The European Union Banking System - Case Study Example

THE EUROPEAN ECONOMY Introduction The European Union banking system is the major conduit that finances the economy of European Union member states. The institution, like most global economies suffered a great blow in the global economic meltdown. The European System of Central Banks (ESCB) constitutes all national central banks of member states and the European Central Bank (ECB), which was incepted in 1 June 1998. All these have embraced a single currency, the euro, forming what is commonly known as the Eurosystem. ESCB plays a central role in strengthening price steadiness within the financial block by formulating and implementing strong financial policies. Main Features of European Banking System In the last two decades some financial driven reforms have been incorporated in member economies in order to spawn economic transformation based on current market centralized models. The comparison majorly concentrates on distinguishing features of the EU- 28 member countries and new member states of the European Union. During the era of financial crisis, the size of GDP per capita in the new member states significantly reduced compared to that registered by the EU- 28 states (Stefan, 2011). After the end of the financial crisis in 2010, GDP per capita increased in the EU-28 countries at 30.14 euro compared to 9.33 euro in the new member states giving them an edge over the new member countries despite the financial crisis. The quick economic recovery enabled the new EU member states to narrow the existing gap thereby enabling them reach 63% purchasing power. This elevation did not occur unanimously among all new member countries prior to the crisis. This in effect triggered several non-performing loans in some of the new entrants; a case of Czech Republic in 2004 severe financial crisis. A score of financial innovations integrated in the European Union block helped was a great leap forward in attaining sustainable economic growth. Concerning the European Union financial system, the EU-28 member countries adopted superior and developed financial system which enabled it propel to its current economic power. Therefore, the value of financial systems asset in the EU-28 rose to a value of approximately 512.5% of the GDP in comparison with 149.4% in the new member states in 2010 (Stefan, 2011). The EU-28 countries represent a larger share of assets held in GDP at 364.24% compared to just 112.63% for new member countries. This implies that the European banking system is dominated by the banking sector followed by the capital market except for some countries like The Great Britain where the reverse is true. For the new members, the level of assets held by insurance companies, investment funds and pension funds remain significantly low in comparison with banking sector due to the fact that the intermediaries tend to be very specific in their field of activity. The above therefore affirms that the main component of the EU financial system is sustained by a healthy bank component alongside the capital markets. Apparently there exist a series of notable differences concerning members’ states financial systems makeup. In 2010, the EU-28 countries recorded an increase in ratio of banking assets in GDP of 364% whilst a dropping ratio of firms capitalization in GDP at only 60%. The case with new members witnessed 113% for banking assets and 18.5% for other firms. This also provides an indication of a huge underlying development potential possessed by the new member states concerning their financial institutions. These differences portray huge potential within the banking systems in the new member states which motivate the foreign banks located in the EU-28 to increase their investment activities within these markets (Chrisdoulaki, 2010). In addition, the deposits and loans from European banking systems is on an increasing trend and almost doubled in the past decade at the EU level. Unlike other states, the rate of development was relatively slow due to the delays incurred in the restructuring of nonperforming loan investments accumulated by the banking sector back in the last two decades. There occurred a common case of declining number of banks from the new European Union member states due to the financial market metamorphosis and changing dynamics triggered by the deepening European integration process (Chrisdoulaki, 2010). A large number of affiliation and possession took place during this transformation phase in the block across regions of the block. The banks located in the EU-28 countries actively transacted in this period which is emphasized by their huge banking asset shares in the new countries to up to 95% in some countries. In the EU-28 countries, the share of foreign banks is much smaller due to the fact that these markets are far more sophisticated therefore reducing the possibility of the foreign banks to absorb a considerable market share to sustain its activity. The value of Herfindahl index in the EU-28 countries noticeably increases compared to the new member states due to the increasing competition in the banking systems. Lately, this has increased in the new member states due to the strengthened banking positions and the divergence of smaller banks in these countries during the financial crisis. In summary, there exist differences in banking activities within each member state outlined in the European banking system which constitutes the major financial system in European Union. The integration of the European financial system in all member state will therefore ensure strong and sustainable financial development achieved at EU level of economic growth. Mitigation of Financial Crisis The adoption of well-structured European Fiscal Compact will spawn radical positive impact in the European Union banking systems. Restrictions to budgetary deficits regulate governmental expenditures and therefore new profitable and safe investments must be assimilated by the big European banks to reduce governmental bonds (Grundmann, 2011). Higher investment in the SME sector can spontaneously produce higher economic gains, and reduce governmental expenditure on non-performing loans. The Europe 2020 strategy provides for a higher incentive funding by banks to the SMEs and overall reduction of its operation costs to break-even. This is fundamental as the banks will be prone to adopt latest technological milestones that will increase tailored customer service penetration at low cost. Recent developments in smart phone technology, expansion of internet coverage and smart cards has already expressed increasing potential of growth of the banking sector. Reduction of large branch networks with large staff to modern internet banking and other smaller distribution channels with call center support has also shown progress in service delivery in the sector. It is projected that the European banking sector will continue their involvement in cross-border transactions in the retail sector due to the adoption of the TARGET2 and SEPA by all member states. These systems will likely reduce banks profit margins and therefore it is expected that they will increase their cross-border volumes and service sales. It is apparent that the EU banking systems will shift attention to increasing internet banking with major emphasis on funds transfer and payment of services for all customers (Arundale, 2007). The Green-Paper policy adopted by the European Commission in 2011 experienced a rising need in internet and mobile payments stimulated by development of new technologies and the ever-changing customer needs. The banks are undergoing major transformations as they recover from the economic crisis and are also strengthening their financial structures to harmonize operations and mitigate future occurrences. Formation of European System of Central Banks (ESCB) The core mission of ESCB is governed by the different decision making bodies of European Central Banks (ECB) which is responsible for realization of ESCB’s mandate. The guidelines outlined by the ECB are also used by central banks of member states in accordance with EU financial policies. The responsibilities of ESCB are managed by the Governing council, which makes major decisions for the ECB necessary for achieving ECB’s mission. It is also mandated with formulating strong financial policies in the member states. The other board is the Executive Board which constitutes the President and Vice-President and four appointed members. The main role of this body is implementing financial policies spelled by the Governing Council as well as running the management of the ECB. The General Council comprises of board’s President and Vice-President and the central bank governors of member countries. It majorly contributes to advising roles of the ECB as well as statistical analysis of the financial roles of the bodies. Responsibilities of the ECB The ECB jointly collaborates with the central banks of member states in order to realize ESCB’s mandate. These responsibilities are instituted in a framework designed by ESCB and include; issuing of bank currency in the euro zone. They are mandated with authorizing the money quantities that is issued by the national banks. It is also their responsibility to open accounts for the credit market participants in the euro zone. The body is also authorised to open market operations in ways of borrowing or lending in the member states and fostering international relations with third countries, international organizations and the national central banks of the member states. Comparison to American Federal Bank The American Federal bank was created after successfully passing the Federal Reserve Act in 1913 so as to provide for a more directional financial management system in the states. The objectives have undergone several changes to suite the changing financial climate. Both institutions have similarities and differences as they are all financial institutions operating in different geological areas. First, EU banking systems mainly target to achieve price stability whereas the Fed aims at achieving monetary stability and a sustainable financial system. Price stability is attained by implementing M3 financial policy which also predicts prospective price changes in the euro zone (Bernanke, 2013). This is accurately achieved by inflation analysis in the region. On the other hand, the federal bank financial system does not provide for a solid intermediary intervention. A solid way of determining independence is hinged on the criteria for appointing members of the central bank board. The president appoints all members of the federal bank and thereafter the senate further approves the board. As mentioned before, the members of the ESCB are not subjected to nomination and confirmation procedure by the European Parliament, as is the case in federal bank system. Changing the statues of ESCB requires changing Maastricht Treaty by all EU member states. In the federal bank system, the parliament directly controls the exchange rate which is driven by the urge to reduce unemployment and pay debts. On the other hand, in European Union bank systems, the exchange rate is not incorporated in the national policy. The federal bank has to work within the limitation of setting targets and formulating policies. These indicators therefore make ESCB the most independent bank as opposed to the federal bank. The aspect of accountability greatly varies between the two banks. The approval procedure makes employment situation in the States a direct responsibility of the federal bank. The absence of strong political institutions in EU responsible for overseeing performance of ESCB portrays weakness in financial accountability in this institution (Bernanke, 2013). The core responsibility of the federal bank is to enhance a strong banking supervision role within the Federal Reserve System. Conversely, in European Union bank system, supervision of banking activities is done by the national banks of member states (Brezina, 2012). The federal bank share responsibilities with other banking agencies to ensure an effective supervision role. ECB ensures price stability and at the same time, it is bound by the Treaty to foster strong economic statutes in the member states provided it does not interfere with price stability. This shows unclear objective of ECB therefore limits its accountability as opposed to federal bank system which advocates for superior accountability in the financial playground (Brezina, 2012). Quantitative Easing (QE) Quantitative Easing (QE) is the process that involves the introduction of new currency into the capital supply by a central bank. It could also include an alternative monetary strategy in which the central bank procures the government and market securities in order to reduce the interest tariff and boost monetary supply. This strategy increases monetary supply by streaming monetary bodies with capital to encourage easy loaning and liquidity. The process focuses on increasing interest rates by avoiding printing of new money. The modern EU was founded on treaties that prohibited the ECB from financing governments, except buying their bonds. The move by the European banks against increasing the supply of funds was geared towards stopping overspending by governments while promoting competition. When the ECB was urged to scale up its stimulus measures, the total government bonds purchased did not exceed nine percent. In contrast, by the end of 2012, the Fed’s balance sheets quadrupled to more than four billion dollars. In Europe, the Fed’s QE style must overcome both political and practicality challenges. In the US, most companies get funds from selling bonds rather than bank loans as is the case in EU. The ECB only purchases sovereign bonds equal to the size of the member state and so the mass will come from some of its member states like France and Germany where yields have reduced to the minimum. Therefore, the effectiveness of the Fed’s QE system proves to be more advanced and market-driven compared to the EU’s QE system. Conclusion The ESCB and American Federal bank constitute the world’s most financial bodies. Significant differences exist between these two financial institutions in terms of objectivity, independence and monetary policy structure. The ESCB offers more independent financial systems than the federal bank. The federal bank however institutes a clear institutional objectivity which instills a higher degree of accountability contrary to ESCB. Due to this reason, the federal bank emerges as a more transparent bank system than ESCB. The European Union financial system is more integrated due to its vastness contrary to the federal bank which has a segmented monetary system. Reference List Bernanke, B. 2013, The Federal Reserve and the financial crisis, Princeton University Press, Princeton. Brezina, C. 2012, Understanding the Federal Reserve and monetary policy, Rosen Publishers, New York. Chrisdoulaki, S. 2010, EUs Position Regulations on the Financial Sector, GRIN Verlag GmbH, München. Grundmann, S. 2011, Financial Services, Financial Crisis and General European Contract Law: Failure and Challenges of Contracting, Kluwer Law International, London. Arundale, K. 2007, Raising Venture Capital Finance in Europe: A Practical Guide for Business Owners, Entrepreneurs and Investors, Kogan Page Limited, London. Read More