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Banking union: a solution for the long haul

17 Dec 2012

As Europe’s banks struggle with sluggish economies and dodgy assets, market values well below par and pricy funding options, a banking union seems the logical way out of the mess. But beware: it is no quick fix, writes Katie Llanos-Small.

When the miniscule Andalucian lender CajaSur folded in 2010, Spain’s five year CDS curve gapped out by 30bp, to 242bp. Looking back, that response seems like nothing. Had investors seen how the tormented relationship between the sovereign and its lenders would evolve over the coming years, CDS would have widened much further.

After rescuing the insignificant CajaSur, the Bank of Spain pressed ahead with pushing through extensive consolidation. But that did little to stabilise the system. Seemingly interminable rounds of stress tests, new provisioning requirements and other stabilisation measures followed, and yet in December 2012 the Bank of Spain was set to inject another €37bn of capital into three failed banks.

At the time of writing in early December, the entire process had left the sovereign teetering on the brink of requesting a full scale bail-out itself. In 2012, the country’s five year CDS hit a high of 638bp in late July — although it had traced back to 271bp by early December.

Spain is the most recent example of the worrying feedback loop between banks and their sovereigns. But, as the crisis has rolled around Europe, debt investors and issuers have learnt that problems among one set of borrowers often affect the other.

A resurgence of risk appetite in the fourth quarter of 2012 opened the credit markets to many European banks that had been marginalised for much of the crisis. But the peripheral borrowers paid elevated spreads for market access.

That stemmed from investors’ continued worries about the linkages between banks and their sovereigns. Could a government bail out its banks if it had to — or would the sovereign’s debt metrics lead to haircuts on bonds held by its banks?

Enter banking union. "If you consider a banking union as a system with a common recapitalisation vehicle and a federal deposit guarantee scheme, it will automatically lead to a reduction of the linkage between sovereigns and the banking sector," says Francesca Tondi, banks analyst at Morgan Stanley in London.

"The effectiveness is dependent on timing and on how fully fledged the union is. The extent to which banks can call on the deposit guarantee scheme is going to be another important factor."

Cost of failure

The sovereign-bank feedback loop has been exacerbated by lenders being encouraged to load up on debt from their own government. But it is also a function of national governments having to bail out — or clean up the mess — from a failed lender. And there the scale of the problem is worrisome.

"If you look at bank balance sheets as a percentage of GDP, for US banks, it’s modest," says John-Paul Crutchley, co-head of European banks research at UBS. "JP Morgan’s balance sheet is 15%-20% of US GDP. Chinese banks are also a manageable number of Chinese GDP. If you look at, for example, BNP Paribas in the context of Europe, it’s a similar number — but in the context of France, it’s a very big number. So as soon as people worry about France, they worry about BNP and vice versa. That’s the nub of the European problem."

In a bid to fix the mess, banking union was set to swoop in on January 1 — flapping cape and super-hero lycra optional, one assumes. With the European Central Bank scrutinising the continent’s lenders, it is hoped the vicious sovereign-bank feedback loop will ease. More streamlined regulation will make it easier for analysts to compare the risk profiles of different institutions. And a supranational regulator will be seen as less likely to allow ad hoc concessions to national lenders.

Avoiding box-ticking

But for a banking union to increase confidence in the system as hoped, there is much more to be done beyond introducing a single supervisor. A deposit guarantee scheme and a resolution and recovery mechanism need to be established to deal with troubled banks. And a single set of rules needs to be agreed.

"The impact of banking union depends on exactly what you mean by that," says Crutchley. "If you simply mean another layer of box-ticking, then sure, they can do that easily.

"But if you fundamentally want to have a true banking union — with the powers to eject management, force recapitalisations, bail-in creditors, etcetera, it’s completely different. You need a regulator that can intervene and do thorough audits. And for that you need a team of supervisors. The difficulty at the moment is that every banking system is different, every regulator has a different focus. There are too many idiosyncrasies."

Crutchley points to the Spanish banking system as one that would benefit from a harder regulatory line. Stress tests in 2012 that allowed banks with a 6% capital ratio under the worst-case outlook to pass did little to lift confidence in the country’s recapitalisation process.

"The regulator is still stress testing them against a low capital ratio. That’s the wrong answer — the market won’t fund you on that. So if you just overlay a supervisor that’s ticking a box in Brussels, you can call yourself a banking union but you haven’t changed anything."

ECB takes power

The logistical hurdles remain high. The European Banking Authority — which remains as the continent’s rule-setter — is increasing headcount, and working on a single supervisory handbook and the finer technical details of capital rules. And the European Commission has set out its stance on common recovery and resolution rules, which are wending their way through the legislative process.

But the crucial question of how a deposit guarantee scheme might work remains untouched. And fundamental uncertainties remain about the first phase of the banking union plan — the common supervisor.

Given the ECB’s heavy financial involvement in helping the continent’s banks balance their books at the end of each day, it makes a certain amount of sense to hand it ultimate supervisory responsibilities. The lender of last resort will have a much clearer understanding of the true state of the banks.

"The one main reason why the ECB needs to be the single supervisor is because of a lack of information," says Michael Schubert, economist at Commerzbank. "They recognised during the crisis that they didn’t have enough information."

Yet the scope of the ECB’s responsibilities is not yet nailed down. Some are pushing for the ECB to have responsibility solely for the larger borrowers. Deutsche Bundesbank president Jens Weidmann hinted at this in a November speech, saying national regulators could retain oversight of banks that do not pose threats internationally.

"The banking union should not overshoot the market with regard to the Europeanisation of competences," he said.

In contrast, analysts say it makes sense for the ECB to oversee all Eurozone banks, noting that problems have cropped up in smaller and mid-sized banks as much as they have in the large ones. Moreover, smaller lenders make up a significant proportion of Europe’s banking system. Around 30% of assets in the euro area are on the balance sheets of smaller lenders, the ECB reckons. And in more than half the euro area countries, small banks hold over 60% of the total assets.

At the same time market participants wonder whether the ECB will have the resources to properly oversee Europe’s roughly 6,000 banks. Some say the new supervisor should leverage the expertise and manpower of existing national authorities.

"The ECB will have to work closely with national supervisors," says Commerzbank’s Schubert. "They can’t supervise all of the banks — they don’t have the staff. But perhaps they will be a sort of supervisor of national supervisors."

That stance sounds closest to the concept of a single supervisor sketched out by Mario Draghi, ECB president, in a speech in late November. The supervisor would be a "decentralised system" revolving around a supervisory board made up of representatives from the national authorities.

It is hard to know whether that will measure up to the market’s expectations. Some analysts say that the supervisor should take a thorough, hands-on approach — they envisage teams of people on the ground at the bigger banks, and a close eye on the smaller ones. Others accept there may be a trade-off between the breadth and depth of supervision.

Standing still

Analysts are clear that the road to banking union is a long one. The first step is for the ECB to become single supervisor — and even that will take time to fully take effect. Few banks are fretting about the new structure yet. For some, like the Netherlands’ Rabobank, the new supervisor is likely to have little impact on the way they operate in capital markets.

"Rabobank has always taken a conservative approach to rules and regulations which we believe would be in line with those put forward by the single supervisory mechanism," says Michael Gower, head of long term funding at Rabobank.

For others, the new supervisory may constitute a shake-up for the bank’s management. But if all goes to plan — and there are plenty of ‘ifs’ — the banking union should, eventually, have a profound impact on the stability of Europe’s banks.

"The Banking Union would promote common standards in the banking sector," says Tondi. "And if established together with a federal resolution regime and recapitalization mechanism, as well as a proper European Deposit Guarantee Scheme, would ultimately lead to a reduction in the cost of equity and the perceived risk level of the banking sector over time."
17 Dec 2012