The wrongs and rights of the euro banking union

December 19, 2013

By George Hay 

The author is a Reuters Breakingviews columnist. The opinions expressed are his own.

The euro zone banking union was always going to have a difficult birth. European governments finally agreed on Dec. 18 the second of three key milestones – a resolution directive establishing a common approach for dealing with struggling lenders. As with most EU compromises, it is an imperfect reform. It was criticized by European Central Bank officials, including president Mario Draghi, and doubts remain. But the euro zone at least has the beginning of a banking union.

Ideally this would have three elements: a powerful central regulator; a separate entity charged with winding up banks going bust; and a mutualised guarantee scheme that would extend peripheral and German depositors the same protection. The first element is there – after checking under banks’ bonnets throughout 2014, the ECB will regulate 85 percent of euro zone banking assets through a so-called “Single Supervisory Mechanism”. The third – the common guarantee scheme – is unlikely to ever see the light of the day. But the new “Single Resolution Mechanism” agreed this week looks, at first glance, like a dog’s breakfast.

The most important consideration when winding down a bank is speed – to avoid depositors panicking. That’s why in most cases the decision has to happen over a weekend.

The Brussels version is complex and could prove cumbersome in the most difficult cases. A group of five permanent members will sit on the executive session of a so-called Single Resolution Board, joined by the regulators of the countries affected by the bank’s demise. For example, had this system been in place when Dexia was first bailed out, the SRB would have consisted of the five members and representatives of the French, Belgian and Luxembourg regulators. Observers from the ECB and the Commission would also sit in.

That would work in most cases, but things could get messy if the Commission opposes the decision. It can ask the European Union council of ministers to rule – then representatives from all 28 member states would vote via a simple majority. Instead of swift, decisive action, there could then be delays and horse-trading.

But the compromise on the knotty question of who will pay to recapitalize the bank is equally questionable. From 2016 on, European taxpayers will have some protection following a reform agreed last week on the “bail-in” of bank creditors and unsecured depositors. Once the bank has burnt through its bail-inable debt and liabilities, it can tap a 55 billion euro resolution fund, to be built up via bank levies and gradually mutualised over ten years. If that is not enough the euro zone’s European Stability Mechanism, the 500 billion euro bailout fund, could be solicited – but probably only via a Spain-style loan to the government rather than direct to the bank.

The new agreement doesn’t make things simple. No more than 10 percent of the resolution fund can be used immediately for recapitalisations, or more than 5 percent in a single year. If more is needed, it will have to be signed off by the five executive members of the resolution board and by at least two thirds of euro zone members supplying 50 percent of the resolution funds. These voting rules heavily favour countries with the largest banking systems.

It’s easy to see how this compromise was reached. Germany fears that weak southern banks could use up all of the resolution fund and then monopolise large parts of the ESM, to which it is the largest contributor. The fear of handing over something for nothing is why the final leg of a banking union, a mutual deposit guarantee scheme, is a pipe dream – and why Germans have successfully demanded such stringent checks and balances in the SRM.

Does this matter?

Yes, but perhaps not in financial stability terms. For one-off busts, the government would be able to tap the resolution fund and ESM resources if bail-in isn’t sufficient. And resolution systems aren’t supposed to prevent systemic collapses: the United States has had one for years, but threw the rule book away in 2008 when it had to rescue all the big banks at once.

The bigger worry is that the new system could cement the balkanisation of European banks. The new European resolution doctrine already created risks to that effect: bail-ins of domestically-held bonds in weaker economies like Spain or Italy could hurt their economies. Since the costs of bank resolution will be borne by domestic creditors, depositors, or governments, peripheral bank and sovereign funding costs could stay elevated. Peripheral banks will keep gorging on their own sovereign’s high-yielding debt, and will have less incentive to expand beyond national borders. That will undermine the single market – the very opposite of what banking union intends.

Politics is more important

Still, the resolution agreement enables banking union to remain on the right track. The really important objective in 2014 is to rigorously check European bank asset quality and stress test their capital positions, which in any case increased by 80 billion euros between December 2011 and June 2013, according to the European Banking Authority.

More importantly, greater political consensus could mean fewer barriers to the ECB solving one of the biggest headaches in European banking: small Spanish and Italian companies’ sky-high borrowing costs. Even though peripheral banks are staying afloat on cheap ECB liquidity, they are too worried about hurting their capital to lend to risky firms.

To break this, the ECB needs to do something unconventional – perhaps cheap funding for lending to small firms, or even direct purchases of securitised small business debt. So far the same German and internal distaste for indirect banking subsidies to the periphery has stopped the ECB from taking these steps.

But once the ECB starts regulating all banks next year, these political barriers could subside. If an embarrassingly dysfunctional resolution regime is the price for keeping the banking union on track, it’s a price worth paying.

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