EU renews bank-failure fight as Merkel faces voters

European Union finance ministers are resuming the fight over rules for failing lenders as they struggle to advance bank-union plans against German resistance that has hardened during the country’s election campaign.

Finance chiefs will meet in Vilnius, Lithuania, on September 13-14, a week before German voters choose their next chancellor, to wrestle over how to handle the banking industry, with some countries seeking to preserve regulatory control and others trying to shield themselves from cross-border liabilities.

The government of German leader Angela Merkel has pushed back against a proposal by Michel Barnier, the EU’s financial services chief, for a single resolution mechanism to complement common bank oversight by the European Central Bank. The Barnier plan, announced in July, would create a 55 billion-euro ($72 billion) common fund and give the European Commission, the EU’s regulatory arm, the final say on when to close banks.

“There is no plan B,” Barnier said on August 29. “It’s urgent that we deliver this second pillar of the banking union, which the euro area needs for its stability.”

Ministers meet against the backdrop of rising government borrowing costs as the euro-area economy emerges from a record-long recession. Germany’s 10-year yield reached 2.04 percent on September 5, the highest level since March 2012. That same day, France paid the most to borrow for 10 years – an average of 2.57 percent – since President Francois Hollande was elected.

Credit risk

Bank credit risk has improved amid the economic recovery. The Markit iTraxx Financial Index of credit-default swaps on the senior debt of 25 European banks and insurers fell to a 21-month low of 121 basis points in January from 357.5 basis points in November 2010. It fell 5 basis points to 141 basis points at 9.25 a.m. in London.

Germany has emerged as the main obstacle to a full-fledged banking union, a plan announced by EU leaders in June 2012, by objecting to any kind of risk-pooling without changes to the bloc’s fundamental laws. The European Commission says delays could reignite the financial crisis that forced five of the eurozone’s 17 nations to seek international aid.

EU countries have begun negotiations with the European Parliament on legislation that sets common standards for national bank-shutdown plans, including rules on when and how bank investors would be forced to take losses. Finance ministers forged a common position on the bill in June. The proposed single resolution mechanism would build on these rules.

Absorbing losses

The debate over who shuts down failing banks and who absorbs losses, which also encompasses the single resolution mechanism, has shown the common ground between German skepticism about sharing risk and a French aversion to ceding too much sovereignty over their domestic banking market.

“There is an unholy alliance on banking union between France and Germany,” said Sven Giegold, a German member of the European Parliament who has been involved in banking union legislation.

“France doesn’t want to lose national discretion in its rulemaking, while the Germans don’t want to share any financial responsibility between national banking systems,” he said. “They want to have shared power but no shared financial responsibility, and that is the antithesis of democracy.”

Common bank supervision is the first leg of the banking union project, which leaders introduced to break the cycle of contagion between banking losses and sovereign debt woes. Now that a deal has been struck on ECB oversight, nations must press ahead to forge a strategy on how to shut down failing banks and protect depositors to keep the project from collapsing.

ECB’s role

The Frankfurt-based ECB is on track to take up its full bank-supervision duties in October 2014, Dutch Finance Minister Jeroen Dijsselbloem said on September 5 in his role as chief of the group of euro-area finance ministers.

“The interests of the eurozone are of course massive in this project,” he said.

This timetable depends on final approval by the European Parliament, which is tentatively scheduled to vote on the legislation Tuesday. If the bill passes, the ECB would step up preparations for its oversight role.

The ECB will conduct a broad-based balance sheet review during the transition period to the new supervisory system, and bank officials have warned that the EU must have a plan to cover any shortfalls that emerge.

“Backstops need to be in place before the assessment has begun,” ECB Executive Board member Yves Mersch said on August 29. “Put simply, if there are no backstops, there will be no assessment.”

Bank assessments

Dijsselbloem said that if the ECB finds shortfalls in its bank assessments, institutions will first have to seek additional capital from private investors. After that, nations must apply new state-aid rules that require some private investors to absorb losses, before turning to national bank-resolution funds or other assistance programs.

ECB President Mario Draghi has said the euro area needs a backstop system, without dictating whether it needs to be a truly common approach or a network of national resources. He signaled in June that the solution could involve the direct recapitalization tool in development for the currency zone’s firewall fund.

“We at least want to make sure that there is an explicit commitment by governments, by the European Stability Mechanism and by the Eurogroup to provide a backstop” to deal with capital shortfalls uncovered in the asset-quality reviews, Draghi said.

Debt burden

Direct bank aid from the ESM, the 17-nation eurozone’s firewall fund, went hand in hand with the EU leaders’ commitment to build a banking union and break the bank-sovereign link. Germany has already won concessions that the new ESM tool won’t be available until after the EU finishes work on national standards for bank resolution and forced investor losses.

Finance Minister Wolfgang Schaeuble said August 29 that the ESM isn’t something Greece should count on as the nation seeks to fix its banks and reduce its debt burden in order to secure an infusion of bailout cash.

The ESM’s ceiling for direct bank recapitalizations is 60 billion euros, and “those who know the figures are aware that the entire capacity of the ESM would be used up very quickly if it was used for the retroactive recapitalization of banks in the program countries,” Schaeuble said.

‘Very difficult’

Direct aid to banks from the ESM will be “very difficult” during the transitional period, Dijsselbloem said. “One of the conditions for the use of direct recap from the ESM is that the supervisory work by the ECB has already started, and it doesn’t start until October next year, so we also have a problem of time and phasing here.”

The ESM debate ties directly to Germany’s fears about the legal basis for a joint resolution system, said Guntram Wolff, director of the Brussels-based Bruegel research group. He said German politicians are wary that the system might be vulnerable to challenges at Germany’s constitutional court or in the European Court of Justice, or struck down in national courts if challenged by the creditors of a failed bank.

“The political concern is that the introduction of a single resolution mechanism will be used as a way to offload all the legacy problems of the banking union on the ESM,” Wolff said. “It’s a real concern in the finance ministry and it’s a very real concern across all parties in the Bundestag.” [Bloomberg]