On September 12, 2013, the European Parliament finally approved the European Central Bank’s role as the eurozone’s single banking supervisor, a position it is set to take up from October 2014. This is later than was originally planned, and market participants have not been shy in pointing that out.
But they seem to forget just how big a project this is. EU Commissioner Michel Barnier admitted the proposal was “ambitious” in a speech on September 12, in which he pledged to deliver “a safer financial sector for the citizens” through banking union.
The dream of banking union rests on three pillars: a single supervisory mechanism, with the ECB as sole regulator; a single resolution mechanism, which will take care of failing banks and aim to ensure that the ad hoc taxpayer bail-outs of the financial crisis are never repeated; and a common, pan-European deposit insurance fund, to protect ordinary account holders from bank collapses.
All of this should make banks safer institutions in which to invest. But at the moment, confusion and uncertainty is reigning, says Olly Burrows, senior financials analyst at Rabobank in London.
“Banking union is a political construct,” he says. “The overarching idea is to formalise the regulation in a centralised EU manner, and to formalise actions taken in the event that a bank runs into difficulty. In practice, we don’t know how or if this will work. Nor is it obvious why or how it would help if we had a rerun of the financial crisis.
“The real test will be whether the ECB as central European regulator will demand punitive actions for a bank and its investors that perhaps the local regulator would not have taken. This could prove counterproductive to fixing the political and fiscal union shortcomings of European Monetary Union.”
Spreading the pain
The key word in the political side of banking union is mutualisation — of deposit insurance, of protection, of support, and ultimately of losses. But that is a difficult sell for European politicians, especially those in the continent’s stronger core.
“Mutualisation of losses is controversial because it would involve taxpayers in financially stronger countries supporting banks in other countries, potentially giving rise to moral hazard,” says Richard Barnes, credit analyst at Standard & Poor’s. “The associated electoral risk obstacles associated with such support are considerable, and, in our view, governments may possibly find them insurmountable. This to us raises doubts over the strength of the banking union that will ultimately be introduced.”
Indeed, Barnier’s September 12 speech, made in Frankfurt, appealed to the Germans on exactly this point.
“I know that Germany, in particular, has some concerns,” he said. “As regards the role of the Commission. As regards the legal basis. We are confident that our proposal is legally solid.”
“I know that Germany shares our ambition. So I see no reason why we could not reach an agreement. As long as we stick to the facts of the debate, as usual I remain with my team committed to make my best efforts to build a robust compromise.”
Uncertainty around how and when banking union will be implemented has driven scepticism around the construct among investors. While market participants seem to have accepted European policymakers’ dedication to the banking union project, many buyers of bank debt believe that it is unlikely to reduce default risk at Europe’s lenders.
A quarterly survey of investors conducted by Fitch in August revealed that over a third of buyers polled believed that not all three pillars of banking union — common supervision, a resolution mechanism and centralised deposit insurance — would be fully implemented. Some 27% expected failing banks to receive less state support under the new system and around 6% said that even full implementation of all the proposed measures would prove insufficient in making banks safer.
Just 28% of respondents were optimistic that the new framework would reduce default risk in the European banking system.
Neutral impact?
Even if it makes the banking sector safer, banking union could be a double edged sword. Ultimately, it is good for banks overall, but not so good for buyers of bank debt, argues Andrew Sheets, head of credit research at Morgan Stanley.
“You have a situation where the banking system is safer, but banking creditors are not safer,” he says. “It is easier for countries or banks to bail creditors in to preserve the broader institution. That is the balance they are trying to strike.”
Indeed, some market participants argue that the benefits offered by banking union could be cancelled out by the reduction it state support it implies.
“In terms of banks’ fundamental financial strength, banking union should be a positive thing,” says Bridget Gandy, co-head of EMEA financial institutions at Fitch Ratings. “But default risk for banks is also reduced by state support. States have so far always supported senior creditors. The EU’s draft Bank Recovery and Resolution Directive looks at resolving insolvent banks without having to use state support. The potential risk of bail-in is already being factored into the market.
“The balance between banks’ standalone strength improving while potential state support is reducing could come out neutral. Banking union will eventually bring more clarity over all of this and should make things more stable as it progresses — the risk, however, is if there are delays.”
And uncertainty over how the ECB will behave as single supervisor is a worry for issuers who are already grappling with bail-in legislation and a funding market which has been hugely distorted by the seemingly endless provision of central bank liquidity.
“My own interpretation is that the ECB taking over is going to lead to another layer of regulatory complexity that we’re going to have to deal with,” says Waleed El-Amir, head of strategic funding and investments at UniCredit. “It’s not like the ECB is going to have so much power that you can say you have one European regulator and all your problems are solved. It’s actually going to make our job more difficult, at least initially.”
Disclosure matters
However, what could be a headache for treasurers could turn out to be a salve for investors. Disclosure has been a hot topic in regulation this year, particularly around risk-weighted asset valuation and consistency in that area.
The European Banking Authority is working on bringing banks’ risk-weighted asset models — which differ vastly — under some sort of reporting framework. And as regulator, the ECB could demand better reporting standards.
“The positive effect on funding costs will come if bond investors get consistent information,” says Fitch’s Gandy. “That is the only way the whole thing is going to work. We need a regulator with teeth to enforce it, in the form of the ECB, and the EBA is already working on disclosure. We need granular information from banks, in a consistent format.”
“Every US bank has to report to the regulator in the same way. You can crunch those numbers and analyse that data in any way you want. We don’t have all that in Europe. When you do have it, you feel more confident. Banking union can’t sort out the dynamics of the market itself, but it can give better supervision, and that should bring down funding costs.”
Even without changes to reporting requirements, the upcoming stress tests and asset quality reviews being conducted by the ECB and the EBA could help investors to get a better handle on how banks are dealing with the aftermath of the financial crisis.
“Before we get there, we’ve got the asset quality review, which is being done jointly by the ECB and the EBA,” says Simon Adamson, chief executive and senior financials analyst at CreditSights. “Whatever comes out of that could have a significant effect on funding costs.”
Long term effects
But could it also eventually push funding costs up again for some banks? The impact of a more level playing field within the European banking industry is hard to assess at this point, but some researchers are already identifying adverse effects.
In a research note published in September this year, Fitch identified one possible long term negative effect of banking union on bank funding costs.
The rating agency argued that a single supervisor could lead to the creation of more pan-eurozone banking networks, collecting deposits in one country and lending in another. This would be an important shift from locally funded operations and could mean that banks operating in deposit-rich countries would have to pay more to compete for funding, eventually passing this cost on to borrowers through their lending rates.
But that is a long way off, says Adamson at CreditSights — banks are still deleveraging, and often retrenching.
“It will take a long time,” he says. “The whole trend so far has been in the other direction, with banks retreating to their home markets. In theory, a proper banking union should erode those borders and encourage more consolidation. But at the moment, banks are concentrating on deleveraging and rebuilding.”
In any case, will it really be so different? Richard McGuire, an analyst at Rabobank, says that in many ways, single supervision, at least, has been around for a while.
“Investors will definitely have to become accustomed to what banking union means for them,” he says. “However, you could argue that the role played by the European Commission since 2009 — demanding various restructuring actions from banks in receipt of state aid — has de facto been that of single supervisor in Europe.”
ECB president Mario Draghi might narrow his eyes at that comment. But the truth is that at some point in the last two years, Europe either had to go all in, or fold. Many in the market regard banking union as simply another step on the road to full fiscal integration. If they’re right, then soon they’ll be too busy trying to work out where the first E-bond should price to think about how much they miss their good old national regulators.