BANKING UNION: Poisoned chalice
Europe’s biggest attempt at unification, more ambitious than the single currency itself, exposes its deep divisions
The eurozones bold plans to set up a banking union have been hailed as the ultimate way to restore unity to an area which, until not long ago, was considered in danger of breaking up, leaving a mess of defaults, economic depression and social unrest in its wake.
Optimists enthuse about the new-found desire of political leaders in the European Union to save the single currency. Pessimists, on the other hand, point to the continents deep divisions as reasons why it will never happen. Even the level-headed oscillate between hope and doubt. However, one thing is clear to anyone taking a closer look at what may well be the most ambitious attempt at economic harmonization in modern history: this is a dangerous project. But without it, the eurozone has little chance of surviving.
There is no alternative solution other than nationalizing everything, undoing everything that Europe has done since the Second World War, Piroska Nagy, senior adviser to the chief economist of the European Bank for Reconstruction and Development (EBRD), tells Emerging Markets. Economically, there is little chance for this continent to compete in the global marketplace unless it is really united and has all the benefits that a single market can give.
But just because the alternative is difficult to contemplate, it doesnt mean that the process of establishing a banking union will run smoothly. David Marsh, the head of London-based Official Monetary and Financial Institutions Forum (OMFIF), a think-tank focused on financial policies, believes the eurozone will achieve a banking union sooner or later, but that it will be quite a long haul.
THREE IN ONE
There are three essential pillars towards achieving full banking union: a common supervision system for all the banks in the eurozone, a common resolution mechanism for banks that fail, and a joint deposit guarantee scheme for savers in the single currency area. Work on the first two has already begun, while the third is still hotly disputed. And in any case, putting in place the technical conditions, though important, is not enough to guarantee success.
The two big countries in the euro area both want the same thing but in a different order, Marsh, the author of Europes Deadlock: how the euro crisis could be solved and why it wont happen, tells Emerging Markets. The French would like to have the banking union straight away and then a fiscal union and then a political union, whereas the Germans say lets have something approaching a political union first, and then a fiscal union, and then a banking union.
Many eurozone politicians, as well as analysts, have complained since the eurozone debt crisis started that the European Central Bank (ECB) acts too much like the Bundesbank, which is good for Germany but bad for the rest of the single currency area. Marsh recalls that, during discussions about building up a banking union back in the 1980s and 1990s, the Bundesbank was always against combining supervision and monetary policy, because they felt this would distract the central bank from its monetary policy role.
FIRST PILLAR, FIRST HURDLE
The first pillar achieving the common supervisory system already gives an indication of how complicated and drawn out the full process will be. In theory, the ECB should take over supervisory responsibility from national supervisors next year, to ensure that the same criteria are applied to all banks in the eurozone. But in order to do this, the central bank has said it would carry out extensive asset quality reviews, to have a clear understanding of the state of the banking system it will take over. The problems start here, because previous stress tests carried out by the European Banking Authority (EBA) have largely been dismissed by markets as not thorough enough, and the eurozone banking systems credibility has suffered as a result.
This happened because Europe, unlike the US, does not have a sufficiently strong capital backstop to ensure that failing banks are recapitalized fully and swiftly, says London School of Economics professor Charles Goodhart. There was no fund to provide additional capital to those banks that failed the required level of capital, Goodhart tells Emerging Markets. Under those circumstances, if the EBA had announced that certain of its own banks didnt have enough capital, without having the means to provide that capital, there was a fear that there would have been a run on these banks. Consequently, when the EBA actually said no bank is severely undercapitalized, nobody believed a word of it.
The ECB is keen that this should not be the fate of its own assessment of the banks strength and this is where the first cracks in the project have already appeared. Yves Mersch, a member of the Executive Board of the ECB, said in a speech at the end of August that he was pleased that, in June this year, the European Council acknowledged the issue of a lack of proper backstops. But the Council called for backstops to be in place before the assessment is completed, which leaves too much room for uncertainty, Mersch warned. Backstops need to be in place before the assessment has begun. Put simply, if there are no backstops, there will be no assessment.
Back in June, some politicians and observers hailed the fact that the European Stability Mechanism (ESM) was given the power to participate directly in the recapitalization of banks rather than giving the money to governments, which in turn would channel it towards failing banks, as was the case before. They saw this as a major step forward towards establishing the banking union. But, Goodhart says, this decision still falls short of what is needed. There are a whole series of qualifications and covenants about who ultimately is responsible for the legacy assets in recapitalizing the banks, even if the ESM funds at the time are enough to support recapitalization, he explains.
Under the proposals, the ESM would directly recapitalize banks in the eurozone only if the country that requests its assistance would see very adverse effects on its own fiscal sustainability without such aid, and if the aid is indispensable to safeguard the financial stability of the euro area as a whole or of its member states. A further condition is that the bank in need of aid is already, or is in the near future likely to be, in breach of the capital requirements established by the ECB as a supervisor and cannot get this capital from private sources or by other means which are not clearly specified. A financial institution must have a systemic relevance or pose a serious threat to the financial stability of the euro area as a whole or to the requesting ESM member to qualify for aid. And the amount of aid the ESM can use to recapitalize banks directly is limited to 60 billion euros, although it can be raised if the ESMs Executive Board agrees.
Also in June, the Council of the European Union agreed on a proposal for a Bank Recovery and Resolution Directive, with the aim of having it approved by the European Parliament before the end of the year. Although it is not part of the Single Resolution Mechanism, analysts say it will likely be used as a template. It includes a bail-in tool, which would allow resolution authorities to write down or convert into equity the claims of shareholders and some creditors of banks that are failing or are likely to fail. Deposits below the EU-wide guarantee of 100,000 euros, wages, secured borrowing, commercial claims relating to goods and services critical to the daily functioning of a bank, liabilities resulting from payment systems whose maturities are below seven days, as well as interbank liabilities with original maturities shorter than seven days cannot be used in the bail-in process. But the proposal allows national resolution authorities to exclude, or partially exclude, some other liabilities of their choice if these cannot be bailed in within a reasonable time or to ensure continuity of critical functions, to avoid contagion and to avoid value destruction that would raise losses borne by other creditors.
Sonia Boulard, an associate analyst with Moodys, notes that the full implications of the proposal are still unclear. The text leaves open to question the latitude national authorities are really intended to have to deviate from the harmonized and strict approach to bailing in creditors at the heart of the agreement, Boulard wrote in a commentary after the proposal was published.
The exclusions can be compensated for either by passing the losses on to the other creditors on the condition that they are no worse off than if the bank had gone through normal bankruptcy procedures or through a contribution from the national resolution fund. This contribution would be capped at 5% of the banks total liabilities and would be available only where losses equal to at least 8% of total liabilities or to at least 20% of risk-weighted assets have been imposed on shareholders and creditors.
Even with these conditions attached, the proposal in its current form still leaves too much room for interpretation, according to some experts. For senior creditors, this flexibility reduces the predictability of potential losses in a bank resolution: the risk of being bailed in will vary across jurisdictions, institutions and circumstances, Boulard says.
Goodhart believes that a programme like the United States 2008 Troubled Assets Relief Programme (TARP) is needed for Europe to sever once and for all the connection between banks and sovereigns, but concedes that it would not be possible. Others agree. Europe is different, points out Alberto Gallo, head of European macro credit research at RBS. Its impossible to have a TARP programme; the banks are three times as big. Bond markets are not developed, and its just not possible to apply the same methodology. And we dont have the worlds reserve currency, and we have less ability to tolerate inflation in the core countries.
These are just a few of the most obvious fault lines in the construction of a European banking and, ultimately, fiscal and political union that have come to light over recent months. They all stem from the same major weakness, which has been at the core of the European Union all along: a tendency to give national interests exaggerated importance, to the detriment of the union as a whole. So far, the ECB has risen above the political noise and has managed to keep the eurozone together and the further integration project going. Its president, Mario Draghi, is seen by many as the saviour of the single currency with these two sentences, spoken more than a year ago during a speech in London: Within our mandate, the ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough.
Despite this, Draghi clearly doesnt want to be known as the man who saved the euro, because he wants the politicians to save it, Marsh says. For that to happen, the banking union, even if successful, will be just one step. To save the euro the richer countries in Europe that have current account surpluses need to agree to take losses on the debt of the poorer, deficit countries which have suffered economic depression and massive unemployment. But as usual, Europe seems to be hoping that salvation will come from somewhere else. There hasnt been enough rebalancing in Europe, says Marsh. We are really waiting for the American recovery to come along: bring in the US cavalry in time to help the euro area.