The EU Council—An Initial Appraisal
The European Union Council has concluded its summit in Brussels by taking another incremental but significant step forward in what is still likely to be a long road toward completing the economic and monetary union. Several decisions stand out in the communiques.1 But what was striking was how their decisions on banking supervision followed the general political pattern of a quid pro quo in which conditionality and limits on sovereignty are imposed on Spain and other errant countries in exchange for acceptance of debt mutualization and contingent liability by Europe as a whole—exactly the framework discussed by C. Fred Bergsten and me in our latest Policy Brief [PDF].
As predicted earlier here on RealTime, the European Central Bank (ECB) was politically designated as the future banking regulator for the euro area. Since the EU Council (consisting of heads of government and state) is the key political decision making body in the European Union, with the authority to designate others to implement its decisions, absence of details is no surprise. The EU Commission, whose members are appointed by various national governments, was tasked to flesh out the details. In late May, the commission proposed an integrated system for the supervision of cross-border banks, a single deposit guarantee scheme, and a banking resolution fund. It is thus appropriate to be optimistic that a new sensibly designed regulatory framework for the euro area banking system will soon be tabled. The key political obstacle has been removed because of the decision by Council leaders to surrender their national sovereignty over at least parts of their banking system—a major political step.
This handover of sovereignty will enable several quid pro quo piecemeal mutualizations of euro area contingent liabilities in the banking system. This will be of particular relevance to Ireland, which is now certain to get a better deal on the costs of its bank bailout.2 It is also relevant to Spain, which will get loans without European Stability Mechanism (ESM) seniority, or possibly even direct ESM injections of capital into its banks in the future. It is finally especially important for both Greece and Portugal, which are burdened by bank recapitalization costs as substantial parts of their existing IMF programs.
There was also agreement in Brussels on the procedures for market interventions in support of Spain and Italy by the European Financial Stability Facility (EFSF)/ESM. These include adherence to a de facto shadow IMF program incorporated in countries' existing commitments under existing agreements to adhere to austerity, including Country Specific Recommendations under the European Semester (the new governance architecture established in 2010), the Stability and Growth Pact, and the EU Macroeconomic Imbalances Procedure. In other words, this agreement will yield a Memorandum of Understanding allowing Prime Ministers Mario Monti of Italy and Mariano Rajoy of Spain to accept conditionality from existing EU institutional channels but also maintain that they have rebuffed new pressure from the "Troika of the European Union, the ECB, and the International Monetary Fund (IMF). This effectively strengthens the hands of the EU Commission and the ECB.
The financial quid pro quo in return for this implicit policy conditionality is envisioned in the form of deploying "EFSF/ESM instruments in a flexible and efficient manner in order to stabilize markets for Member States. In return, "the ECB has agreed to serve as an agent to EFSF/ESM in conducting market operations in an effective and efficient manner. This is diplomatic code for finding innovative ways to use ECB leverage for ESM market interventions. It can be done in many ways. European authorities can establish ESM bond insurance for ECB bond purchases (an option mentioned by Chancellor Angela Merkel of Germany after the Summit), or set up direct loans from the ECB to the ESM (i.e., a de facto banking license granted to the ESM). They could also undertake simultaneous interventions by the ESM and its "ECB agent in markets.
The key political issue is that with the surrender of national sovereignty implied in both the agreement on banking integration and the adherence by Spain and Italy to a "shadow IMF program, both the ECB and ESM (e.g., the German and other Northern governments) will accept these types of support interventions. One should expect relatively few details to be provided about these interventions (at least in real time) because of the obvious political sensitivity—the desire to fly under the radar screen, avoiding parliamentary hassles and public inquiries.
Yet, the financial outcome should not be in doubt. The actual financial capacity to intervene by the ESM with the political blessing of the ECB in the euro area financial markets in the future will be far larger than the nominal €500 billion ESM volume would suggest.
The market reaction to all this? Caveat "brevis venditor!*
*Readers can look it up.
2. As discussed on RealTime a while ago, Ireland can in all likelihood look forward to a refinancing of its NAMA promissory notes through the ESM/EFSF.