Having been an advisor to the German Federal Ministry of Finance for the last decade, and president of Germany’s ZEW Institute, Clemens Fuest’s opinion is one worth hearing. Especially since the pro-European professor is also said to have the ear of German Chancellor Angela Merkel.
Although the worst of the financial crisis is probably past, Fuest doubts the speed of the expected recovery and fears that Europe could face a recession not unlike Japan’s, which lasted 20 years.
Europe’s periphery has yet to regain its competitiveness, and for this to be restored, prices and wages need to be realigned, governments and households need to reduce debt and some banks may need to be recapitalised — without making their own governments insolvent.
The key to all this will depend on whether a sound banking union can be constructed, says Fuest. “I don’t think the eurozone has a future if we fail to set up banking union,” he says.
However, banking union is not a cure-all solution, argues Petya Koeva Brooks, chief in the Advanced Economies Unit in the IMF’s European Department. “Banking union is not a panacea and is not alone sufficient condition for growth,” she says. “Continued demand support and structural reform are also necessary.”
Breaking the bank-sovereign link may also be a challenge as it is hard to prevent banks from holding their own government’s debt.
Despite these concerns, in July this year, Michel Barnier, European commissioner for the internal market and services, proposed a Single Resolution Mechanism. This gave the European Commission the authority to set up a restructuring agency, with the power to decide when to wind-up a bank, along with a common restructuring fund.
The legal basis for Barnier’s proposal is Article 114 of the Treaty on the Functioning of the European Union, which says there should be no distortion of competition in Europe.
“Barnier says banking union is not driven by the desire to stabilise the financial sector, but rather by distortions in competition, which obfuscates the two issues,” says Fuest.
Fuest says Article 352 of the Treaty provides a better legal basis as it allows member states to introduce joint policies if they think it supports the EU objectives. However, this can only be enacted if there is unanimous agreement.
Shaky ground
Apart from the shaky legal basis for a banking union, there is also bigger concern over whether unsecured bank investors could be bailed in, following a bank’s insolvency.
The Barnier proposal and the Bank Recovery and Resolution Directive say that a minimum of 8% of a bank’s balance sheet must be bailed in before access is given to the restructuring fund.
But the 8% rule can be circumvented if the national regulator believes the bail-in of one bank’s unsecured investors will have a systemic impact on the rest of the banking system.
And, though it is hoped market forces will lead banks to issue bail-inable unsecured debt, this debt might become too expensive.
In this context there may be sense in setting a regulatory ratio of debt that can be bailed in. “We need regulation that sets a certain level of equity, as well as the amount of debt that can absorb losses,” says Fuest.
Adding to these complications are concerns over the valuation assumptions to be used by the European Central Bank in its asset quality review (AQR).
A recent Fitch report showed repossessed Spanish properties were being sold, on average, 71.6% below their original valuations, but it is unlikely the ECB would assume such a draconian haircut.
“How do you value assets to determine losses, and how does the ECB run the AQR to make German or Dutch saving banks believe periphery banks are solid? My expectation is they have to exaggerate massively and I fear it will be difficult to agree on joint restructuring funds,” says Fuest.
But if the AQR is rigorous it could play a crucial part in reversing the economic fragmentation of Europe by helping to ease credit conditions in the periphery.
“A comprehensive bank balance sheet assessment can play a vital role in resolving balance sheet uncertainty and underpinning recovery in credit and growth,” says Koeva Brooks.
Whatever the outcome, Fuest is convinced the proposed banking union will not take off in its present form.
“The Barnier proposal will come to a dead end, we need a mix of national restructuring funds and a more convincing form of investor bail in,” he says.