Banking union's major omission: debt mutualisation
28.03.14 @ 09:18
Should we fear another banking crisis in Europe? European leaders would have you think that this is not possible anymore.
Indeed, after intensely caffeinated negotiations that ran late into the night, the leaders of the eurozone emerged with a deal in hand and smiles on their faces, proclaiming that the long awaited compromise on a banking union has been reached.
Michel Barnier, the EU’s internal market commissioner quickly declared that the deal “will put an end to the era of massive bailouts”.
But will it?
The convoluted history behind Europe’s latest effort of achieving “an ever-closer union” can be traced back to the dark times of the financial crisis that rocked international markets half a decade ago. After the dust settled and some 110 banks caved under the weight of outstanding debts, the Union had already spent €1.6 trillion just to bail out its financial institutions.
With “never again” on their lips, Europe embarked on a grand project, conventionally called “the banking union”. In reality, it indicates a system of four major elements: a single rulebook for the financial market coupled a single supervisory and resolution mechanism, backed by an emergency fund.
The overarching idea was to preserve the European single market and break the noxious relationship between banks and its sovereigns.
Soon thereafter, tensions rose between major political stakeholders over how this new union should be achieved. Should it be a first step towards greater federalism or should it be simply a safety mechanism, controlled by national governments, meant only to address the single issue of banks’ solvency? On 20 March, the second option prevailed.
The compromise was clinched only after the German Finance Minister was woken up at 5am in order to sign off on key aspects. Under the deal, the Single Resolution Mechanism as it has been agreed will be responsible for supervising and/or shutting the 130 biggest eurozone banks as well as 200 cross-border banks and 6000 eurozone lenders.
The ECB, alongside a specialised agency, will undertake the regulatory supervision and will come to the rescue of troubled institutions by drawing from a €55 billion fund. Banks themselves will fill the funds’ coffers, through annual levies imposed by national governments. Under this deal, eurozone governments no longer have the final say whether a bank is too big to fail. It is up to the ECB to decide if funds are to be released.
Every country for itself
Fact: Italian banks have an estimated €150 billion worth of shaky, non-performing loans, while Europe prides itself with almost €1trillion. These figures are enough to give the shakes to any bank wanting to expand its lending business.
Fortunately, the European countries coming together under the banking union scheme can now act decisively and prevent another collapse of the system, right? Well, not quite. And I’m not referring just to the roughly 100 eurocrats that have to cast a formal vote on the closure of a bank.
The major fault of the system stems from German reluctance to accept debt mutualisation across the continent. This means that each country has to shoulder its banks using its own taxpayer money in case of a financial shock that overpowers the rescue fund’s existing capacity. And since the fund only has a few billions at its disposal, if major bank failures were to happen, the burden would once again fall back on individual countries. It doesn’t sound like a true banking union, does it?
The banking union was meant to reverse one of the most resilient financial laws, the so-called “financial trilemma”. In a nutshell, this triple dilemma is defined by three impossibilities: achieving financial stability, integration while maintaining national financial policies in an integrated market. Since the financial system is a dense web made up of streams of capital flows going from one node to the other, a faulty circuit can affect the entire market, threatening financial stability.
The watered down variant of the Single Resolution Mechanism that emerged in the wee hours of the morning of 20 March has severely weakened its initial purpose.
Investors are unsure about the health of banks’ balance sheets, the rigour of supervision and the capacity of cash-strapped European countries to provide the safety net needed to challenge the financial trilemma.
Although this is clearly a political victory for the European Parliament, which managed to force Germany’s hand into accepting a compromise, it is still a far cry from what Europe truly needed to turn around its wobbly banking sector. Like most rules coming from Brussels, the banking union is simply a jack-of-all-trades-master-of-none deal.
Robert Merton, an American sociologist, would have found the banking union a worthy inspiration for his studies. To illustrate how a false understanding of a given situation becomes an integral part of it and affects its outcome – otherwise known as a “self-fulfilling prophecy” – Merton used the parable of a fictitious bank run.
In his example, The Last National Bank, a profitable and stable institution, is suddenly affected by a false rumour that it was on the verge of insolvency. Panicked, its customers immediately flocked to take out their savings, overrunning the bank and forcing its default. The originally false definition of the situation – that the bank was insolvent – had become true, transforming into a self-fulfilling prophecy.
Like in Merton’s case, the EU’s banking union is geared in such a way that it automatically assumes that banks, maybe even big banks, will fail in the future. Unfortunately, the intricate decision-making mechanism and the limited scope of the fund are simply insufficient to reassure the market. Therefore, this is not a mechanism meant to help the banks that are now starving for cash, but a paradoxical way of instilling the idea, in both consumers and bankers, that a future liquidity crisis will happen.
This is a dangerous notion, which has the potential to act as an accelerant for future defaults.
Let’s just hope this will not turn into a self-fulfilling prophecy.
The writer is a Geneva-based economist.