Blog Post

Criteria for entry into the ERMII and the banking union: the precedent from Bulgaria

In its bid to join the single currency Bulgaria has made commitments on financial supervision but also wider structural reform which set a precedent for future applicants for participation in the exchange rate mechanism ERMII. Most conditions, though not all, are justified by the additional demands of the banking union. But the envisaged timeline seems ambitious, and verification will not be straightforward.

By: Date: August 29, 2018 Topic: European Macroeconomics & Governance

The Eurogroup in July clarified Bulgaria’s path into the European Exchange Rate Mechanism (ERMII). This will be preceded by a close cooperation with the ECB in the context of the banking union, which in turn will depend on fulfilling a number of commitments on financial sector supervision and structural reform. Once ERMII entry has been agreed there will be no option by other currency union members to veto euro adoption. Bulgaria would then become the first EU country to accede to the economic and monetary union (EMU) since Lithuania did so in 2015.

Following a devastating debt and banking crisis, Bulgaria has successfully operated a currency board since 1997 with a rate irrevocably fixed to the German mark and the euro. It would seem that exchange-rate stability can be easily maintained.

But there have been persistent doubts about the quality of banking supervision in Bulgaria. Membership in the banking union is therefore desirable and has been actively promoted by Bulgaria (see the previous Bruegel research and blog on this topic). Three-quarters of Bulgaria’s banking sector are foreign-owned, but in 2014 the country saw runs on its locally owned third- and fourth-largest banks, and the collapse of the latter. Only last year, indictments were brought against the main owner of that bank, and senior central bank managers.

Common supervision will now be prepared over the coming year, including a stress test of the banks. In addition, Bulgaria has made a number of wide-ranging commitments – including on governance, legal and judicial reforms – which it seeks to implement over the coming months.

These commitments seem desirable in their own right – but which are essential for participation in the banking union, and can they realistically be implemented within the short timeframe that is envisaged?  The conditions can be summarised under five headings:

  • Strengthen bank and systemic supervision. This is an essential addition to the euro-entry criteria and, in light of Bulgaria’s recent crisis, clearly very relevant. Within Bulgaria’s currency board regime the national bank is experienced in applying ‘macroprudential’ supervision and has already had some success in stemming a credit boom ahead of the financial crisis. The two conditions seem well defined, realistic and desirable for entry into the banking union.
  • Strengthen supervision of the non-bank financial sector. It is less clear why this is essential for entry into the banking union, within which a common standard of bank supervision and procedures for bank resolution have been established. As in most new EU Member States, Bulgaria’s non-bank sector is small, accounting for about a quarter of system assets. A recent review flagged problems in the capitalisation of some insurance companies and risks to benefits accruing from pension funds. The supervisor is outside the central bank, and may have failed in some of its tasks. While these are important issues in financial supervision, the relevance for bank soundness and potential resolution costs within the banking union is less clear.
  • Strengthen the anti-money laundering framework. This seems a timely and sensible addition to the requirements for banking union membership. As was clear in the recent banking crisis in Latvia, even a hint of operational and conduct risk can have immediate consequences across the banking system. The implementation into law of the latest EU Directive should be straightforward to verify, and could be done swiftly. Empowering the independent financial crimes unit and establishing the information exchange with the supervisor may prove to be more protracted processes.
  • Address gaps in the insolvency framework, and strengthen the judiciary. Poor insolvency regimes and inefficient judiciaries are a key reason for the slow pace of non-performing loan (NPL) resolution in many Member States, where provisioning is often inadequate. Different creditor rights and problems with enforcement will limit integration between national financial markets. In the case of Bulgaria, an extensive report flagged a large number of shortcomings relative to best practice in the World Bank’s insolvency standards. The average time to resolve insolvency is over three years, though this is by no means the worst in the euro area. Best practice in insolvency law is easy to define and clearly desirable for a well-functioning and open financial system. But implementation will crucially depend on the reform of the judiciary, which will be much harder to monitor.
  • Align legislation with the OECD Guidelines on corporate governance of state-owned enterprises (SoEs). This seems the most ambitious of the conditions, and the one least relevant to membership in the banking union. It sets a high hurdle for other future applicants in emerging Europe with traditionally extensive state sectors, importantly for Croatia as another likely applicant. There is a sizable sector consisting of about 800 state enterprises in Bulgaria, accounting for about 6% of output. This is large, though not necessarily out of line compared to others in the currency union. In its country assessments the Commission has pointed out weak performance in the sector. It does not follow that the state sector poses a direct risk to financial stability, and in fact this issue is scarcely mentioned in the latest IMF assessment. It is no doubt possible to reflect the OECD standards in national legislation in the coming months, but implementation within the administration could be lengthy. For instance, a state-ownership agency will need to be resourced and empowered. Governance practice within enterprises will likely lag such standards for some time.

Bulgaria’s recent banking crisis underlined important shortcomings in financial supervision. This is now to be addressed relatively swiftly, and a full stress test should give further confidence. But since EU accession in 2007 there has been a long history of delayed structural reforms, which the Commission has tracked through its so-called Cooperation and Verification Mechanism.

As the Eurogroup expects to follow a similar approach with other Member States seeking to join ERMII, it should be mindful that structural and governance obstacles to deep financial integration cannot be overcome quickly.


Republishing and referencing

Bruegel considers itself a public good and takes no institutional standpoint. Anyone is free to republish and/or quote this post without prior consent. Please provide a full reference, clearly stating Bruegel and the relevant author as the source, and include a prominent hyperlink to the original post.

View comments
Read article More on this topic More by this author

Blog Post

Croatia’s path into the banking union

Croatia seems a suitable candidate for euro area accession: there is a tight peg to the euro, high public debt is coming down, and the banking sector is already dominated by euro area banks. But the Eurogroup has rightly targeted reforms of the state’s role in the economy as a precondition for participation in ERM II and the banking union. None of the announced reform plans are new or easily concluded within the timeframe that has now been agreed.

By: Alexander Lehmann Topic: European Macroeconomics & Governance Date: July 18, 2019
Read article More on this topic

Blog Post

‘Lo spread’: The collateral damage of Italy’s confrontation with the EU

The authors assess whether the European Commission's actions towards Italy since September 2018 have had a visible impact on the spread between Italian sovereign-bond yields and those of Germany, and particularly whether the Commission’s warnings have acted as a ‘signalling device’ for bond-market participants that it might be difficult for Italy to obtain the support of the ESM or the ECB’s OMT programme if needed.

By: Grégory Claeys and Jan Mazza Topic: European Macroeconomics & Governance Date: July 8, 2019
Read article More on this topic More by this author

Podcast

Podcast

Director's Cut: Priorities for the new ECB president

In this Director's Cut of 'The Sound of Economics', Guntram Wolff talks to two of the authors of Bruegel's memo to the new ECB president, Maria Demertzis and Grégory Claeys, to specify the most important issues at the beginning of this eight-year cycle and to clarify the parameters within which the new incumbent will have to work.

By: The Sound of Economics Topic: European Macroeconomics & Governance Date: July 4, 2019
Read article Download PDF More on this topic

Policy Brief

Preparing for uncertainty

Memo to the president of the European Central Bank. Grégory Claeys, Maria Demertzis and Francesco Papadia present the challenges that the next ECB president will face during the upcoming mandate, reinventing monetary policy in a system riddled with uncertainties.

By: Grégory Claeys, Maria Demertzis and Francesco Papadia Topic: European Macroeconomics & Governance Date: July 3, 2019
Read article More on this topic More by this author

Podcast

Podcast

Director's Cut: ECB monetary policy decisions deconstructed

In this Director’s Cut, Bruegel’s Grégory Claeys and Maria Demertzis take a deeper look at whether the monetary policy decisions made by the ECB over the past three presidential eras arrived by consensus, by unanimity or by majority votes of the governing council.

By: The Sound of Economics Topic: European Macroeconomics & Governance Date: June 27, 2019
Read article More on this topic

Blog Post

The evolution of the ECB governing council's decision-making

Before it is decided who will chair the governing council for the next eight years, the authors look back and examine precisely how decisions have been taken since the ECB was created – by unanimity, by majority, or by consensus.

By: Grégory Claeys and Tanja Linta Topic: European Macroeconomics & Governance Date: June 27, 2019
Read article More on this topic More by this author

Blog Post

The next ECB president

On May 28th, EU heads of state and government will start the nomination process for the next ECB president. Leaving names of possible candidates aside, this review tries to isolate the arguments about what qualifications the new president should have and what challenges he or she is likely to face.

By: Konstantinos Efstathiou Topic: European Macroeconomics & Governance Date: May 27, 2019
Read article More on this topic More by this author

Blog Post

Developing resilient bail-in capital

Europe’s largest banks have made progress in issuing bail-inable securities that shelter taxpayers from bank failures. But the now-finalised revision of the bank resolution directive and a new policy of the SRB will make requirements to issue such securities more onerous for other banks. In order to strengthen banking-system resilience, EU capital-market regulation should facilitate exposures of long-term institutional investors.

By: Alexander Lehmann Topic: Finance & Financial Regulation Date: April 29, 2019
Read article Download PDF More by this author

External Publication

European Parliament

Taking stock of the Single Resolution Board: Banking union scrutiny

The Single Resolution Board (SRB) has had a somewhat difficult start but has been able to learn and adapt, and has gained stature following its first bank resolution decisions in 2017-18. It must continue to build up its capabilities, even as the European Union’s banking union and its policy regime for unviable banks continue to develop.

By: Nicolas Véron Topic: European Macroeconomics & Governance, European Parliament, Testimonies Date: April 18, 2019
Read article More on this topic More by this author

Podcast

Podcast

Director's Cut: The case for a legislative remedy for recessions

Bruegel's Maria Demertzis welcomes Yale Law School professor Yair Listokin to this Director's Cut of 'The Sound of Economics', to discuss how law might be deployed as a macroeconomic tool to counter financial crisis.

By: The Sound of Economics Topic: European Macroeconomics & Governance Date: March 12, 2019
Read article More on this topic

Blog Post

The European Union must change its supervisory architecture to fight money laundering

Money laundering scandals at EU banks have become pervasive. The authors here detail the weaknesses the current AML architecture's fundamental weaknesses and propose a new framework.

By: Joshua Kirschenbaum and Nicolas Véron Topic: European Macroeconomics & Governance Date: February 26, 2019
Read article More on this topic More by this author

Blog Post

Greening monetary policy: An alternative to the ECB’s market-neutral approach

The ECB’s market-neutral approach to monetary policy undermines the general aim of the EU to achieve a low-carbon economy. An alternative tilting approach would foster low-carbon production, accelerating the transition of the EU to a low-carbon economy, and could be implemented without undue interference with the chief aim of price stability.

By: Dirk Schoenmaker Topic: European Macroeconomics & Governance Date: February 21, 2019
Load more posts