Single supervisor is first step toward European banking union

Genevieve Signoret & Patrick Signoret

Earlier this week we wrote a brief guide on the European Union (EU) deal to set up a single banking supervisor for the euro area and other EU countries who choose to opt in. We ended by saying that a full banking union is still far off. Today we share material on (1) what is still missing from last week’s deal and (2) encumbrances that may lie ahead. Stated more optimistically (and prosaically), we lay out an agenda for monitoring this market risk in 2013 and beyond.

Necessary legislation must be submitted and approved

“The package will still require approval from the EU parliament and the German Bundestag, a process that could take several months”, says Financial Times. We haven’t seen such pessimism elsewhere. Ecofin’s statement mentioned hopes that the EU Parliament would adopt the legislation by the end of 2012. German statements to the press depict contentment with the deal for its success in preventing German local and regional banks from falling under direct outside supervision. Germany experts tell us that these banks are famous for their heavy political clout.

New EBA voting rules may have to be changed

One of the things agreed to last week was to subject European Banking Authority (EBA) decisions to the “double majority rule”— approval not only by a majority of all EU members but also of all EU member countries opting out of the SSM. The EBA will write the rule book. The double majority rule ensures that SSM countries can’t act as a block to impose the rule book on all EU members.

Open Europe explains that the rule isn’t entirely safe:

According to the agreement, if the number of ‘outs’ falls below four then the EBA voting rules will need to be reviewed – and could be completely rewritten. Currently only three countries have explicitly said they won’t join the banking union: the UK, Sweden and the Czech Republic. If all the other countries decide to join, then these new voting rules might need to be changed almost immediately.

Seven countries haven’t decided yet whether they’ll form part of the SSM: Denmark, Hungary, Poland, Latvia, Lithuania, Romania, and Bulgaria. Open Europe describes their positions in this blog entry.

The “vicious circle” between banks and sovereigns has yet to be broken

Earlier this year, the single supervisor was thought to be urgently needed given that it’s a prerequisite for the ESM to recapitalize banks directly through “regular decisions” (a majority of votes). “This will enable the vicious circle between banks and sovereigns – which has been a salient feature of the debt crisis in Europe – to be broken”, said Ecofin in last week’s statement. But last week’s decision doesn’t have the ECB taking on its supervisory role until at least the end of March 2014.

There is a backup plan for next year: the Ecofin decided that “a bank could be recapitalized if the ESM adopts a unanimous decision to this effect and then asks the ECB to take direct control of a financial institution” (Europolitics).

That doesn’t solve uncertainty over “legacy assets”: debt already taken on by troubled countries such as Ireland and Spain to bail out their banks. Previous agreements hinted that, with the SSM in place, that debt might be taken on by the European rescue funds. Barclays (requires subscription):

Although the Council acknowledged once again the need to break the vicious circle between banks and sovereigns, the question of ‘legacy assets’ remains unresolved. EU leaders will take six more months to agree on the definition of these ‘legacy assets’ so that when the SSM is up and running in March 2014, direct recapitalisations by the ESM will be possible. This is a very controversial issue and Northern countries are likely to continue to support a very cautious approach. Therefore, the question of ‘legacy assets’ for countries such as Ireland and Spain is going to remain on the table for some time.

A Single Resolution Mechanism is the next priority

Mario Draghi called it a priority last Monday. ECB Executive Board member Jörg Asmussen explained why in a speech on Wednesday:

The agreement on a Single Supervisory Mechanism (SSM) by the EU Finance Ministers is an important first step towards a real financial market union. But it is only one component. A financial market union has to involve a Single Supervisory Mechanism and a Single Resolution Mechanism (SRM). This is the only way to ensure that taxpayers do not end up paying for the mistakes of the private sector. Let me explain why.

Banks that are “too big” or “too interconnected” to fail at the national level – making bailout the preferred strategy – would not benefit from this status at the European level. The SRM would have the legal and financial capacity, as well as independence, to ensure that viable banks survive and non-viable banks are closed down.

Moreover, banks that are “too complex” to resolve via cross-border cooperation – making early action impossible – could be dealt with more effectively at the European level. The SRM would create an authority that could concentrate decisions on resolution and act pre-emptively and quickly, helping to preserve the value of the banks and save money for taxpayers.

However, a strong resolution mechanism cannot remove risks for taxpayers entirely. Certainly, any costs incurred from resolution should first and foremost be covered by the private sector, through establishing a European Resolution Fund raised by levies on the banking sector. But a real financial market union must also contain a public sector dimension at the European level. In this context, the European Council called for the operational framework for direct bank recapitalisation by the ESM to be ready by the first semester of 2013.

I am aware that the prospect of ESM direct bank recapitalisation raises serious concerns: that European taxpayers will end up paying for the bad assets accumulated over the past decade; that mutualisation will become standard practice for dealing with banking sector problems. But let me reassure you that these concerns can be contained with what I would see as the three key principles for European support.

First, European support has to be accompanied by European control, meaning public funds can only be used after the SSM has effectively assumed its duties and on the basis of strong conditionality.

Second, European support should only be granted to banks that are systemically relevant, or pose a serious threat to European financial stability, and therefore affect the common good.

Third, European support must come at the end of a sequential process, involving the following steps:

One, the beneficiary banks must undergo a thorough and independent economic evaluation of their assets to ascertain their real capital needs and reveal any legacy problems;

Two, those banks must be assessed to have a viable business model and so be deserving of additional capital, otherwise they should wound down;

Three, if the banks are to be kept going, private sector sources should be exhausted first – meaning bailing-in of shareholders and bondholders, and if needed, use of the bank-funded resolution financing;

Four, if there are still capital shortfalls, the financial resources of the beneficiary Member States should be drawn on;

Only in the very last step, would European public funds be used.

This pecking order underscores that, the stronger the European resolution framework, the lower the eventual costs for European taxpayers. The more the financial sector can be bailed- in, the less it has to be bailed- out. We see in the US how this can work: the FDIC closed down more than 400 banks during the crisis, without any cost for taxpayers. This is the standard we should be aiming for in Europe – and a real financial market union is the only way to achieve it.

But it won’t be easy. The issue might not be addressed until after Germany’s elections in September. Here’s FT last week:

There is dispute about how quickly to push forward with much more ambitious plans for a European resolution authority and backstop. France and Germany are already at odds over timing and scope. It is the beginning of a long and contentious fight.

[…] France wants the European Commission to bring forward negotiations on setting up the EU resolution regime. Even fiscally conservative Finland is open to the idea.

[…] Berlin is less convinced. Before new initiatives, it wants progress on existing national reforms. It is not sure that a common European resolution framework is urgently necessary. And it is certainly not satisfied that a common backstop or resolution fund is required. Germany is as reluctant as ever to share financial risk at a central level.

[…] Looming large over the debate are the Bundestag elections. German opposition leaders are already accusing Angela Merkel, the German chancellor, of deliberately delaying ECB supervision to 2014 to keep the question of resolution out of next year’s campaign.

Common deposit guarantee scheme is hardly being discussed

Common deposit insurance prevents bank runs and is considered one of the three pillars of a banking union (four, if you include the single rulebook, as the European Commission does). If Germany and other countries are uncomfortable with a common resolution mechanism, though, they are far more uncomfortable about guaranteeing other countries’ bank deposits. A decision on this will almost certainly be postponed until at least 2014.

Must reading: Wolfgang Münchau’s gloomy thoughts on the deal.