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Tuesday, 02 September 2014

Dos and Don’ts of banking union

Hugo Dixon: Dos and Don'ts of EU banking union

Conventional wisdom has it that the euro zone needs a banking union to solve its crisis. This is wrong. Not only are there alternatives to an integrated regulatory structure for the zone’s 6,000 banks; centralisation will undermine national sovereignty.

“Create a banking union” became a rallying cry earlier in the year when it looked like the euro was going to explode. Advocates of a single banking authority said it would break the “doom loop” which tied troubled banks to troubled governments. European Union governments will this week continue their attempt to agree on a single supervisor, the first stage of a banking union.

There are two parts to the doom loop: when banks go bust, their governments bail them out, adding to their own debts; and when governments become over-indebted, the nation’s banks are usually big lenders, so the banks get sucked into the sovereign debt vortex.

A full banking union would break the first part of this loop. There would be a central mechanism which would either recapitalise troubled banks or close them down. There would also be a single euro zone-wide deposit guarantee scheme. The cost of dealing with banking crises would, therefore, be borne by the whole euro zone rather than national governments.

The other half of the loop - the way that sick governments infect banks - would be left intact. This is worrying; banks in peripheral countries have doubled lending to their own governments to 700 billion euros over the past five years, according to the Bruegel think-tank.

The scheme currently under discussion doesn’t even address the first part of the loop. The politicians are focusing only on supervision. Although leaders did agree in June to let the euro zone directly recapitalise banks, Germany subsequently insisted that this would not apply to “legacy” assets - meaning that the promise offered no help to Spain, Ireland and Greece, which are currently in the midst of banking crises. Meanwhile, the idea of a common deposit guarantee scheme has been shelved.

Moreover, there is no agreement how a single supervisor should work. Germany doesn’t want its savings banks covered, an exemption other countries think would be unfair. Germany is also worried that the European Central Bank, which will take over supervision, could be diverted from its main role of fighting inflation - say if it felt the best way to stop a banking blow-up was to keep interest rates artificially low.

There are also difficulties satisfying the interests of EU countries that aren’t in the euro. Some, such as Poland, might want to join the banking union but complain they don’t have any say at the ECB. Meanwhile, the UK doesn’t want to join banking union but wants to protect the London financial centre. Christian Noyer, governor of the Banque de France, fanned British fears last week when he told the Financial Times there was “no rationale” for the euro zone’s financial hub to be offshore in the UK.

There is an alternative way to break the doom loop. First, banks should be required to have much more loss-absorbing capital, in equity and bonds. If banks had a cushion of 15-20 percent of their “risk-weighted” assets, roughly double the equity-only cushion demanded by new regulations, there would be less risk that governments would need to bail out their banks. The European Commission has bought into this concept, but hasn’t quantified the buffer. It should do so.

Second, banks should be required to diversify their holdings of government debt. Instead of Greek banks holding mainly Greek bonds and Spanish lenders owning mostly Spanish debt, all banks would have a mixture of bonds from across the euro zone. That would make them less vulnerable to over-indebted national governments.

With these two mechanisms in place, supervision, deposit insurance and “resolution” - the orderly wind-down of bust banks - could be left to national authorities. Governments would also be free to devise their own policies for pricking future bubbles - say by further jacking up banks’ minimum capital ratios or capping the size of mortgages.

There would still need to be coordination across the euro zone. The ECB would also need to have enough courage to refuse to act as a lender of last resort to inadequately capitalised banks. But, at least, yet more powers would not be transferred to an unelected central bank in Frankfurt.

If, though, the euro zone is still determined to create a single banking supervisor, it should at least do a proper job of it. That means giving the ECB authority over all banks, not just the big ones. After all, the most recent problems have been concentrated in fairly small lenders, such as Spain’s savings banks. If euro zone taxpayers’ cash is to be on the line, the ECB needs the authority to clean national banking systems from top to bottom. It also needs to be more accountable.

The worst outcome would be a fudge. What is at stake now is comparatively minor. Banking supervision is only the first step of banking union; and banking union only the initial stage of a planned political union. If euro zone leaders cannot stomach the necessary transfer of sovereignty, they should devise a more decentralised model both for banks and their overall project.

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Context News

European Union finance ministers will meet on Dec. 12 to work on a plan to create a single supervisory mechanism for banks in the euro zone and potentially other countries within the EU. They failed to agree on such a plan on Dec. 4.

The topic is also expected to be discussed at a summit of EU leaders on Dec. 13 and 14.

Research by Viktoria Dendrinou

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