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Hornets’ nest

5 July 2012 By Hugo Dixon

Euro zone leaders declared last week that they would break the vicious circle between banks and sovereigns; create a single supervisory mechanism for the industry involving the European Central Bank; and let their bailout fund, the European Stability Mechanism, recapitalise banks once an effective supervisory mechanism was in place.

Creating a “single supervisory mechanism” – this gobbledygook may be important – is the first step to a euro zone banking union. Giving the ESM the right to recapitalise banks directly – rather than lend to debt-laden governments which then rescue their banks – is the second step.

More steps will clearly be required. But even filling in the details on the first two will require many complicated decisions.

Which banks would be covered by supervision?

Should the single supervisory mechanism cover all banks in the euro zone or only systemically important ones – or some other subset of the total universe?

The idea of focusing on the big, cross-border lenders sounds attractive. The snag is that none of the current problem cases counts as a significantly important financial institution (SIFI) on a global basis. The Irish, Greek and Cypriot banks don’t fit in this category. Nor do Spain’s troublesome cajas, including the biggest mess of all: Bankia.

An alternative is to cover all the banks. But this would raise the hackles of national politicians, particularly in those countries which think they are the saints of the crisis and shouldn’t therefore have to surrender sovereignty. The biggest problem could be in Germany, where local politics is closely interwoven with the Sparkassen. But if Berlin insists on carving these savings banks out of the regime, it may be hard to persuade other countries to include all their smaller lenders too.

A compromise, which the ECB is believed to be pushing, is that the single supervisor would have responsibility for all the SIFIs and the option to supervise any other smaller bank in case of emergency or if, for some other reason, it thinks that is necessary.

Who would do the supervision?

The summiteers agreed that the new supervisory mechanism would “involve” the ECB. One way this could work is for it to set the overall policy, while farming out to national supervisors most of the day-to-day monitoring. In 14 out of the 17 euro states, the supervisors are the national central banks. In others, like Germany and France, they are separate bodies.

The main advantage of putting the ECB in charge of banking union is that it has a strong reputation – certainly stronger than that of the European Banking Authority, the fledgling body responsible for regulation within the wider European Union. The EBA blotted its copy book with a couple of weak stress tests.

Another reason to give the ECB the job is that it is the lender-of-last-resort. If it supervises lenders as well, all the expertise would be in one place – leading to more joined up thinking.

But there are also concerns about potential conflicts of interest if the ECB is responsible for supervision as well as monetary policy. Might it, for example, go soft on inflation in order to bail out banks in its charge?

What’s more, making the ECB the banking supervisor would concentrate more power in a body that is only loosely accountable to the citizens of the euro zone, and rarely feels the needs to explain itself.

Some form of enhanced accountability should be worked out. But it could be tricky to do this without at the same time opening a window for politicians eager to meddle in the ECB’s core competence: monetary policy.

Who would manage the bank recaps?

If all the troubled Spanish, Irish, Greek, Portuguese and Cypriot banks are covered, the operation might cost up to 200 billion euros. Controversial questions will have to be addressed such as: how the stakes should be valued; whether the euro zone would receive ordinary shares in the banks being “supranationalised”; and how the lenders would be restructured.

While the ESM would inject capital into banks, this so far non-existent body would not have the skills and resources to examine lenders, negotiate the deals and then restructure them. An alternative could be for the ECB to negotiate the recaps. But it doesn’t have the skills either.

A third idea, proposed by the Bruegel Institute, a Brussels think-tank, is to set up a special task force to take the problem banks in hand. It could be staffed by a mixture of civil servants and private-sector restructuring experts.

Breugel’s Nicolas Veron says such a task force could be analogous to the Treuhand, the agency set up to manage, restructure and ultimately privatise East German industry after unification. The analogy highlights how this could be a thankless task. The Treuhand was unpopular with both West Germans who were worried about excess generosity) and East Germans (who disliked the extensive restructuring). Its first boss was assassinated.

How would the supervisor treat sovereign bonds?

The vicious circle linking banks and sovereigns has two parts: troubled lenders infecting their governments because they require bailouts; and troubled states infecting their banks because they hold so many of their bonds.

Allowing direct recapitalisation of banks by the euro zone would solve the first problem. A single supervisor could theoretically solve the second by telling banks that they shouldn’t hold too many of their own government bonds but should instead spread their risk around by owning a balanced portfolio.

But would a supervisor really have the guts to tell Italian banks that they should reduce their exposure to Italy’s bonds, at the price of driving Rome to the wall? The euro zone could be damned if it did, but also damned if it didn’t.

Who would be responsible for macroprudential policy?

Supervising individual banks is one task; setting monetary policy another. But what about managing the financial system as a whole – so-called macroprudential policy? During the credit bubble, this fell through the cracks.

There is now a commitment across the world to create such a capacity. The idea is that the authorities would have the ability to do things like raise banks’ minimum capital ratios if they thought there was too much credit sloshing around – and cut them if there was too little.

Who would do this in the euro zone? The obvious answer is the ECB. The snag is that a one-size-fits-all policy would be a bad idea. During Spain’s property boom, it would have been sensible to restrain mortgage lending – something that might be appropriate today in Germany.

The challenge will be to create a system that allows local variation and central coordination. The body for doing this could be the new body called the European Systemic Risk Board. Although it is chaired by the ECB president, a potential complexity is that it also includes EU countries which don’t use the euro such as the UK.

Conclusion

All these connected issues need to be solved to bring into effect what the summiteers decided last week. They’ve set an ambitious deadline: by the end of the year the governments are supposed to consider a proposal from the European Commission. It won’t be a smooth ride and, if they are not careful, the destination may not even be pretty.

 

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