Summary of the July Monthly Report

European Single Supervisory Mechanism for banks – first step on the road to a banking union

The current financial crisis has exposed flaws in the architecture of banking supervision in the euro area. To solve this problem, a fundamental political decision was taken in 2012 to transfer extensive prudential tasks and powers, including the right to take sovereign measures, to the European level.

The European Council and the European Parliament have since reached a consensus on a regulation establishing a European Single Supervisory Mechanism (SSM). This confers far-reaching supervisory powers on the European Central Bank (ECB); the SSM itself will comprise the ECB and the national supervisory authorities of the euro-area countries. EU member states whose currency is not the euro are entitled to opt into the SSM.

The distribution of tasks within the SSM depends on whether an institution is classified as significant or less significant; the ECB will have direct supervisory powers over significant institutions, receiving assistance from national authorities in verification activities and the preparation of decisions. For less significant institutions, by contrast, these powers will lie primarily with national authorities, although they must exercise them in accordance with the ECB’s general instructions. In addition, the national authorities will be involved in the SSM’s panels and committees.

The SSM is only one component of the banking union; another key pillar will be a Single Resolution Mechanism with uniform rules for the resolution of banks. Work has already begun on these compo-nents of the banking union, too. Although the banking union cannot solve the current crisis, it can play a valuable role in making crises less likely in the future. To achieve this, it is important to ensure effec-tive governance structures, a clear-cut separation between monetary policy and prudential tasks and a sound legal basis for the new framework. Ongoing work on the banking union should therefore also involve examining the legal basis of the SSM and investigating potential improvements.

Differences in monetary and lending growth dynamics within the euro area and among its member states

At present, the key monetary developments in the euro area are moderate growth in the M3 money measure and a fall in the volume of loans to the domestic private sector. However, the aggregated euro-area figures mask very different developments among the individual euro-area countries. Portfo-lio shifts in the core euro-area states, notably Germany, are driving the positive M3 growth, whereas the weak lending dynamics mainly reflect the ongoing reduction of loans to the private sector in the peripheral euro-area countries.

These diverse developments pose a challenge for euro-area monetary analysis. Evaluating monetary dynamics purely on the basis of aggregated euro-area developments would be simplistic. Instead, an essential first step is to identify the causes of the countervailing developments in monetary and lending growth at national level. Looking at Germany, which is currently making by far the largest positive contribution to euro-area M3 growth, these analyses point to a temporary rise in money demand. This raises the question of how form these increased liquid holdings will be run down again. By contrast, an analysis of the peripheral countries shows that, alongside economic developments, the main reason for the reduction in loans is the necessary correction of credit overhangs that had built up in the past. Downside risks could arise for these countries if any further adverse shocks were to occur because of negative feedback effects between credit supply and developments in the real economy.

Euro-area monetary policy can only respond to these kinds of country-specific risks if they pose a threat to price stability throughout the euro area. Otherwise, action must be taken in other policy areas. If, say, there were signs of asset price inflation in certain market segments in Germany but this did not have an impact on the entire euro area, macroprudential tools would have to be employed at national level to counter this development. By contrast, the downside risks in the peripheral countries are mainly due to the fact that their banking systems are vulnerable to further negative shocks. A whole range of measures will be needed to combat this problem, such as the disclosure of existing or expected losses – including corresponding write-downs on balance sheets – a decision on the resolu-tion, restructuring or recapitalisation of troubled banks and legislation designed to prevent new vul-nerabilities from arising in the future.

Estimating yield curves in the wake of the financial crisis

Yield curves capture the relationship between bond maturities and bond yields. They provide a whole range of information, such as insights into market participants’ growth and inflation expectations, and are therefore also relevant to monetary policy. Since the onset of the financial, banking and sovereign debt crisis, however, it has become more difficult to interpret yield curves, as factors such as liquidity risk or default risk are now having an increasing impact on yields.

Against this backdrop, the July Monthly Report comments on the results of methods that can be used to isolate a wide array of yield curve determinants. These include growth and inflation expectations and term premiums which change over time, as well as influences stemming from the market struc-ture, such as liquidity haircuts. These methods range from simply determining the differences between two yield curves to identify premiums which are contained in only one of the two curves to estimating affine term structure models with macroeconomic factors.

The article finds that it is not always possible to clearly identify changes in inflation expectations or changes driven by liquidity or credit ratings. However, the analytical tools it presents help to shed some light on developments in yield curves and their determinants. Yield curve models are therefore also a valuable point of departure for gaining a better understanding of monetary policy transmission.