The centralisation of banking supervision in the euro zone is expected to lead to mergers among European banks and a stronger reliance on market funding, European Central Bank Vice-President Vitor Constancio said today.

Constancio is one of two Executive Board members tasked with setting up a new banking watchdog under the ECB's roof.

This is part of a broader push to more closely integrate the European financial system to help it weather future crises.

The Single Supervisory Mechanism (SSM) will streamline banking supervision across the currency bloc by applying the same rules to all 6,000-odd lenders, making it harder for national authorities to protect their national champions.

"I see that the SSM will create the conditions for further integration of the European banking market," Constancio said in a speech at a banking conference in Dublin.

"I would not be surprised if the SSM would open a period of restructuring in the European banking sector, in particular through more mergers and acquisitions," he said, adding that he expected a gradual decline in the size of the sector over time.

Companies in the euro zone mainly use banks for their funding needs rather than tapping capital markets as the majority does in the US. Constancio said this traditional model could change.

"Going forward, we can predict that the European capital markets will develop further," he said, pointing to a deepening of corporate bond and equity markets.

Improvements in securitisation could benefit small and medium-sized enterprises (SMEs) in particular, Constancio said. "Securitisation may be one way to stimulate credit to SMEs, as banks would feel more confident that they could shift risks to non-bank investors."

But he warned against relying too strongly on capital markets, adding the euro zone should not try to "replicate the US model", saying that "a balanced funding mix between banks and capital markets is best for financial stability".

Before the ECB starts supervising banks from November next year, it will run a series of stringent tests on the euro zone's largest lenders to uncover potential balance-sheet risks and capital shortfalls.

The ECB has already decided that euro zone banks will be allowed to avoid complex new definitions for bad loans in their first data submissions and Constancio said the ECB would explain its methodology in more detail by the end of January. 

"There will be a totally harmonised concept that will be applied in the comprehensive assessment, in the asset quality review and that will be disclosed at the beginning of the year," Constancio told reporters at the conference.

As a result of unified banking supervision, Constancio said he expected liquidity to be more fungible within cross-border banking groups than in the past.

Provided that capital was freely transferable within the group, banks would be allowed to meet capital requirements at the group level instead of each individual institution being held to the standard then, Constancio said.