A missed opportunity on banking union

In June 2012, at the height of the debt crisis in the eurozone, its leaders decided to create a banking union. Their aim was, as the conclusions of that summit stated, to “break the vicious circle between banks and sovereigns.” In this case, the sovereigns were members of the single currency whose economies were suffering.

The euro leaders wanted to find a way to ensure that banks which went bust or needed recapitalization would not drag the sovereign down with them, as they did in Ireland, Spain and Cyprus. The plan was to also prevent the reverse happening, as in the case of Greece. It is clear that the only way to break the “vicious circle” is to prevent member states from having to use their taxpayers’ money to save troubled lenders. Instead, this burden should be shared among all members of the euro area.

A year-and-a-half later, an agreement was reached in principle in Brussels on what form the single resolution mechanism for this banking union would take. Wednesday’s deal simply confirms the worst fears: The German leadership’s lack of vision and the timidity of other members condemns the banking union to failure and the eurozone to a lost decade at best or, at worst, a new crisis that will tear it apart politically and economically.

The eurozone banking union is supposed to be built on three pillars: a central supervisory authority, a common resolution mechanism and a system providing for common guarantees of deposits up to 100,000 euros. However, German Chancellor Angela Merkel questioned the architecture of the banking union and undermined some of its basic elements from the start.

For example, the European Central Bank will take on the central supervisory role from November 2014 but Berlin succeeded in its goal of ensuring that the Frankfurt-based central lender will only oversee the eurozone’s 128 biggest banks. The remaining 6,000, including some 2,000 German savings and regional (Landesbanken) lenders, will initially be excluded from this and their supervision will be carried out by national authorities.

However, until now the biggest problems have been caused by similar small and medium-sized banks in Ireland, Spain, Greece and Cyprus. Why did Germany not want the ECB to supervise small German banks? Because they are the main financial sponsors of German politicians at a local level and, as we know, “all politics is local.” In spite of this, and risking its credibility, the ECB will proceed with an asset quality review (AQR) of the big banks and will put all lenders through stress tests. The ECB’s involvement gives us hope that the results of these tests will be reliable.

Resolving the eurozone banking system by recognizing losses and proceeding with recapitalization wherever it is needed is a fundamental precondition for economic recovery. European businesses, in contrast to those in the USA which mainly draw funds from the bond markets, rely heavily on banks for financing. If the banking system is not put in order, there will be no new lending or investment and unemployment will continue to leave a scar, mainly on the countries of Southern Europe.

This brings us to the second pillar, the single resolution mechanism that was agreed on Wednesday night and through which troubled banks identified by the ECB will supposedly be restructured or shut down. A couple of days earlier, ECB President Mario Draghi warned bluntly, “We should not create a single resolution mechanism that is single in name only.” He expressed fears that “the decision making may become overly complex and financing arrangements may not be adequate.”

Despite the warning, finance ministers acting under Berlin’s intense pressure did just that. The resolution mechanism they agreed on will be financed by national resolution funds that will be gradually merged into a single system by 2026 (yes, 2026). Levies on banks will help build up the common fund but it is envisioned that the total amount will only reach 55 billion euros in 12 years’ time, an amount that is clearly paltry if one considers that rescuing Greek banks has already cost 40 billion euros.

Until then, national resolution funds will be able to call on the funds of other member states for assistance through a very complex mechanism. Even worse, Berlin managed to deflect the requests of Southern European countries to allow the European Stability Mechanism to finance their resolution funds if needed in the meantime. This decision also sounded the death knell for the idea of a direct recapitalization of banks from the ESM, let alone the retroactive recap that Greece and Ireland had hoped for.

In short, each member state will be responsible for saving its own banks. In the worst case, a member state will be able to turn to the ESM, agree a memorandum of understanding and borrow the money it needs to rescue its lenders, as Spain did in 2012. Of course, in this case the money borrowed will be recorded as public debt and will impact on the state’s finances. This, however, means that the “vicious circle” between eurozone member states and their troubled banks is not going to be broken. In other words, eurozone leaders failed to achieve their main goal.

As if that was not enough, the decision to resolve a failing bank will not be taken by the ECB or the European Commission but by a council that will consist of national authorities, independent experts, the Commission and finance ministers. This means that up to 126 people could be involved in the decision-making process. How they would manage to maintain secrecy and prevent bank runs if details are leaked remains a mystery.

There could be a bulwark against the uncertainty created by the feeble banking union and the precedent set in Cyprus, where the Eurogroup initially agreed to a haircut on insured deposits. This could be created by a common guarantee system for savings of up to 100,000 euros. Unfortunately, Merkel has already demolished this third pillar by ruling out any possibility of the ECB guaranteeing these deposits even though it is the only institution that could take on this role.

This means that member states will have to continue guaranteeing deposits on their own. Are they in a position to do that? Perhaps it would be possible for the countries with stronger economies. The rest are either unable to do it or would blow their public finances sky high if they had to even attempt it. I am afraid that in years to come we will look back with great bitterness on the missed opportunity to create a genuine banking union.

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