The "unrecognized" risk for banks from joining ERM-II

Last week, we thoroughly refuted Prime Minister Borisov's claims about the alleged "benefits" of joining the ERM-II exchange rate mechanism in the current crisis. Now we turn our attention to the other side of the coin - the potential risk that we would take upon joining the ERM. The biggest risk is related to the banking system and is in line with the requirement that Bulgaria join the Banking Union upon joining the ERM-II exchange rate mechanism before it becomes part of the euro area.

We have already written about the myths about the quality of the European Central Bank's banking supervision (compared to that of the Bulgarian National Bank). The Banking Union is not a panacea and certainly will not give us guaranteed protection against a repeat of the Corp. But in essence – what is the problem with the condition to join the Banking Union upon entering ERM-II, which condition the ECB sets for us?

First, this condition contradicts the intentions of the government itself at the beginning of the negotiations for joining the exchange rate mechanism. In early 2018, Finance Minister Vladislav Goranov said that they were working on joining ERM-II, "in order to continue towards simultaneous, I emphasize simultaneous membership in the euro area and the Banking Union, because you cannot be a member of the Banking Union without being a member of the euro area.

Note that then Mr. Goranov "emphasizes" that the goal is to join the Banking Union and the Eurozone simultaneously. Why? Well, because joining the Banking Union before joining the Eurozone itself carries with it serious risks related to the stability of the banking system, according to the words of the Governor of the Bulgarian National Bank, Dimitar Radev. A few years earlier, in 2015, at a hearing at the Budget and Finance Committee of the Parliament, he declared himself against joining the Banking Union before joining the Eurozone. According to him, if Bulgaria joins the Banking Union without being a member of the Eurozone, this will lead to:

"erosion in the control functions of the BNB, before full membership " in the eurozone and adds that "incentives will arise for banks from the eurozone to convert their subsidiaries in Bulgaria into branches, which will firstly not have the obligation to maintain capital in the country. And secondly, they will not be subject to control by the BNB in terms of their liquidity. In my opinion, such a development, especially in the context of the crisis with Greece, is unacceptable from the point of view of our interests."

Here Dimitar Radev talks about the banking crisis, which was still seriously raging in our southern neighbor at that time, in 2015. Remember that despite the deep debt and banking crisis that Greece fell into a few years ago, this was practically not felt in Bulgaria. Although there were many banks with Greek ownership in our country, none of them experienced problems with their capitalization and liquidity. While their Greek mothers such as Alfa Bank, Piraeus and Eurobank (owner of Postbank) were on the verge of bankruptcy and had to be rescued by the state, their subsidiaries in Bulgaria remained stable. In fact, the only bank that went bankrupt during this period was with Bulgarian ownership.

This is exactly what Mr. Radev is talking about. During the Greek crisis, our Greek-owned banks remained stable precisely because they were not integrated into the eurozone banking market and the regulatory framework of the European Central Bank, as they would be if we entered the Banking Union. As the Governor of the BNB says, with membership in the Banking Union, foreign bank owners can convert their Bulgarian companies into branches in order to freely transfer capital in the event of a crisis, which, by the way, we are currently in. This means that they will be able to decapitalize Bulgarian banks in order to capitalize their main larger companies abroad. This would threaten the stability of the Bulgarian banking system in order to support the one in...Italy, for example.

Italy is not a random example, but in fact a very relevant one, especially given that 1) Italy will most likely be the economy hardest hit by the current crisis, 2) the largest bank in Bulgaria (UniCredit) is Italian-owned, and 3) the Italian UniCredit is less well capitalized than the Bulgarian one. Recall that in the last ECB stress test last year, UniCredit Bulbank was one of the best capitalized banks in Bulgaria (and in Europe as a whole). After the asset quality review, UniCredit Bulbank had a core capital ratio of 23.1%, compared to a minimum of 8.0%. At the same time, a stress test in 2018 showed that the SET1 ratio of the Italian UniCredit was around 13%. Also above the minimum requirement, but still significantly lower.

What do you think could happen in a hypothetical scenario of a banking crisis in Italy, which is even very likely given the crisis that is hitting the economy there? A scenario in which the capitalization of banks in the country would collapse? This, of course, could happen with a different bank and in another eurozone member state, UniCredit and Italy are just examples. We must take these risks very seriously, given the very uncertain economic environment in which we find ourselves and the extremely severe crisis in which a number of economies in the eurozone, such as Italy, are on the verge of falling according to absolutely all forecasts at the moment (the IMF predicts a 9.1% decline in GDP in Italy in 2020).

Naturally, the question arises, even if there is this risk, which the BNB governor spoke about back in 2015, are there no rescue mechanisms through which the ECB could support the banking system in Bulgaria in the event of a possible liquidity and capital crisis? In principle, there are, but the catch is that we will not be able to take advantage of them until we become a member of the eurozone itself. The rules of the Banking Union are such that the ECB's regulatory supervision applies to all its members, but only banks in eurozone member states can benefit from the liquidity support mechanisms. In other words, if in principle the Banking Union is a coin with two sides, with risks on one side and support mechanisms on the other, when joining it before the eurozone we only take on the risks.

Kalin Hristov, head of the "Issue" department at the Bulgarian National Bank, also raised the alarm about this dangerous asymmetric treatment of countries that are in the Banking Union but outside the eurozone. In 2018, he wrote that "there are clear unattractive factors inherent in the "close cooperation" - the mechanism intended for member states whose currency is different from the euro, for inclusion in the Single Supervisory Mechanism." Here he speaks of a possible accession to the Banking Union in parallel with accession to ERM-II and adds:

"A country with a "close cooperation" will face extremely asymmetric treatment:

• It will remain excluded from final decision-making on supervisory matters in the Governing Council of the European Central Bank (ECB);
• ECB supervisory decisions that are not legally binding outside the euro area will have to be reproduced in acts of the local supervisory authority. The latter will be responsible in case of disputes;
• It will remain without access to liquidity support from the ECB;
• There will be no access to the Single Stabilization Mechanism as a potential source of funds for direct and indirect bank recapitalization."

As you can see, both the Governor of the BNB and the Head of the "Issue" Department believe that the requirement for Bulgaria to join the Banking Union in parallel with ERM-II, before adopting the euro, is an extremely asymmetric condition that carries with it serious risks for our banking system. The EKIP finds their assessment in this regard to be completely sober, especially in the context of a deep economic crisis, which we are currently entering. In view of this, two natural questions arise:

1. Why are the Prime Minister and the Finance Minister so persistently pushing Bulgaria towards membership in ERM-II and the Banking Union simultaneously, given that, according to the BNB, this would create risks for the banking system?
2. Why has this momentum been renewed and intensified right now, in April, when it is certain that the European economy is falling into a severe crisis with an unclear recovery horizon? In such a situation, any risks to the banking system are exacerbated many times over.

Prime Minister Borisov’s actions seem absolutely illogical. In February, before the outbreak of the economic crisis, he was ready to postpone Bulgaria’s application to join ERM-II until a broader debate on the topic was held and a public consensus was reached on whether this would be positive or negative for Bulgaria. There is still no such consensus, and at the same time, the eurozone economy is on the verge of falling into a severe recession, which will certainly shake the stability of its banking system. If we join the banking union at this very moment, these risks could be transferred to us, to our otherwise generally well-capitalized banking sector, in the words of the BNB Governor Dimitar Radev himself.

The EKIP believes that Minister Goranov and Prime Minister Borissov must first answer these questions before we rush headlong into ERM-II and the Banking Union. As is evident from the statements of the highest-ranking officials in the BNB, if the government does not carefully consider the risks of this step, led astray by unrealistic expectations of "trillions" of financing from the ECB, the security of the banking system and the savings of Bulgarian citizens could be seriously threatened, especially in view of the crisis that is sweeping Europe.

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