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Draghi’s poisoned banking chalice

4 February 2013 By Hugo Dixon

When euro zone governments agreed last year to give the European Central Bank the power to supervise its banks, that looked like another victory for its President Mario Draghi. It is more like a poisoned chalice.

The ECB will certainly get a chunk of extra power. But it will also be blamed when banks run into trouble, as they inevitably will. Draghi himself is experiencing this first hand following the scandal at Monte dei Paschi di Siena (MPS), which has had to be rescued by the Italian state. He has been lambasted for failing to supervise the country’s third largest bank properly when he ran the Bank of Italy – although the criticism seems overdone and has often been fuelled by his political opponents back in Rome.

The potential reputational risks for the ECB from banking snarl-ups on its watch are probably even bigger than they are for national central banks. This is because it doesn’t yet have the full set of tools to do the job properly. Moreover, a huge amount is at stake since the ECB is the euro zone’s most credible institution. If its reputation gets tarnished because of perceived supervisory failures, that could rub off on its ability to conduct monetary policy or manage crises effectively.

The Bank of Italy rejects the notion that it was guilty of supervisory lapses with MPS. It pointed out in a seven-page document last week the host of regulatory actions it had taken since it first became worried about the bank in the second half of 2009.

The bottom line is that MPS did not blow up – something which could have triggered a new euro panic. The Bank of Italy deserves some credit for avoiding such a calamity. It did eventually force the Sienese bank to strengthen its weak liquidity and capital buffers as well as push for the management to quit.

That said, the country’s central bank seems to have been slow to get to grips with MPS. For example, the bank took nearly a year to raise capital after it was told to. The Bank of Italy also waited over a year before launching a second in-depth inspection, even though it found a host of problems in its 2010 probe and discovered other problems afterwards.

There are mitigating factors: the management was hiding information and dragging its feet; the Bank of Italy didn’t have the power to kick out individual bankers; the euro crisis was getting worse for much of the period, making it harder to bring the damaged bank into a safe harbour; and Italy’s recent record on bank failures has been better than that of many other European Union countries.

But such arguments may count for little if and when the ECB faces similar problems with the banks under its watch. Indeed, its position could be worse because the political fudge which set up the euro zone’s “single supervisory mechanism” left some confusion over who is in charge. While the ECB has overall responsibility for supervising the zone’s 6,000 banks, day-to-day responsibility will be left with the national supervisors.

This is a recipe for a mess. If a national supervisor such as the Bank of Italy couldn’t stay on top of MPS, how much harder will it be for the Frankfurt-based ECB to do so. It may not be able to spot which banks are in difficulty. In some cases, national supervisors – who may be jealously guarding their fiefdoms – may not even pass on relevant information. But if a Greek or German bank gets into trouble in the future, the ECB won’t really be able to pass the buck.

The ECB’s position as a supervisor will also be difficult because the euro zone’s leaders haven’t completed the job of setting up a so-called banking union. The critical missing bit is that there is, as yet, no “resolution authority”. Such a body would take control of failing banks and sell them off, break them up or wind them down in an orderly fashion.

The European Commission is working on a plan for such a body but there isn’t yet political agreement on how it would operate. Until there is, the single supervisory mechanism is like a half-built bridge. Although the ECB will be able to monitor banks, its powers will be limited if they still get into trouble. It won’t want to cause mayhem by closing a big bank down; but it’s not supposed to keep bust banks on life support with large liquidity injections either.

This problem is exacerbated by the fact that taxpayers still typically foot the bill when banks get into trouble. Talk of bailing in bondholders rather than bailing them out remains just talk. Witness last week’s 3.7 billion euro rescue of SNS Reaal, the Dutch bank.

Draghi may hope that he will be able to avoid reputational risks from future banking crises by having a Chinese wall between the ECB’s supervisory and monetary policy arms. This would be a bit like the setup in the United States, where the Federal Reserve in Washington conducts monetary policy and its sister organisation in New York supervises the big banks. But such a structure won’t totally insulate the ECB from blame. Once the new supervisory mechanism is up and running, it may be worth reviewing whether it wouldn’t be better to spin it off into an entirely separate organisation.


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