period of time. These are not always quantifiable. The main benefits of the Banking Union are as follows: replacing home - host relationships between supervisors with home, host - European supervision relationship, which means reducing the risk of a possible nationalization of losses in the host country; decision-making rules within the framework of the SSM which safeguard interests of countries outside the euro area; possibilities of using the ESM mechanism; increasing financial stability of the entire banking system in the European Union; perceiving the banking industry as safer sector. It is therefore important to talk about joining the SSM while stressing the need for equal treatment of all countries, calling for:

9 favourable solutions with regard to the BRRP (Banking Recovery and Resolution Plan); extending the ESM mechanism to all SSM countries; determining appropriate rules for the financing of the resolution fund; providing liquidity support from the European Central Bank to all banks directly supervised by the ECB, for example in the form of a currency swap; establishing of the EU deposit guarantee scheme. The Banking Union is an important step towards political integration of the European Union. Centralization of the supervisory decisions should be accompanied by the transfer of fiscal responsibility to the supranational level (EMS, resolution fund, European Deposit Guarantee System). The most important conclusion for the countries outside the euro area is the need to accelerate efforts aimed at joining the euro zone. Being outside the euro area will become more and more irrational in the case of a successful implementation of the Banking Union project. An opposite situation will take place if the Banking Union project fails to be implemented and will be limited solely to the centralization of the supervision without transfer of fiscal responsibility to the supranational level.

10 Appendix 1 Decision-making mechanism based on the principles of CRD IV/CRR and SSM The decision-making mechanism depends on the task assigned to the ECB. When referring to the ECB decision, one should each time understand it as a collective decision of the Board of Supervisors consisting of representatives of all supervisory authorities included in the SSM and representatives of the ECB. The decision will then be formally approved (or rejected) by the ECB, that is by the Governing Council. Decision-making mechanism for the tasks assigned to the ECB The task assigned to the ECB Current status Changes introduced by the CRD IV / CRR Changes after introduction of the SSM Granting of banking license Decisions on granting a banking license are taken by national authorities, also in the case of a bank belonging to a banking group. CRD IV does not Nothing will change after make any changes in introduction of the SSM for countries this area. outside the SSM. In the case of countries within the SSM, the ECB will have the right of veto. The application for a license will first be filed with the national authorities who will examine it. If they reject it, there is no follow-up. If they accept the application, it is sent to the ECB which approves or rejects it. It does not matter whether a country belongs to the euro zone or just established a close cooperation. Revocation of banking license Decisions on revocation of a banking license are taken by national authorities, also in the case of a bank belonging to a banking group. CRD IV does not Nothing will change after make any changes in introduction of the SSM for countries this area. outside the SSM. In the case of countries within the SSM, decision on the revocation of the license may be take both by the national supervisor and the ECB. In the latter case, the national authorities and the ECB may specify the date by which they would take actions in order to solve the problem without resorting to the revocation of the license. If they do not, the ECB may revoke the license immediately. Acquisition and disposal of major blocks of shares Decisions in this regard are taken by national authorities. Regulations impose an obligation on CRD IV does not make any changes in this area. Nothing will change after introduction of the SSM for countries outside the SSM. In the case of countries within the SSM, the change consists in the fact that the national

11 the investor to notify the supervisor about acquisition of a major block of shares. The supervisor may refuse consent to exercise voting rights at the general meeting of shareholders. No decision within the set time limit is equivalent to granting the investor the right to exercise voting rights attached to shares. authorities must prepare a draft decision faster and send it to the ECB at least 10 working days before the expiry of the period within which it is possible for the supervisory authorities to raise objections. The ECB decides whether to raise objections or not. Assessment of the bank's procedures conformity with the rules concerning the bank capital requirements, securitization, the limit of large exposures, liquidity, leverage ratio, reporting and supervisory disclosure. Supervision over banks - evaluation of the bank management, risk management and all relevant requirements. The rules are the same as in section 4. Decision to authorize the use of advanced methods and second-pillar capital charges on the Bank is taken by: - the local supervisor, if the bank is not a member of a banking group, and - college of the supervisors, if the bank is a member of a banking group, however, in the absence of agreement between supervisors the decision is taken by the consolidating supervisor. The CRD introduced institution of colleges of supervisors that have to deal with a unified exercise of supervision over entities within the same banking group. At the level of an autonomous bank, the CRD IV does not make any changes in this area. In the case of a bank belonging to a banking group, the CRD IV significantly expands the consolidating supervisor's powers to virtually all supervisory decisions. The EBA has obtained a right to issue binding technical, supervisory and regulatory standards. The EBA is also supposed to develop a Single Supervisory Handbook (SSH), which, according to the EBA authorities, The SSM entrusts the ECB with rights and obligations of the consolidating supervisor with regard to all the tasks entrusted to the ECB. Decision-making procedure within the SSM and its comparison with the CRD IV approach are shown below. Procedures similar to the SSH are being developed by the ECB. They are to be applied within the SSM.

12 is to be binding on all EU supervisors. Remedial Actions. The rules are the same as in section 4. This issue is not addressed by the CRD. This issue is not addressed by the CRD. Remedial actions are dealt with in a separate directive. The SSM does not provide any special solutions in this field. The main principles set out by the BRRD will apply. Supervisory decision-making mechanism Differences in the corresponding decision-making procedures under the CRD IV and SSM regimes are shown below. CRD IV and colleges of supervisors SSM (and possibly colleges of supervisors) 1. Each supervisor prepares a draft decision on the bank under supervision. Each supervisor prepares a draft decision on the bank under supervision. 2. College of supervisors discusses decision concerning the group and the resulting possible decision amendments relating to individual entities. Board of Supervisors discusses decision concerning the group and the resulting possible decision amendments relating to individual entities. 3. Supervisors are to seek consensus. Supervisors are to seek consensus. 4. If it is not possible to reach consensus, decision is taken independently by the consolidating supervisor. If it is not possible to reach consensus, the Board of Supervisors votes and adopts a draft decision by majority of votes. The governing Council approves or rejects this draft. 5. A party not satisfied with the decision of the consolidating supervisor may apply to the EBA with a request to settle a dispute in the course of binding mediation. 6. In the course of binding mediation, a panel headed by the EBA Chairman and two supervisors prepares a proposal of the verdict which then is approved or rejected by the majority of the EBA members. 7. Failure to abide by the EBA decision is to be considered as breaking the European Union law. It is possible to point to adverse fiscal impact, but this fact requires a convincing justification. For the SSM countries outside the euro zone, a possibility has been provided to immediately withdraw from the SSM if the decision taken by the Board of Supervisors brings about adverse fiscal consequences for those countries. It is

13 important to note that position taken by a participating supervisor does not require a detailed justification. If the Governing Council does not approve the proposal submitted by the Board of Supervisors concerning a country outside the euro zone, the said country has the right to request a renewed examination of the matter, and in the case of unfavourable settlement may refuse to abide by the decision of the Governing Council. The ECB (Board of Supervisors, Governing Council) may remove such a country from the SSM after due and detailed consideration of the consequences of such exclusion for a given country and the rest of the SSM.