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The Road to a European Banking Union: Part III



In two previous posts, I have addressed the political deals struck by euro area and European Union (EU) finance ministers as part of the European banking union.  In the first, I discussed the European Stabilization Mechanism (ESM) direct bank recapitalization instrument. The second post dealt with the new EU directive on bank recovery and resolution. Despite the progress, much work remains. The deals announced in Brussels must be negotiated with the European Parliament, though this should not be difficult. But many challenges lie ahead.

The first challenge will be the creation of a single resolution mechanism (SRM) in the euro area with the power to overrule national regulatory authorities. Its creation would speed the arrival of genuine euro area decision making, rather than harmonization of national rules agreed upon in the last week.

Considerable public money will be at stake, illustrating the familiar trade-off in European integration between national sovereignty and the need for financial risk mutualization. This raises the equally familiar problem in Europe that European institutions generally lack legal authority under the EU treaty to compel national governments to incur financial losses or for that matter impose losses on private investors. I agree with my colleague Nicolas Véron's assessment in his recent excellent Policy Brief on the European Banking Union. A revision of the European treaties will be required to establish a legally sound basis for an SRM and thereby the banking union as a whole. The discussion will likely be long and contentious once the European Commission publishes its SRM proposal next month. But as illustrated in my previous post citing the cases of Bankia and Anglo-Irish Bank, a commitment by national governments to follow the new resolution rules will make a difference by weakening the dangers of a doom loop.

Another thorny question is the European Central Bank's (ECB) upcoming asset quality review of the balance sheets of the major European banks. The ECB is likely to take over supervision in September 2014. Before then, it must review bank balance sheets and stress test them to ensure that it does not take responsibility of a closet full of bank skeletons. Subsequent bank failures could undermine the central bank's institutional credibility in the eyes of financial markets and European publics. In any bank stress test, one should never ask a question tougher than what the bank and the government standing behind it can answer. European banking regulators and the ECB must thus make sure that credible financial backstops are available to deal with any financial shortfalls uncovered.

Europe's deals on access to ESM direct bank recapitalization and bail-ins of bank creditors are in principle not applicable to such a stress test. The new rules are only scheduled to come into force after the ECB takes over as regulator. European governments would thus still be largely liable for any capital shortfalls uncovered in their national banks. This sequencing raises the risk that a credible backstop might not be available for euro area banks in countries facing severe fiscal stress already, and therefore of another dud stress test on the table.

Because this task poses a reputational risk for the ECB, it will likely try to force the euro area governments to establish the necessary backstops. Plenty of opportunities exist for it to apply such pressure by ratcheting up economic pressure. Mario Draghi, the ECB president, may not want to go to the brink, as the bank has earlier in the euro area crisis, but the ECB is hardly in a mood for stimulus in the coming months. Until the bank's governing council feels convinced that governments are ready to use the necessary tools to succeed in their upcoming bank stress test, don't expect further ECB loosening of standard or nonstandard monetary policies.

The recent EU Council conclusions stated that "member States taking part in the SSM [Single Supervisory Mechanism] will make all appropriate arrangements, including the establishment of national backstops, ahead of the completion of this exercise [e.g., ECB stress test]." But how credible can national backstops be in countries already in weak fiscal positions?

The European Commission's new state aid rules dictate that shareholders and junior bondholders must be written down before state aid can be granted to a bank. These rules will be in force later this summer and will become law when the ECB conducts its stress tests next year. Because the rules fall under the EU Commission's executive powers, member state governments cannot interfere. This is a potentially big deal!

One can argue that the European Union is introducing a rolling bail-in requirement ever higher up the creditor ranking—shareholders and junior bondholders later this summer and then senior bondholders and uninsured depositors in 2014. When the ECB conducts its bank stress test next year, any bank lacking capital must presumably first bail-in its shareholders and junior creditors before getting state aid. Bail-ins are thus certain to be part of the response to any credible new round of stress tests.

The political agreement among EU finance ministers, likely to become legally binding next year, thus lays down the rules of the game in European bank restructurings going forward. Since everyone in the markets now knows these facts of life, euro area governments already face a reduced "first mover stigma" from implementing the new bail-in rules covering even senior bondholders and uninsured depositors in their own country. Thus individual national governments in weak fiscal positions should be willing to impose losses on senior creditors even before the Single Supervisory Mechanism begins and the ECB becomes the banking regulator.

There should be ample opportunities for bailing in bank creditors, rather than stressing government finances further, provided that EU Commission competition authorities are vigilant in enforcing their new bail-in state aid rules next year. The ECB (and European Banking Authority) will be encouraged to impose a credible bank stress test on Europe's banks—a test that once and for all dispels counter-party risks and concerns about their capitalization levels and restores the interbank lending market in Europe.

The upcoming ECB stress test is probably Europe's best shot at finally getting over its banking crisis, but by no means is it a done deal yet. With new state aid rules soon in place and final political agreement on bank resolution rules later this year, concerns over the credibility of "national backstops" can increasingly be addressed by market-based capital injections (such as new equity that would dilute existing shareholders in banks) or creditor bail-ins in Europe. The tools are being readied. But undoubtedly the ECB and EU Commission competition authorities will be under pressure from national euro area governments and the European banking industry in the coming year. Whether they budge will determine the future of the European banking system and the regional economy.

Ultimately, all these developments show that steady progress on Europe's road toward a banking union is under way, but many issues remain unsettled.

See also Part I and Part II of this post.

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