EU banking union a product of the euro crisis but also its solution?

There is a dirty little secret at the heart of the euro crisis and it concerns Europe’s banks. Many politicians and much of the media have focused their attention on the role sovereigns – particularly in southern Europe – had in triggering uncertainty and economic instability in the single currency area but the part banks played in laying depth charges at the euro’s foundations has been largely absent from public debate.

Yet, most places you look, eurozone banks have left their mark through a mixture of risky practices, undercapitalization, and over-exposure to government bonds and the US subprime market. Ireland is the most obvious case, where taxpayers have been asked to stump up about 70 billion euros to bail out reckless and troubled lenders. Spain has just asked for a 40-billion-euro bailout for its banks, which fuelled an unsustainable property boom through cheap credit in the previous years. The most prominent example of the short-termism and entangled interest that led to this imprudent lending was Bankia, formed by the merger of seven savings banks, or cajas, in 2010.

Bankia has so far absorbed 19 billion euros of taxpayers’ money, shed 50 billion euros of assets as part of a restructuring and cut 6,000 jobs. French-Belgian bank Dexia found itself in a similar situation. France and Belgium have so far spent about 15 billion euros rescuing the lender and provided up to 85 billion euros in state guarantees after it was caught short by its reliance on short-term financing in 2008 and then to Greek debt in 2011.

Cyprus is currently in talks with the eurozone and International Monetary Fund (IMF) for a bailout largely to cover the recapitalization costs of its banks, which run to an estimated 10 billion euros.

In Greece, nearly 50 billion euros of public money is needed to prop up lenders that were hit particularly hard by the private sector restructuring earlier this year but as the crisis has rolled on, the institutions’ lending practices have come under greater scrutiny. Questions are now being asked about the money the banks provided to failed businesses, cronies, political parties and media groups.

However, it should not be forgotten that at the start of the crisis, German and French banks were heavily exposed to Greek debt, as some of them had been to the US subprime market in 2008. Bank of International Settlements (BIS) figures show that in early 2010, German and French banks held an estimated 34 billion euros of Greek bonds. They reduced this exposure in the ensuing months but were aided by the fact that until this month, about three quarters of the bailout money Greece received went toward repaying existing debt, ensuring that losses for banks were minimized as much as possible.

In Germany, the public rescue fund for banks (SoFFin) has accumulated 23 billion euros of losses since 2008. It is no surprise, then, that the business daily Handelsblatt wrote last week that German taxpayers should “rejoice” at progress on creating a banking union in the EU through more central regulation.

“The failure of German bank regulators cost them more than the Greek bailout,” the newspaper said. “Hopefully the European Central Bank will do better. It would be difficult to do worse.”

While most people’s focus has been on bailouts and austerity measures, the European Union has been working behind the scenes over the last few months to fix some of the deficiencies in its banking system. This culminated in finance ministers agreeing early on December 13 on the first of three elements the EU believes it needs to form a banking union that will provide greater financial safety and robustness to withstand future shocks.

The ECOFIN’s decision to back the creation of a single supervisory mechanism (SSM) was seen by many as a landmark moment. French daily Le Monde called it “historic” and a “great leap forward” to prevent the “death of the euro.”

There is still much work to do before the central supervisor, which will operate under the auspices of the European Central Bank, is able to fulfill its mandate, while details of the two other pillars of the banking union (a common deposit guarantee system and a resolution mechanism for failed lenders) are due to be finalized next year.

Nevertheless, it is significant – even symbolically – that the EU’s first real breakthrough in the four responses to the eurozone crisis included in a road map agreed by EU leaders at a June summit should be in creating a banking union. The other three elements are closer fiscal, economic and political union. Last week’s summit failed to lead to any significant progress on these elements, with key decisions being put off until June next year. The developments with regard to the banking union emphasize that banks could not be approached as a side issue in the euro debate.

“The Single Supervisory Mechanism constitutes a major qualitative step towards a more integrated financial framework,” EU leaders said in their concluding statement following a two-day summit held in the wake of ECOFIN’s decision. They added that a banking union would “help restore normal lending, improve competitiveness and help bring about the necessary adjustment to our economies.”

The creation of an SSM means that the supervisor will have direct oversight over banks whose assets are worth at least 30 billion euros or more than 20 percent of GDP. This relates to more than 100 banks, including Greece’s main lenders. At the end of the first quarter of this year, Piraeus Bank had assets worth 47.5 billion euros, Alpha 57.6 billion, Eurobank 73.6 billion and National 104.1 billion. Recently announced acquisitions and mergers will lead to these assets increasing, with Alpha, National and Piraeus remaining as the dominant players.

The supervisor will work with national regulatory authorities to ensure that there is proper monitoring of the remaining lenders (some 6,000 in total) in countries that sign up to the banking union, which applies to all eurozone countries. The UK, Sweden and Czech Republic have so far opted out of the scheme.

The ECB will have the power to intervene if it feels that lenders’ practices are too risky and to ask them to increase their capital requirements. Most contentiously of all, it will have the authority to withdraw licenses and wind up lenders not deemed fit to continue.

“It took a big crisis and a lot of our money to decide this. It is a courageous decision,” Karel Lannoo, chief executive at the Center for European Policy Reforms (CEPS) think-tank, told reporters at a European Journalism Center (EJC) seminar in Brussels. “We have a much more powerful authority that can stop funding banks if they do not cooperate,” said Lannoo.

The agreement on the SSM still needs approval from the European Parliament and national parliaments but the aim is for the ECB to start generating the capacity to take on its added role from early next year, with a view to begin executing its supervisory powers in March 2014. Creating what the Wall Street Journal termed a “powerful policeman for banks” is tantamount to a confession of just how wrong the EU, and the eurozone in particular, got it in the financial sector in previous years.

Flawed investment practices, risky tactics, a lack of transparency, undercapitalization and a lack of regulation in the banking sector have all had a damaging impact on the euro and the eurozone economy.

“Nobody had a pure view of the systemic risk when the crisis started,” Isabelle Vaillant, a director of regulation at the European Banking Authority (EBA), told the EJC seminar.

Lannoo said the ability of the ECB to have detailed access to banks’ balance sheets will create a safer environment: “The most important thing for me is that the ECB will have proper information about the banks.”

He added, though, that the creation of an independent supervisor will help break the cycle of influence between banks, business and politics, which proved a disastrous mix in so many euro area countries. “The banking supervisor should not be motivated by political reasons. We saw what problems that created in Spain,” Lannoo said.

Eric De Keuleneer, a professor at the Solvay Brussels School of Economics and Management, identifies the creation of new supervisor as the moment to ensure that banks do not continue to serve narrow interests, creating problems that require taxpayers’ money to be solved.

“Governments found it difficult to regulate and distinguish between the interest of the banks and the interest of countries,” De Keuleneer said, citing the example of Ireland. “The regulating mechanism should be strengthened and be given more effective means to protect the general interest.”

Bart Van Craeynest, chief economist at the Petercam stock brokerage, believes the EU has an opportunity to rectify the weaknesses in its financial supervision, which allowed lenders to take on too much risk.

“There was a fallacy in Basel I and II, which was that there was zero risk attached to banks owning government bonds,” he said, citing the accords on banking supervision signed in 1988 and 2004 and named after the Swiss city where the committee meets.

“It’s become pretty clear over the last couple of years that national regulators were not doing their jobs,” Van Craeynest said.

Despite the general recognition that the EU took a significant step forward last week by agreeing on the SSM, there are still a lot of loose ends to tie up. Also, not everybody remains convinced that the Brussels agreement will be as effective as EU officials hope.

Van Craeynest expressed concern that the ECB’s role in controlling the eurozone’s money supply and maintaining price stability could be compromised as a result of adopting a dual role as the central supervisor.

“Placing supervision with the ECB is a bad idea. There is concern about the impact it could have on independent monetary policy,” he said. “The ECB has no track record of supervising one bank, let alone 6,000.”

The fact that the ECB will only have direct supervision of the biggest EU banks is a result of the compromise forced by the lengthy negotiations on the subject. Berlin, in particular, had raised objections to the ECB directly monitoring its local savings banks, known as sparkassen, which come under the control of authorities in Germany’s 16 federal states. This still leaves significant work for national regulators in each of the 17 eurozone countries and beyond to do in the years to come.

“The banking union will help make sure that the rules are implemented safely and in a harmonized manner but it will not be a regulator,” sais Vaillant of the EBA.

“If the ECB can put in place an administrative system where the biggest banks can be supervised, this could be moved to a new entity but there would also need to be strong supervision of national regulators,” argued De Keuleneer. “The mechanism has to be strengthened.”

Beyond that, there are the outstanding issues of creating a unified system to guarantee bank deposits in all participating member states and a resolution mechanism for dealing with lenders that need to be closed down or restructured. The former touches on the issue of creating a transfer union, which the Germans are very sensitive to, as money collected in countries with healthy lenders might have to be used to protect deposits in countries with weaker economies and where banks are more likely to go to the wall.

Creating a resolution mechanism is also a touchy issue as the EU will have to decide the circumstances under which a lender would be considered non-viable. Having agreed this – which will prove no mean feat – the ECB will then be tasked with shutting those banks down or advising national regulators to do so, a function that could bring it into direct confrontation with governments.

“The test will eventually be if you have a bank going too far in extending credit and if someone will then step in and shut it down,” said Van Craeynest. “I don’t see the ECB going into Germany and shutting down a sparkasse or landesbank.”

For Greece, though, part of this discussion is academic as its banks are already going through a thorough restructuring process that is leading to some lenders, such as ATEbank, disappearing. Equally, the troika has insisted that Greek banks come under much tighter and much more independent supervision. The expected completion of the recapitalization process early next year will lead to a panel of commissioners, including foreign officials, monitoring Greek lenders.

The creation of a single supervisor under the ECB is highly significant for Greece in a completely different respect, though. In June, EU leaders also agreed to the direct recapitalization of eurozone banks from the European Stability Mechanism, the single currency’s 700-billion-euro permanent crisis fund. The main condition for the direct recap to take place was that the SSM would be created so there could be some degree of confidence that ESM money was not being poured down a black hole.

The possibility of the 48 billion euros for recapitalizing Greek banks being recorded as ESM liabilities rather than national debt is momentous in terms of achieving debt sustainability. It would reduce Greece’s debt-to-GDP ratio by more than 20 percent, meaning the IMF’s target of 124 percent of GDP by 2020 could be easily achieved. In fact, under such circumstances national debt of under 100 percent of GDP at the beginning of the next decade would be within the country’s reach, rather than being the economic fantasy it seems at the moment. The implications this would have for killing off the menace of currency risk and augmenting stability are clear.

However, the use of the ESM for the recapitalization of eurozone banks appeared to disappear from the agenda after the eurozone’s AAA-rated countries – Germany, the Netherlands, Finland and Austria – announced in late September that the funding process could only apply for banks under the supervision of the SSM and not for “legacy assets” or debt that had accrued before the central supervisor had been set up.

This position appeared to be in direct contradiction to the one adopted by EU leaders in June, when they said it was “imperative to break the vicious circle between banks and sovereigns.” The September statement put the interests of the AAA countries at odds with those of Spain, Ireland, Cyprus and Greece – all of whom could hope to benefit from a direct recap. It also appeared to kill any debate over the issue. Recent developments, however, suggest the matter is far from settled.

In fact, EU finance ministers discussed “legacy assets” in their meeting and the issue was referred to in the conclusions of the leaders’ summit a day later. It suggests that some kind of compromise could be found. The summit statement reaffirms the need to “break the vicious circle between banks and sovereigns.”

“Further to the June 2012 euro area Summit statement and the October 2012 European Council conclusions, an operational framework, including the definition of legacy assets, should be agreed as soon as possible in the first semester 2013, so that when an effective single supervisory mechanism is established, the European Stability Mechanism will, following a regular decision, have the possibility to recapitalize banks directly,” the leaders’ statement reads.

The statement renews hope for countries like Greece and Ireland that their recapitalization costs might not be recorded as national debt in the future. The subject seems to be returning to the forefront of the eurozone debate.

“It will certainly come back,” said Lannoo. “Ireland has already made the case for it to be reconsidered. It could be a possibility in the case of Greece as well.”

He added that the eurozone has often crossed red lines, such as the one drawn by AAA countries on “legacy assets,” over the last few years. “During the crisis, we have not always applied the rules evenly,” said the CEPS analyst.

Some critics argue that the ECOFIN and the EU summit could have made more substantial progress on the ESM recap issue last week if there was real willingness to break the debilitating bonds that bind sovereigns and banks. However, Commission sources point out that the ESM and its uses are a product of intergovernmental talks between eurozone members and not discussions at an EU institutional level. This means that discussions on the banking union and on the role of the ESM will not necessarily happen absolutely in parallel.

Another concern is that it could be late 2014 by the time the ESM is in a position to take on the cost of recapitalizing Greek banks. Again, though, Commission sources suggest that things could move more quickly. They indicate that a direct recapitalization via the ESM could happen once regulation for the single supervisory mechanism is effective, which could be as early as next year.

In a sense, though, it is almost irrelevant for Greece when such a move might happen. The decisive moment will be when it is clearly communicated that there is a consensus for the recapitalization to happen in this manner. That’s when the uncertainty about Greece’s debt sustainability and its future in the eurozone could be lifted. That’s when Eurogroups will no longer have to run through the night to find ways of reducing Greece’s debt. And, that’s when the possibility of Greece coming out from under its debt burden and being in a position to attract long-term investment will emerge.

Of course, an ESM recap on its own will not solve Greece’s problems: 2013 promises to be a supreme test for the Greek government, economy and society. A cascade of structural reforms will fall on a rock of resistance; a torrent of austerity measures will sweep through a broken society and a sixth year of recession will stretch a feeble economy. All of this points to a new secret at the heart of the eurozone crisis: while steps to create a genuine banking, political, fiscal and economic union are foundation stones for preventing and weathering future crises, there remains serious doubt about whether the single currency area is doing enough to address the current one.

[Kathimerini English Edition]