As indicated by Spanish and Italian secondary market 10-year bond yields of 6 to 7 percent, the euro area remains a work in progress. Italy, on the other hand, seems capable of issuing new bonds, at least to domestic buyers, at slightly lower rates, despite its recent Moody's downgrade. Because the European Central Bank (ECB) and the euro area are most concerned about Italy's direct funding costs (especially at the shorter maturities) and bond auction coverage ratios, direct financial support does not look imminent.
Several other aspects of the euro area crisis remain in flux, however. These include the state of the banking union, Germany's Constitutional Court ruling on the European Stability Mechanism (ESM), and the situation in Spain.
Road Map for a European Banking Union
At a recent talk at the Peterson Institute, the EU Internal Markets Commissioner, Michel Barnier discussed the road map for the European banking union. On the issue of timing, the EU Commission will publish its legislative proposal on the single banking supervisory mechanism in early September, with the aim of getting it approved by the EU Council in December 2012. The intent of the Commission (and the ECB) is to include as many EU and euro area banks as possible under a new single supervisor, not just the global statistically important financial institutions (SIFIs) identified by the Financial Stability Board (FSB). Some member states are certain to push back and try to retain national control of as many smaller banks as possible. But the expansive intent of the Commission/ECB on this point is encouraging. The current state of the European banking system will make it hard for member states to resist.
As for the creation of EU member-state based national deposit guarantee funds (DGFs) covering up to €100,000, this mechanism has been legally in the works since July 2010. It seems probable that the second phase of the banking union—the euro area-wide DGF and a euro area bank resolution mechanism to be implemented once a single supervisor has been established—can proceed quickly in 2013. An initial proportional pooling system of national DGFs, combined with an ESM access, seems the most probable temporary system, until a permanent fee-based insurance system is established.
The ECB has indicated that it does not want to house the inevitably politicized euro area DGF and institution for banking resolution. Accordingly, the ESM seems the logical choice for this function because it has gradually expanded into a precursor for a euro area Treasury. The ESM will shortly (see below) become operational, with its own legal entity, market access, and political board consisting of the euro area finance ministers. There is thus no reason to establish an entirely new Brussels-based institution. Ultimately, the relationship between an ESM with these powers (mandatory for euro area members) and non-euro area members looks like it will be on a pragmatic "opt-in basis." This means that non-euro area members can choose to join prior to potential future euro membership.1
Institutionalized in this way, an ESM with such banking sector powers would provide a powerful new incentive for countries to seek membership in the euro area banking union.2 Without such membership, they would lack influence on ESM decisions in the same way that Norway and other European Economic Area members must slavishly implement Internal Market laws and regulations without having any political input into their formulation. For obvious political reasons, the United Kingdom, with its huge national banking system, would probably never join such an arrangement (despite the risk of being viewed by markets as relatively weak). But other non-euro members have strong reasons to opt in. Most of the banks in the Central European non-euro members are already owned by euro area banks, for example. These countries would therefore feel the consequences of banking sector ESM decisions directly in any case. A similar incentive would apply to Denmark, a non-euro member of the European Union. In 2008, the Danish government had to engineer a rescue of the too-big-to-fail (TBTF) Danske Bank after it neared collapse resulting from reckless expansion and inept management. Having Danske Bank supervised by the ECB and subject to ESM decisions would likely not be opposed by the Danish government, given its long-term commitment to joining the euro. Danish taxpayers should welcome outside supervision as well, having observed how the ownership structure of Danske Bank (which is controlled by the prominent and politically influential Maersk family and its funds) enabled it to extract a sweetheart bailout shielding shareholders and management from the Danish government.
Another related new piece of information has recently emerged of relevance to the banking union. The ECB seems in favor of imposing haircuts on senior bond holders of Spanish banks to be liquidated (i.e., not those merely downsized or consolidated). This shift for the central bank may not be implemented, at least right away, because the euro area governments oppose it. But it marks a possible change in policy direction for the ECB, because it opens up the opportunity of the European Union's new banking resolution powers imposing debt write-downs on junior and senior unsecured bondholders before the previously announced introduction date in 2018. This possibility may unsettle the markets for senior unsecured bank debt in the euro area. But by raising this possibility, the ECB has indicated its intention to be a "hands on" regulator not shying away from regulatory decisions on capital requirements potentially painful for existing private shareholders. Hopefully, the ECB as a banking regulator would demand—rather than suggest as the European Banking Authority has done—that bank capitalizations in the euro area be improved though issuance of new equity (and not through deleveraging). The ECB's shift is also very important for Ireland. It is precisely what Ireland earlier requested when it insisted on haircuts for senior bondholders in the liquidated Anglo-Irish Bank, only to have it rejected by the ECB and other euro area governments. As the Irish government negotiates with euro area governments and the ECB about "further improving the sustainability of the well-performing adjustment ," the political prospects for alleviating the costs of cleaning up from the liquidated Anglo-Irish Bank seem improved.
The German Constitutional Court Steps In
The decision by the German Constitutional Court to rule on the constitutionality of the ESM on September 12, 2012 has postponed the launch of that mechanism until then. This was seen as bad news for the euro area from a short-term financial stability perspective. Many have interpreted the German Constitutional Court's decision to review the ESM as more proof of Germany turning euro-skeptic. But this view is a mistake.
First, the Court is unlikely to reject as unconstitutional a step approved by more than 80 percent of the German Bundestag. Instead the Court seems likely to insist—as it has done in the past—that the Bundestag retain enough oversight over, and information about, the ESM to preserve the constitutional requirement for German budgetary sovereignty. Such enhanced powers for the Bundestag would probably not be welcomed by financial markets (which tend to oppose all potential obstacles to future bailouts). But concerns in democratic states over parliamentary supervision must not be dismissed easily. Indeed, the German Constitutional Court should be applauded for taking the time to thoughtfully consider the implications of the ESM and the enhanced euro area decision making powers it entails. Thus the Constitutional Court's decision should not be viewed as euro-skeptic. Rather it is part of the long-run fight between governments and parliaments over the power and extent of parliamentary oversight over government actions. It is comparable to the battles in the United States between Congress and the Executive Branch over "executive privilege" and the ability of the White House to act outside the reach and oversight of Congress.
Article 19 of the ESM Treaty states that "the Board of Governors may review the list of financial assistance instruments provided for in Articles 14 to 18 and decide to make changes to it." Indeed there might be something to investigate. Article 19 essentially allows for the euro area governments (which make up the ESM Board of Governors) to decide to change what the ESM can be used for in the future. This is a very useful and necessary step for the ESM Board of Governors. No one knows the future, but envisioning the national circumstances for parliamentary oversight over such a decision is especially difficult. And it is precisely such issues that the German Constitutional Court will now study.
More broadly, the euro area politician that should be most worried about this development is probably President Francois Hollande of France. The Constitutional Court is likely to insist on more accountability in the European Union/euro area if the Bundestag has to surrender some of its budgetary powers. This is what Chancellor Angela Merkel of Germany is referring to when she has talked about the need for political union. In other words, the Constitutional Court has underlined that Merkel is not bluffing when she cites the need for the court's approval in negotiations with other leaders over her insistence that political union must follow in lock-step with fiscal/banking union. Hollande will feel these pressures acutely because France has been the most reluctant member state to yield political power to Brussels. The German Court's decision is therefore a good thing for those who wish to see the European Union imbued with more democratic accountability along with its expanding financial and regulatory powers.
Spain Moves Toward More Austerity
By launching a third round of austerity measures, Spain has now moved toward a shadow International Monetary Fund (IMF) reform program. Madrid also demonstrated its intent to go further on structural reforms. These moves, immediately following the political agreement with the euro area of a Memorandum of Understanding (MoU) for the Spanish banking sector recapitalization, makes it clear that the "implied conditionality" of the MoU goes beyond the financial sector specific conditionality (recapitalizations, bad-bank establishment, etc.). Partly because of the early fumbling of the administration of Prime Minister Mariano Rajoy, Spain is now enduring an unofficial IMF-type program intended to keep it in the financial markets (even at high costs) and avoid a regular, full IMF program with explicit policy conditionality and removal from the markets for a prolonged period. Rajoy's popularity deserves to suffer from this misstep. The rest of the euro area must hope that he will do better.
1. Some might favor a more integrationist "opt-out system," where all 27 members are assumed to be members unless they wish not to. However, given that the ESM is a euro area only institution, this seems implausible and implementation of an opt-out system would seemingly require an unnecessary establishment of an entirely new stand-alone EU-27 (minus x) DGF and resolution entity.
2. Note that the transfer of bank supervision to the ECB would operate in the same manner for non-euro members opting-in.