For the ECB, 2012 ended on a high note. Mario Draghi was proclaimed person of the year by the Financial Times, and at the December summit the ECB was given the final say on euro area banking supervision. Amid a general collapse in confidence in banks, politicians and national supervisors, all hopes are now directed towards the ECB, as the new beefed-up guardian of the financial system. In this environment, it is easy to forget that the ECB has always had a responsibility for the stability of the financial system and that her track record in this area is not impressive.

The case for moving towards a banking union, starting with the Single Supervisory Mechanism, is strong. The euro has led to a huge increase in systemic risk. The combination of a single currency, free capital flows and low interest rates created a macro-economic environment conducive to bubbles in housing and bond markets. In the process, banks and sovereigns became more intertwined while the option to address domestic problems with a national central bank had gone. This is how an Irish banking problem or a Greek fiscal problem infected the euro area as a whole.

Since her inception, the ECB is tasked with contributing to the smooth conduct of policies relating to prudential supervision and the stability of the financial system (TEU, article 127.5). Based on this mandate, the ECB has published a Financial Stability Review (FSR) since 2004. In the first FSR Jean Claude Trichet lists three steps to gain insight into financial stability:

“The  first  entails  forming  an assessment  of  the  individual  and  collective robustness  of  the  institutions,  markets  and infrastructures  that  make  up  the  financial system. The  second  involves  an  identification of  the  main  sources  of  risk  and  vulnerability that could pose challenges for financial system stability in the future. The third and final step is  an  appraisal  of  the  ability  of  the  financial system  to  cope  with  crisis,  should  these  risks materialise.” (FSR, December 2004)

This quote shows that the ECB early on saw it as her duty to identify systemic risks, even though the term “macro-prudential” was not yet in vogue and the European Systemic Risk Board (ESRB) had not yet been established.

Now that all hope is pinned on the ECB as the European supervisor, it is quite legitimate to ask how the ECB has acquitted herself from her financial stability task in the past. The bi-annual FSRs are an obvious place to look for an answer. If the ECB detected faults in the design of the monetary union, worried about German capital flows to bubbling Spain or the exposures of the financial system to sovereign debt, we should have read it in this publication.

Without pretending a full analysis of the FSRs, two observations stand out from reading the FSRs which were published before the crisis:

1) When the FSRs identify macro-economic imbalances, in almost all cases these relate to the global imbalances between China and the US. Similarly, mentions of current account problems refer to the US. Internal imbalances in the euro area get little timely attention.

2) The FSRs take a “holistic” view of the euro area, implicitly assuming a homogeneous internal economy. Most tables and graphs present aggregated euro area data. You will not find data on German bank loans to Spain or on the exposure of Greek banks to their sovereign. Before the crisis the FSRs thus provided little insight into the intertwinement of sovereign and banking risks, which proved to be a crucial risk factor.

In short, prior to the crisis the FSRs assumed internal stability and focused on global risks, mostly originating from the US. My interpretation of this blind spot is that the ECB – as the guardian of monetary unity – suffered from cognitive dissonance. The internal economic divergences just didn’t fit in with the ECB’s preferred view of the euro area.

A blind belief in unity which is not there has probably been more dangerous to the euro than an early recognition of the economic differences between member states would have been. At present, the ECB is much more aware of the role of internal macro-economic imbalances and the sovereign-bank nexus in the euro crisis. To successfully fulfill her expanded supervisory responsibility the ECB needs to continue shedding her holistic view of the euro area and establish a supervisory culture in which differences between individual member states are recognized and addressed earlier and more forcefully than in the past.