In 1999, 11 European countries introduced the euro as their single currency. These countries, which were joined by others as time passed, form the euro area.
There are many advantages to a single currency area.
The advantages of a currency union are plain to see. When a country introduces the euro, it replaces its individual national currency. Travellers within the euro area countries no longer need to change money. It is easier to make purchases abroad or compare prices. Trade barriers, such as currency exchange, no longer exist. Similarly, there is no more uncertainty about how exchange rates will develop in the future. Businesses gain planning certainty and can reduce their costs. This strengthens cross-border trade and promotes growth and employment. In addition, the euro has created a single European financial market, which makes it easier for enterprises to raise capital and for investors to invest capital.
The journey to a single European currency took several decades. After two devastating world wars, the formerly hostile countries of Europe slowly came closer together in the 1950s.
In April 1951, the European Coal and Steel Community (ECSC) was established by Belgium, France, Italy, Luxembourg, the Netherlands and West Germany. The ECSC was the first supranational European institution.
In 1957, these same countries established the European Atomic Energy Community (Euratom) and the European Economic Community (EEC), which created a single European market. These resolutions are named the Treaties of Rome, after the place where they were signed.
In April 1965, Europe came even closer together: the economic unions – the ECSC, Euratom and the EEC – were merged to form the European Communities (EC).
In October 1970, a commission chaired by the Prime Minister of Luxembourg, Pierre Werner, presented a plan for European Economic and Monetary Union (EMU). The plan consisted of three stages: stronger coordination of economic and monetary policy from 1971 to 1973, more binding harmonisation of economic and monetary policy from 1974 to 1979, and the transfer of economic policy powers to the European level and the introduction of a single currency in 1980.
The first step in the gradual implementation of the Werner Plan was the creation of the European exchange rate arrangement (also known as the “currency snake”) in 1972. The idea was for the exchange rates of the EC countries to fluctuate only within a band of 2.25% above or below a central rate. Because there were too many exchange rate adjustments between the EC countries, the European exchange rate arrangement not only lost many participants, but the second stage of the Werner Plan was never even implemented. Nonetheless, the EC continued to grow: in 1973, the six founding members of the EC were joined by Denmark, Ireland and the United Kingdom.
With the introduction of the European Monetary System (EMS) in 1979, the EC Member States launched a new effort to coordinate their monetary policies. The EMS was based on the concept of stable but adaptable exchange rates. Within the EMS, exchange rate fluctuations were steered by an exchange rate mechanism. This was centred on the European Currency Unit (ECU).
The plans for the monetary union of today were laid out in 1989.
In February 1986, the 12 EC Member States – following the accession of Greece, Portugal and Spain – signed the Single European Act (SEA). Its objectives included the establishment of the single European market by 1992, allowing for the free movement of goods and services, persons, and capital and payments within the EC.
In the spring of 1989, an expert commission chaired by the President of the European Commission, Jacques Delors, presented a new three-stage plan for European Economic and Monetary Union. Following on from this, the European Council decided in June 1989 to start the first stage of achieving Economic and Monetary Union on 1 June 1990.
The first stage of the plan aimed to align the monetary and fiscal policies of European countries more closely than before with the requirements of price stability and fiscal discipline. In order to achieve this, measures were implemented that strengthened central banks’ independence from their respective governments. In addition, the participating countries abolished all capital controls in order to ensure the unrestricted movement of capital.
The Treaty on European Union (also known as the Maastricht Treaty), which was signed by the EC Member States in Maastricht on 7 February 1992, is considered an important milestone of the first stage of Economic and Monetary Union. The Treaty deepened the integration of Europe, giving it the new name of European Union (EU), and specified the roadmap for the implementation of the next two stages by January 1999 at the latest.
Furthermore, the signatory states committed themselves for the first time to “convergence criteria” (also known as the Maastricht criteria). Compliance with these fiscal and monetary standards across EU countries is intended to ensure economic stability and soundness within the Economic and Monetary Union.
The second stage began on 1 January 1994 with the establishment of the European Monetary Institute (EMI) in Frankfurt am Main.
The EMI paved the way for the third stage in terms of regulation, organisation and logistics. However, the national central banks continued to implement monetary and exchange rate policy until 1 January 1999 – in Germany, this was the Deutsche Bundesbank.
In December 1995, the Heads of State or Government of the European Union (European Council) agreed on the name “euro” in Madrid. The following year, the EMI unveiled the winners of the competition to design the new euro banknotes.
On 17 June 1997, the European Council agreed on the Stability and Growth Pact in Amsterdam. In the pact, the EU countries undertook to maintain fiscal discipline, as already set out in the Maastricht Treaty, and to continue to do so after joining monetary union.
On 2 May 1998, the Council of the European Union concluded that 13 of the 15 EU Member States fulfilled the convergence criteria laid down in the Maastricht Treaty. Sweden and Greece did not meet the criteria at that time.
On 1 June 1998, the European Central Bank (ECB) and the European System of Central Banks (ESCB) began their work. They replaced the EMI.
Of the 13 countries that fulfilled the convergence criteria, 11 adopted the euro as the single currency at the beginning of 1999: Austria, Belgium, Finland, France, Germany, Ireland, Italy, Luxembourg, the Netherlands, Portugal and Spain. Denmark and the United Kingdom decided to opt out of the single currency and thus not to take part in the third stage of Economic and Monetary Union.
With the launch of the third stage of Economic and Monetary Union on 1 January 1999, the exchange rates of the participating countries’ national currencies to the euro were irrevocably fixed. The euro became the single currency of 11 countries. The Deutsche Mark conversion rate was set at EUR 1 = DEM 1.95583.
While trying to find a name for the single currency, various options were discussed, including “Ecu”, “thaler”, “ducat”, “franc” and “florin”. In December 1995, the European Council decided on “euro”, a newly created name with a clear reference to the continent of Europe that is the same in all official languages of the European Union while also being easy to pronounce. The euro symbol (€) was derived from the first letter of the word “Europe” and its design was based on the Greek letter epsilon, thus establishing a link to ancient Greece as the cradle of European civilisation.
The look of the euro banknotes was determined in a design competition. Designs could be submitted based on either the theme of the “ages and styles of Europe” or a freely selected abstract or modern design. Out of 44 submissions, the design proposed by Robert Kalina, a graphic artist from the Oesterreichische Nationalbank, was selected as the winner.
For the first three years, the euro only existed as book money. The banknotes and coins of the national currencies continued to serve as cash. In the financial markets, prices were already being quoted in euro, and all euro area Member States issued their sovereign debt instruments exclusively in euro from the start of 1999. Outstanding securities were converted to euro.
The euro was introduced as book money in 1999, then as cash in 2002.
Euro banknotes and coins were introduced as legal tender on 1 January 2002. The national currencies that had been legal tender up to that point lost this status. During a transitional period, it was initially possible to pay using both old national cash and euro cash, and many businesses still displayed their prices in both currencies. However, the national central banks issued only euro and gradually withdrew the national banknotes and coins from circulation.
Of the 27 EU countries, 20 now belong to the euro area: Austria, Belgium, Finland, France, Germany, Ireland, Italy, Luxembourg, the Netherlands, Portugal, Spain, Greece, Slovenia, Cyprus, Malta, Slovakia, Estonia, Latvia, Lithuania and Croatia.
Accession to the euro area is conditional on meeting the convergence criteria.
EU countries that have not yet adopted the euro as the single currency are, in principle, obliged to join the euro area once they meet the convergence criteria. One exception to this is Denmark, which has negotiated an opt-out clause. It can decide for itself whether to adopt the euro as its currency if it meets the convergence criteria. The same also applied to the United Kingdom until its withdrawal from the EU (Brexit) on 1 February 2020.
In order to assess the stability level of potential participating countries, the “convergence criteria” were established and are used to decide whether a country can adopt the euro.
the inflation rate may not exceed the inflation rate of the three best-performing EU Member States by more than 1.5 percentage points.
the nominal interest rates of long-term government bonds or comparable securities should not exceed those of the three best-performing EU Member States in terms of price stability by more than 2 percentage points.
the annual fiscal deficit should not exceed 3% of gross domestic product and overall government debt should not exceed 60% of gross domestic product.
the candidate country must have participated for at least two years in the exchange rate mechanism (ERM II), a system of fixed exchange rates with the euro as its key currency. Within those two years, the exchange rate of the candidate country’s currency must not have been subject to strong fluctuations against the euro. The idea is for the candidate country to thus demonstrate that its own economy is not dependent on occasional currency devaluations.
As not all EU Member States are part of the euro area, a distinction is made between the European System of Central Banks (ESCB) and the Eurosystem.
Eurosystem: European Central Bank (ECB) and national central banks of the euro area countries
The ESCB is composed of the European Central Bank (ECB), which is based in Frankfurt am Main, and the national central banks (NCBs) of all EU Member States. The Eurosystem comprises the ECB and only the NCBs of the EU Member States that have adopted the euro as the single currency.
The ECB is the central institution of the ESCB. Its primary task is to ensure price stability in the euro area and thus preserve the purchasing power of the euro. Since 2014, the ECB has also been responsible for banking supervision in the euro area under the Single Supervisory Mechanism.
The Governing Council of the ECB is the Eurosystem’s highest decision-making body. It comprises the six members of the Executive Board of the ECB (including the ECB President) and the governors of the NCBs of the Eurosystem. The President of the Deutsche Bundesbank is therefore a member of the ECB Governing Council and takes part in Council meetings. However, in this capacity they act independently rather than as a representative of the Bundesbank or the Federal Republic of Germany because, like all members of the Governing Council, they are not bound by any instructions. This means that, collectively, the Governing Council is politically independent when formulating monetary policy. Each member of the Governing Council should therefore be guided solely by the stability policy needs of the euro area as a whole.
The Governing Council of the ECB is the Eurosystem’s highest decision-making body.
The ECB Governing Council normally meets twice a month. Monetary policy meetings generally take place every six weeks. The members of the Governing Council sit at a round table. Members are seated alphabetically based on their last name – and not based on the alphabetical order of the Member States.
The Governing Council decides on monetary policy in the euro area.
The ECB Governing Council is not only tasked with deciding on monetary policy, it also has almost all other central decision-making powers. In particular, it has the right to issue guidelines and to make decisions on the tasks conferred on the Eurosystem. Since 2014, it has been responsible for adopting decisions related to the ECB’s banking supervision activities. The Governing Council also stipulates the rules of procedure and organisation of the ECB and its decision-making bodies as well as the conditions of employment for its staff. The majority of decisions are made according to the principle of “one member, one vote”, i.e. each member’s vote is of equal value. However, for some decisions taken by the Governing Council, the weight of votes is determined not by headcount but by the national central banks’ fully paid-up shares in the ECB’s capital. These include decisions on the ECB’s capital, on the contributions of the national central banks to the ECB’s foreign reserves, and on questions of profit distribution in the Eurosystem. The members of the ECB Executive Board may not vote on these issues. The Bundesbank’s share in the ECB’s capital is currently 26.1%.
In order to safeguard the ECB’s independence from political influence, it has its own capital, subscribed by the national central banks. The subscribed capital currently amounts to €10.83 billion. Every country that joins the EU is factored into the calculation of the capital key. This means that the ECB’s capital stock is owned not just by the central banks of the euro area Member States, but by all NCBs in the EU. Each national central bank contributes a fixed percentage of this capital according to the capital key. A Member State’s share is determined by the country’s size in relation to the European Union as a whole, as measured by population and gross domestic product in equal parts.
The Bundesbank’s share in the subscribed capital is around 21%. However, the ECB’s actual paid-in capital amounts to just €8.9 billion, because only the central banks of euro area countries actually have to pay up their capital share in full. All other members of the ESCB are only obliged to pay 3.75% of their share, to help cover the ECB’s running costs. The capital key for the fully paid-up capital is therefore only spread across the central banks of the euro area Member States. The Bundesbank’s contribution is €2.32 billion, corresponding to a share of around 26%.
Because the NCBs of the euro area Member States have paid up their subscribed capital in full, they share in the ECB’s surpluses or deficits. If the ECB posts a profit in a given year, that profit is paid out to the euro area NCBs in accordance with the capital key. In 2021, the profit distribution to the Bundesbank amounted to €50.5 million.
In the early years of the Eurosystem, each member of the ECB Governing Council present for decisions had a voting right. After Lithuania joined the euro area and became the 19th Member State at the start of 2015, a new rule entered into force.
Since then, voting rights have been held by the six ECB Executive Board members plus a maximum of 15 national central bank governors. They exercise their voting rights on the basis of a monthly rotation system.
Now that the euro area includes more than 19 Member States, voting rights in the ECB Governing Council “rotate”.
In this system, euro area countries are divided into two groups according to the size of their economies and financial sectors. The NCB governors of the five largest countries form the first group, and share four voting rights. Each member of this group therefore has no voting right for one month out of five. The NCB governors of all other euro area countries, of which there are currently 15, form the second group, and share 11 voting rights. In this group, too, the list of NCB governors who then have no voting rights for three months at a time changes on a monthly basis.
If the euro area is enlarged to include more than 21 countries, three groups will be formed alongside the six members of the Executive Board. The NCB governors of the five largest countries will continue to form the first group, still sharing four voting rights. The second group will consist of the NCB governors of medium-sized euro area countries. This group will comprise half of all euro area countries and hold eight voting rights. Finally, the third group will consist of the NCB governors of the remaining, smallest euro area countries, sharing a total of three voting rights.
As a result of these rules, some NCB governors have no voting rights at times, but they still participate in Governing Council meetings and also have the right to speak. Decisions are made by a simple majority vote. In the event of a tie in the Governing Council, the ECB President casts the deciding vote.
The Executive Board of the ECB manages the institution’s day-to-day business, prepares the meetings of the ECB Governing Council and is responsible for the consistent implementation of monetary policy in the Eurosystem, in accordance with the guidelines established by the Governing Council. In addition to the ECB President and Vice-President, the Executive Board consists of four other members. These members are appointed by the European Council, acting by a qualified majority, on the recommendation of the Economic and Financial Affairs Council (ECOFIN Council) after consulting the European Parliament and the ECB Governing Council.
The Executive Board members should be persons of recognised standing and professional experience in monetary and banking matters. The ECB President represents both the ECB and the Eurosystem and explains decisions to the public at press conferences following the Governing Council’s monetary policy meetings.
The Eurosystem and the ECB regularly report on their activities.
The General Council of the ECB exists alongside the ECB Governing Council as long as there are EU Member States that have not yet adopted the euro as the single currency. It comprises the ECB President and Vice-President as well as the NCBs governors of all EU Member States. The General Council forges a link to the central banks of non-euro area EU Member States. Although it does not have monetary policymaking powers, the General Council carries out important preparatory work on issues relating to the expansion of the euro area and the harmonisation of statistics.
As Germany’s central bank, the Deutsche Bundesbank, along with the other NCBs, is part of both the Eurosystem and the ESCB. It brings euro cash into circulation in Germany, is involved in banking supervision, works towards a stable financial and monetary system and ensures that cashless payments run smoothly. It conducts extensive economic research and produces statistics that are made available to the public.
The Deutsche Bundesbank is part of both the Eurosystem and the ESCB.
Furthermore, the Bundesbank manages Germany’s foreign reserves, advises the government on monetary policy matters and, in its capacity as the government’s “fiscal agent”, provides account management and cash or portfolio transaction services for the public sector. The Bundesbank also represents Germany’s interests in numerous international bodies, including the International Monetary Fund (IMF).
Although a common monetary policy was implemented alongside the single currency, other policy areas remain under the national jurisdiction of each euro area country. A single European monetary policy means that, in monetary policy terms, the central bank of each individual euro area country is no longer able to respond to economic shocks that affect only that country. A monetary union therefore eliminates the possibility of a country devaluing its own currency in the event of an economic downturn, for instance by adopting a very loose monetary policy.
When monetary union was established, it was therefore clear that stability would have to take centre stage in all euro area countries’ economic and fiscal policies. Wage bargainers also need to factor in the changed circumstances in the euro area when setting wages. Otherwise, economic developments in the euro area countries will start to drift apart over time, leading to conflicts within the single currency area – both between policy areas and between countries.
To prevent this from happening, a common governance framework of legal provisions and specifications exists, which is intended to guide and coordinate national economic and fiscal policies.
To conduct a successful stability policy, a central bank needs both a clear legal mandate and, above all, political independence. It must be allowed free rein in its choice of monetary policy instruments and must not be forced to take any action that contravenes its mandate.
When exercising the powers and carrying out the tasks and duties conferred upon them (…) neither the European Central Bank, nor a national central bank, nor any member of their decision-making bodies shall seek or take instructions from Union institutions, bodies, offices or agencies, from any government of a Member State or from any other body. The Union institutions, bodies, offices or agencies and the governments of the Member States undertake to respect this principle and not to seek to influence the members of the decision-making bodies of the European Central Bank or of the national central banks in the performance of their tasks.
Independent central banks are in a better position to keep the value of money stable because they are not subject to governments’ short-termism and their election-oriented tactical deliberations.
This independence is enshrined in Article 130 of the Treaty on the Functioning of the European Union (TFEU). Neither this Treaty nor the Statute of the ESCB can be changed by mere national legislation. Such changes require the unanimous approval of all EU Member States. This independence is not limited to the ECB; each NCB must also have been granted independence by the time the respective country adopts the euro at the latest (legal convergence).
The Eurosystem’s independence is assured at the institutional, functional, personal and financial levels. Independence is institutionally safeguarded by the fact that national and supranational bodies – such as the European Commission, for example – are forbidden from giving instructions to the ECB or NCBs. Even attempts at exerting influence are prohibited.
The Eurosystem is functionally independent in that it is responsible for deciding on its own strategies and measures to achieve price stability. Furthermore, this autonomy must not be undermined by any kind of obligation to provide loans to general government. NCBs are prohibited from lending to the European Union, to national governments and to other bodies governed by public law, just as they are forbidden from directly purchasing public sector debt instruments. This ban on the monetary financing of governments is set out in Article 123 of the TFEU.
There is, however, one qualification with regard to functional independence: the ECOFIN Council can conclude formal agreements on an exchange rate system for the euro. Such resolutions require prior recommendation from the European Commission or the ECB and may not threaten the primary objective of maintaining price stability.
Aspects of personal independence include the long terms of office of ECB Governing Council members and their protection from arbitrary and premature dismissal. ECB Executive Board members are appointed for single terms of eight years that cannot be renewed. This is to ensure that their decisions are not influenced by their chances of being reappointed for a second term of office. Only when the ECB was founded were Executive Board members given terms other than the regular eight years, in order to prevent all of the contracts from expiring simultaneously after this time.
NCB governors serve terms of office of at least five years, with the possibility of being reappointed.
Furthermore, the Eurosystem is also financially independent. Central banks are free to manage their finances autonomously as they see fit. This responsibility may not be transferred to any national government or parliament. Moreover, independent NCBs are the sole shareholders of the ECB.
(1) Overdraft facilities or any other type of credit facility with the European Central Bank or with the central banks of the Member States (…) in favour of Union institutions, bodies, offices or agencies, central governments, (…) other bodies governed by public law, or public undertakings of Member States shall be prohibited, as shall the purchase directly from them by the European Central Bank or national central banks of debt instruments.
The independence of the Eurosystem is intended to ensure that monetary policy actions are conducive to price stability. At the same time, the Eurosystem is obligated to stay within its mandate – it is not allowed to pursue any other political objectives for which, by law, elected parliaments are responsible. This political independence requires the Eurosystem’s central banks to be transparent: they are accountable to the public for their decisions and the success of their measures. To this end, the ECB reports to the European Parliament, the European Commission and the European Council on its monetary and foreign exchange policy as well as on all other Eurosystem activities. Aside from this, the ECB has to publish a report on its activities at least every three months. It fulfils this obligation by publishing an Economic Bulletin every six weeks.
The ECB President answers questions from the media at press conferences following the monetary policy meetings of the ECB Governing Council. Since the start of 2015, the ECB has also published accounts of Governing Council monetary policy discussions. Aside from this obligation of accountability, it is in any case in the Eurosystem’s own interest to explain its objectives and actions to the public so as to gain and maintain credibility and support.
In the monetary union, the individual responsibility for national fiscal policy also means that a country must shoulder its public debt alone. To this end, Article 125 of the TFEU stipulates a mutual exclusion of liability, stating that neither the Community (i.e. the EU) nor the Member States shall be liable for or assume the debt of another Member State. In technical jargon, this is referred to as the “no bail-out” clause. This ban is intended to encourage all Member States to pursue sound fiscal policies.
No euro area Member State is responsible for the debt of another (“no bail-out” clause).
This clause is also designed to ensure that investors in the financial markets assess a country’s government debt solely on the basis of that country’s financial strength. This, in turn, should have a disciplining effect on national policy.
(1) The Union shall not be liable for or assume the commitments of central governments (…) or other public authorities (…). A Member State shall not be liable for or assume the commitments of central governments (…) or other public authorities (…).
If investors conclude that a country is running up excessive debts, they will see an increased risk of it not making interest and principal payments on its debt punctually. On account of the heightened risk, they will grant this state new loans only at higher interest rates. This makes government borrowing more expensive. This “financial sanction” should result in less debt being accrued, thus tending to bring the government budget back on track.
Sound public finances are important for a stability-oriented monetary policy. When doubts emerge over the sustainability of public finances, monetary policymakers risk coming under pressure to finance excessive debt by printing money. In a monetary union made up of sovereign states, there is less of an incentive for any one euro area Member State to maintain sound public finances. When an individual state accrues excessive debt, the necessary monetary policy response (raising interest rates) is weaker for the monetary union as a whole than would be the case for a national currency. Meanwhile, all other Member States are affected by one state’s excessive debt and the monetary policy reaction it provokes. Sound public finances are thus essential for the euro area.
A fiscal framework was agreed in the Treaty on European Union in order to work towards sound public finances. The Stability and Growth Pact (SGP) fleshes out the requirements set out in the Treaty. It was agreed in 1997 and has since been revised and expanded on multiple occasions.
In signing the Stability and Growth Pact, the euro area countries commit to prudent budget management.
First, the SGP includes the goal of structurally close-to-balance budgets (preventive arm). This means that after adjustment for cyclical and temporary factors, national budget balances should be close to zero. If this budget target has not yet been reached, the structural balance should move towards this goal. If the Member States do not adhere to these rules over an extended period of time, sanctions may be imposed.
Second, the corrective arm of the SGP specifies how to proceed if the reference values are breached. The reference values for a country’s budget deficit and debt level stand at 3% and 60% of GDP respectively. However, the reference value for debt also counts as having been met at levels over 60% if the debt level is moving towards the limit quickly enough.
If these reference values are breached, an excessive deficit procedure is usually initiated. This sets out the measures needed to correct the deficit. In particular, a deadline for compliance with the reference value is issued. If target levels continue to be breached, financial sanctions may be imposed. As in the preventive arm, the threat of sanctions is intended to create an incentive to follow the rules.
Compliance with these fiscal rules is monitored by the European Commission within the framework of the European Semester (see below). To this end, it studies the outcomes of previous years. In addition, it analyses national governments’ medium-term plans (stability programmes), as well as their budget plans for the coming year. The Commission plays an important role in fiscal surveillance. However, the ultimate decision-making power in terms of procedural steps and sanctions lies with the Council of the European Union (usually the ECOFIN Council).
The Stability and Growth Pact is only effective if it is implemented rigorously.
In principle, the central guidelines of the preventive and corrective arms of the SGP are intended to contribute to sustainable public finances in the euro area. In the case of close-to-balance structural budgets, high debt ratios would generally decline quickly and a sound position would be achieved. In the event of a breached target, the recommended fiscal policy stance would result in the target being met again soon.
In actual fact, however, the binding effect of the rules is limited. The reference values for the deficit and debt have been frequently breached since the beginning of monetary union. Member States have rarely achieved a structural budget that is close to balance. This is due to policymakers’ generally observed propensity to run up debt.
The numerous exceptions, considerable complexity, and, above all, the scope for discretion in the provisions have contributed to targets being missed. Additionally, the European Commission itself has never yet imposed sanctions, in spite of very high and ever increasing debt ratios. Aside from this, the final decisions rest with the Council of the European Union. Speaking metaphorically: “Sinners sit in judgement on fellow sinners.” This is the case because the ministers represented in the Council may themselves come into conflict with the rules of the SGP and be affected by sanctions at any time. This demonstrates that fiscal rules alone are not enough to safeguard sound public finances in the monetary union. It is therefore all the more important to create incentives for achieving solid public finances through other channels. Here, the financial markets especially play an important role in restricting Member States’ propensity to take on new debt. However, this can only succeed if Member States with high and rising debt levels are required to pay higher rates of interest than Member States adhering to the SGP.
The limited binding effect of the Stability and Growth Pact helped sow doubt about the sustainability of public finances in some Member States as the financial crisis unfolded. This crisis ultimately culminated in a sovereign debt crisis in the euro area. During this period, temporary rescue mechanisms to support individual euro area countries were initially introduced. Later, the permanent European Stability Mechanism (ESM) was established. In exchange for the extension of joint liability within the euro area that this entailed, the fiscal rules were to be reinforced. To this end, the Fiscal Compact (part of the Treaty on Stability, Coordination and Governance in the Economic and Monetary Union) was established in the form of an intergovernmental agreement.
The governments of 25 of the then 27 EU Member States agreed on the Fiscal Compact. It is intended to strengthen the individual responsibility of the Member States for compliance with the common fiscal rules. The Fiscal Compact entered into force at the start of 2013. It is an expanded version of the reformed Stability and Growth Pact. As the Czech Republic and the United Kingdom declined to participate, the Fiscal Compact is not an extension of the TFEU, but rather an intergovernmental agreement.
The majority of the EU Member States agreed on a “debt brake”.
With the Fiscal Compact, each participating country made a commitment to enshrine the European rules for a structurally balanced budget in its national law. National legislation should also specify that a correction mechanism, known as the “debt brake”, should be triggered automatically if the rules are breached. Aside from this, independent institutions (referred to as fiscal councils) are to monitor compliance with the rules at the national level. Furthermore, it was agreed in the Fiscal Compact that an excessive deficit procedure in the SGP can only be prevented by a two-thirds majority vote in the European Council.
In February 2017, the European Commission confirmed that all participating Member States fulfilled the requirements of the Fiscal Compact. This is a prerequisite for a country to be able to apply for financial aid from the ESM.
The European Semester regulates the planning and reporting cycle for economic governance and budgetary surveillance. Within these cycles, Member States’ national economic policy developments as well as the reform and stability programmes are coordinated and synchronised. Furthermore, the Member States receive political guidelines and country-specific recommendations ahead of their national budgetary procedures.
The purpose of the European Semester is to prevent excessive public debt.
The European Semester is intended, first of all, to prevent excessive public debt. To this end, the European Commission assesses whether the Member States’ budgetary plans are compliant with the SGP. The Member States submit their budget plans for the following year by mid-October. In April, the euro area countries present their national stability programmes and the non-euro area countries (with the exception of Denmark) present their national convergence programmes. In them, they lay out their mid-term budget plans.
Furthermore, in order to avoid unhealthy economic policy developments, the European Semester contains a procedure intended to identify macroeconomic imbalances at an early stage (macroeconomic imbalance procedure, or MIP).
Additionally, the European Semester is intended to aid the year-round coordination of economic policy, enabling economic challenges that affect the whole EU to be countered jointly where possible. To achieve this, the Member States each present their national reform programmes in April. These include planned structural reforms to encourage growth and employment. The Commission evaluates the national reform programmes and develops country-specific recommendations that are adopted by the European Council.
In the wake of the sovereign debt crisis, the European Council decided to establish a permanent stability mechanism. The European Stability Mechanism (ESM), created for this purpose, comprises all 19 euro area countries. It commenced its work in October 2012.
The ESM stands ready to safeguard the financial stability of the euro area as a whole and its Member States. In the event of a crisis, it can do so by providing financial aid to euro area countries dealing with severe financing problems or likely to face such problems.
In order to maintain the no bail-out principle, lending is linked to certain requirements. First, an adjustment programme must be agreed upon with the country concerned. The reforms included in this programme should be capable of rectifying the problems that have arisen. Second, financial aid may only be granted to states with debt levels that are fundamentally sustainable. Should this not be the case, sustainability must be restored first through an appropriate level of private sector involvement (haircut).
Third, all of the countries participating in the ESM agreed to incorporate collective action clauses into the terms of their sovereign bonds with maturities of more than one year. In the event of a sovereign default, these clauses make it easier to agree on the restructuring of government liabilities – such as a haircut. This is in line with the monetary union’s regulatory framework, in which a government default is possible in principle even for euro area Member States, and government sustainability problems will not be taken on by the ESM or by other Member States.
The ESM was established as a “permanent bail-out fund”.
To provide financial aid to Member States, the ESM has a total of €500 billion at its disposal. It acquires these funds largely by issuing bonds in the capital market. The total capital subscribed by the Member States is higher than the maximum lending volume (oversubscription) so that the ESM is able to borrow on favourable terms. The total capital amounts to €700 billion. Euro area countries have paid in a total of €80 billion of this in cash, while the remaining €620 billion is callable on demand. Germany contributes around 27% to the ESM’s subscribed capital. Germany’s liability risk is therefore equivalent to around €190 billion.
To date, Greece, Cyprus and Spain have claimed ESM assistance. Greece, Portugal and Ireland also received assistance loans from the preceding, temporary rescue mechanisms.
On 27 January 2021, the ESM members passed a reform of the stability mechanism. This will enter into force as soon as the corresponding Agreement Amending the ESM Treaty has been ratified by all Member States.
The adopted reform aims to enhance the ESM as an instrument for tackling crises in order to ward off risks to the stability of the euro area as a whole and that of its individual Member States. Key elements include reforming the ESM’s precautionary credit lines and the collective action clauses in future terms of sovereign bonds, the introduction of the ESM as a backstop for the Single Resolution Fund (SRF) as well as a stronger role for the ESM in crisis prevention and in designing and monitoring future assistance programmes.
In response to the financial and economic crisis, the EU created the legal foundation for a “banking union”, a system of new European institutions. Alongside the Single Supervisory Mechanism, the banking union comprises a Single Resolution Mechanism and a common deposit guarantee scheme. All euro area countries participate in the banking union. Other EU countries may opt in.
The banking union consists of three pillars.
The purpose of the banking union is to standardise and improve banking supervision in participating Member States, increase financial stability in the euro area and loosen the nexus between financial sector and sovereign debt.
The Single Supervisory Mechanism (SSM), the first pillar of the banking union, has created a new framework for banking supervision in Europe. Its main purpose is to guarantee the security and soundness of the European banking system and to strengthen financial integration and stability in Europe. Ties between banks and sovereigns are to be reduced, depositors and creditors of financial institutions protected against losses, and the public’s confidence in the European banking sector strengthened.
The SSM commenced its work on 4 November 2014. As an independent body of the EU, the ECB carries out banking supervision from a European perspective by developing a common approach towards ongoing supervision, taking harmonised supervisory and corrective measures and ensuring the consistent application of the regulations and supervisory policies.
Together with the national supervisory authorities (referred to as the national competent authorities, or NCAs), the ECB is responsible for ensuring that European banking supervision functions smoothly and effectively.
New committees were formed in order to ensure the separation of the ECB’s supervisory and monetary policy functions. The highest decision-making body in the SSM is the Supervisory Board, which consists of high-ranking representatives of the ECB and national competent authorities. The Supervisory Board prepares decisions for the ECB Governing Council, which ultimately has to approve all decisions.
The Supervisory Board submits draft decisions to the ECB Governing Council, which the latter cannot change. It can only approve them or send them back to the Supervisory Board. The Chair of the Supervisory Board is appointed by participating Member States for a single term of office. The position of Vice-Chair is held by a member of the ECB Executive Board. Other members of the Supervisory Board come from the ECB (four in total) and from the Member States’ national competent authorities (one each). For Germany, the member comes from the Federal Financial Supervisory Authority (BaFin), who may be accompanied to meetings by a representative of the Bundesbank.
The Supervisory Board performs the ECB’s tasks in matters of banking supervision.
At present, the ECB is responsible for the direct supervision of 115 significant banks in participating Member States. These banks account for more than 80% of all banking assets in the participating Member States. The decision of whether a bank is classified as “significant” depends on its size (total assets worth more than €30 billion or more than 20% of GDP, but not less than €5 billion) or its significance to the economy of the country in which it is domiciled. In each participating Member State, at least the three most significant banks are subject to direct supervision by the ECB, irrespective of their absolute size.
For the ongoing supervision of significant banks, the ECB establishes Joint Supervisory Teams (JSTs) made up of ECB staff and representatives from the national competent authorities, such as the Bundesbank. Each significant bank has its own JST. The supervision of less significant institutions lies with the national competent authorities. There are roughly 2,500 less significant banks in the euro area at present, of which around 1,600 are located in Germany. They are jointly regulated by BaFin and the Bundesbank.
The ECB cooperates closely with national competent authorities on banking supervision.
In this context, the Bundesbank is responsible for ongoing supervision and on-site inspections at banks. It carefully examines the institutions’ operational and risk management procedures and checks compliance with capital and liquidity requirements. Besides ongoing supervision, the Bundesbank is also involved in updating and improving prudential regulations, notably in the international Basel Committee on Banking Supervision.
Banking supervision sets and checks quantitative regulations.
Banking supervision does not directly intervene in the individual transactions conducted by banks. Rather, it sets general quantitative regulations, e.g. minimum capital requirements for banks. Banks have to submit regular reports on compliance so that the supervisory authorities can check whether these requirements are being met. Besides these quantitative regulations, banks must meet qualitative standards regarding their organisation and management. Government supervision is supplemented by monitoring by other market participants, such as banking associations and rating agencies, and by the disclosure of balance sheets to other market participants.
Central banks and banking supervisors from the major industrial countries and emerging markets – including the Deutsche Bundesbank – cooperate in the Basel Committee on Banking Supervision. “Basel II” entered into force in 2007 at the initiative of this Committee. This regulatory framework sets minimum capital requirements for banks.
The framework also requires banks to hold sufficient capital in order to cover losses from the risks they take, and it defines certain disclosure requirements.
Many regulations were tightened or newly drafted in response to the financial crisis. In 2010, the Basel Committee adopted stricter standards. The “Basel III” framework updates the provisions of Basel II by requiring banks to hold more capital and capital of a higher quality, amongst other things. This is intended to make banks significantly more resilient to losses they might suffer as a result of credit defaults, for instance. Basel III also defines bank liquidity standards and a minimum leverage ratio as well as a countercyclical capital buffer, which supervisors can activate in order to bolster financial stability if necessary. The Basel III regime is a key element of a European Union legislative package better known as CRD IV/CRR (Capital Requirements Directive IV/Capital Requirements Regulation). It also forms the basis for banking supervision in Europe.
The second pillar of the banking union was created in 2016 with the Single Resolution Mechanism (SRM). The SRM creates a framework for the orderly resolution of distressed banks. This seeks to allow banks an orderly market exit that does not jeopardise financial stability and thereby reinforce the market economy principle that everyone, including banks, should be liable for their own losses. During the 2007-08 financial crisis, policymakers used taxpayers’ money to save countless banks from insolvency because it was feared a disorderly collapse could jeopardise financial stability. The owners and creditors of these banks were thus partially or fully spared from losses, thereby violating the liability principle.
The Single Resolution Mechanism entered into force in 2016.
In principle, the SRM applies to all banks that are also covered by the SSM. The institutional set-up of the SRM is characterised by two elements: one is the Single Resolution Board (SRB), which makes decisions on the resolution of banks. It does not operate on its own, but cooperates with national resolution authorities (BaFin in Germany). The other is the Single Resolution Fund (SRF), which is funded by the banks and provides the financial resources necessary for resolutions. The SRF is set to be supplied with around €70-75 billion of funding by the end of 2023.
Starting in 2022, the SRF has also been reinforced by the establishment of a common backstop, which is a credit line from the ESM to the SRF. This line of credit may not exceed a nominal upper limit of €68 billion. The common backstop covers all of the SRF’s uses, thus bolstering the SRB’s clout in order to resolve complex banks under difficult market conditions with as small an impact as possible on the economy, financial stability and public funds.
The third pillar of the banking union – a common deposit guarantee scheme (DGS) – has been postponed for now. The basic idea is to set up a European deposit protection fund, which would shield a bank’s creditors from losses up to a determined amount in the event of bankruptcy. Common EU rules to harmonise national DGSs are currently in force.
The current legal basis is the EU Deposit Guarantee Schemes Directive passed in 2014, whereby the national DGSs in each EU Member State guarantee to safeguard deposits of up to €100,000 per customer per bank. The directive was transposed into German law through the Deposit Guarantee Act (Einlagensicherungsgesetz). Even before this act was passed, a statutory deposit protection scheme had been in place in Germany for many years.
According to the Deposit Guarantee Act, all banks conducting deposit business must join a DGS. These include statutory indemnification schemes and what are referred to as “institutional protection schemes”. Cooperative banks and savings banks belong to the latter.
These schemes provide sureties or guarantees to protect against insolvency and liquidation in the event of looming or actual economic problems within their respective categories of banks. According to the Deposit Guarantee Schemes Directive, deposits at dependent branches of banks from other EU Member States in Germany are covered by that country’s DGS.
Private banks have a DGS in addition to the statutory deposit compensation scheme.
In addition to the statutory deposit compensation scheme, private banks in Germany have a voluntary DGS that also guarantees deposits of private customers, partnerships and certain foundations. The level of protection will be gradually reduced to €1 million for private customers and €10 million for enterprises by 2030. Deposits by public bodies, securities firms and financial institutions do not fall under the voluntary deposit guarantee scheme. Most, but not all, private banks in Germany belong to the voluntary deposit protection fund. Dependent branches of banks from other EU Member States may also join this voluntary deposit guarantee scheme offered by private banks and thus supplement the harmonised EU deposit guarantee scheme in their home country.