Blogs review: The bumpy road to a banking union

What’s at stake: The revival of the Spanish crisis and the chorus of support from academics have made the establishment of a EU-wide banking union – with euro-wide deposit insurance, bank oversight and joint means for the recapitalization or resolution of failing banks – a centerpiece of the upcoming European Summit on June 28-29. A banking union would contribute to the resilience of the monetary union by strengthening financial integration and reducing the potential correlation between sovereign crises and banking crises. The Commission announced on 30 May 2012 the goal of moving towards a banking union. It adopted on 6 June 2012 a legislative proposal for bank recovery and resolution that is seen as a first step towards this goal.

The recent momentum for a banking union

Jean Quatremer reminds us that the policy move towards considering a banking union is very recent. Only a month ago, this move was not considered. Before the revival of the Spanish crisis, the Commission had not put forward a proposal out of fear that Member States, which had already blocked the deposit guarantee fund for over a year, would reject it. The proposal is now out because the debate has significantly evolved over the last month.

Colm McCarthy writes at the Irish Economy blog that Mario Draghi made an important speech at the European Parliament on Thursday. He described the existing Eurozone structure as ‘unsustainable’, and called for the creation of a banking union to under-write the failing currency union. ECB executive council member Peter Praet, speaking in Milan on May 25^th said that “Europe needs to move towards a ‘financial union’, with a single euro area authority responsible for the supervision and resolution of large and complex cross-border banks. This authority should also be responsible for a euro area deposit insurance scheme. With bank resolution and deposit insurance funded primarily by private sector contributions, taxpayers would be shielded from picking up the bill for future banking crises. Essentially, I envision an authority similar to the Federal Deposit Insurance Corporation in the United States”. Two other Executive Council members, Jorg Asmussen and Benoit Coeuré, have expressed similar sentiments in recent speeches.

Wolfgang Munchau writes that Mario Draghi, along with Mario Monti, were the driving force behind a discussion on the subject during a recent informal dinner of the European Council. A previously skeptical Angela Merkel seems to be more open to the idea, but lacks enthusiasm. It was the German chancellor who in 2008 rejected the idea of a pan-European fund to cope with the collapse of Lehman Brothers. At that time, the eurozone took the catastrophic decision that each country must rescue its own banks.

The Commission’s proposal

On 6 June 2012, the Commission adopted a legislative proposal (see here for the full version of the text) for bank recovery and resolution. The proposed framework sets out the necessary steps and powers to ensure that bank failures across the EU are managed in a way, which avoids financial instability and minimizes costs for taxpayers.

In a FAQ document attached to the directive proposal, the Commission argues that the directive proposal is a necessary first step to improve efficiency and cohesion. The reflection towards a more integrated banking union signaled by the Commission on 30 May is an essential subsequent step. It will look into key measures, which need to be taken to ensure closer integration.

A more integrated banking union will rest on the following 4 pillars:

·         a single EU deposit guarantee scheme covering all EU banks;

·         a common resolution authority and a common resolution fund for the resolution of, at least, systemic and cross-border banks;

·         a single EU supervisor with ultimate decision-making powers, in relation to systemic and cross border banks;

·         a uniform single rule book for the prudential supervision of all banks.

Alex Barker writes for the FT that the proposal does challenge at the margins some national taboos over sharing the burden of insuring bank deposits, suggesting that governments must lend to each other’s deposit guarantee schemes in a financial emergency. But it does not attempt to overturn the convention that national authorities remain in control of their own banking systems and are responsible for underwriting the system as a last resort.

Geoffrey Smith writes at the WSJ Europe controversially attempts to create an EU-wide safety net by linking all of the resolution funds of the EU's 27 member states, forcing them to make up to 50% of their funds available to meet emergencies in another member state. But the commission backed away from initial attempts to ask all banks to issue a specific amount of debt that could be "bailed-in" in the event of a failure, seemingly acknowledging that the proposal was too politically sensitive at present.

Eurointelligence points that with respect to resolution, it’s still all national. Each country sets aside a tax, of 1% of bank deposits, which it pools in a piggy bank. Should a bank get into trouble, a process kicks in where the shareholders and bondholders take the first losses, before the joint fund pays out. That means all risk is shared within countries, but not across countries.

The distributional impact of a European-wide bank deposit guarantee scheme (DGS)

John McHale writes that given the differences in the solvency of the banks in different euro zone countries, any move towards centralized deposit insurance has potentially large distributional implications across euro zone countries.

Jacob Funk Kirkegaard writes that a major political obstacle to a pan-euro area banking resolution fund, which would relieve national authorities of the responsibility to fund bank rescues, has always been the implied “fiscal transfers” between euro area governments. That is to say, the government in the country of a bank rescued by the pan-euro area fund would receive an automatic de facto fiscal transfer in the same way that, for example, Nevada did when regional banks went bust during the housing crash and were rescued by the Federal Deposit Insurance Corporation (FDIC). Germany has previously resisted such an implied transfer. But the enhanced potential for imposing losses on bank bondholders would lower the potential magnitude of bank rescues. In the process, the total cost to taxpayers and the associated fiscal transfers between euro area member states in the process would be reduced. This prospect should make a banking union more politically palatable.

Megan Greene argues even if the German government were willing to sign Germany up to backstopping bank deposits in the southern European countries, the German Constitutional Court would find it illegal on the basis that Germany’s financial exposure would be unlimited in nature. To get around this problem, a cap could be placed on the European-wide bank deposit guarantee scheme, with only deposits up to a certain level guaranteed.

Gavin Davies argues that a much greater headache is that this form of DGS would not be sufficient to protect deposit holders against a systemic collapse in an entire banking system within a member state. Nor would it protect against currency redenomination risk if a country were to leave the euro and then devalue its bank deposits by introducing a new national currency.

Dealing with the immediate bank jog in Greece and Spain

The Brussels blog points that the hottest proposals on short term crisis-fighting is to allow the EU bailout funds (the EFSF and ESM) to shore up banks directly with extra capital, without increasing the government’s debt pile. Even that, though, requires a form of banking union. Who would decide what capital a bank needs, what restructuring is required and how the (ownership) stake should be managed and sold down? If the money bypasses the sovereign, should it retain the power to make these decisions? If instead the EU institutions decide how the EU money is used, then that is another step towards a banking union. The question is whether the expertise and institutions exist to do it.

Daniel Gros and Dirk Schoenmaker write in VoxEU unless the banks in both Greece and Spain are soon recapitalized, the on-going gradual deposit flight might turn quickly into a classic run, the consequences of which are hard to imagine. For the medium term, the creation of a European Deposit Insurance and Resolution Fund (EDIRF) could make the European banking system more resistant to national shocks and the contagion from the Greek and Spanish cases. However, the crisis in both Greece and Spain are threatening the survival of the system today and thus require an immediate solution, before the long-run solution can be made operational.

For Greece, the best might be to make the (new) Greek government the following offer. The ESM/EDIRF could provide a partial insurance for retail deposits (say up to 10 % of the maximum) provided the government agrees to implement the adjustment programme (and thus qualifies for further financial support). Each year, the government continues to implement the adjustment programme the ceiling on the guarantee could be increased. But the entire guarantee would be forfeited if the government decided to stop implementation and exit the euro. This combination would immediately create the strong constituency in Greece for a real adjustment that has been missing so far.

In Spain, the toughest decision is what amount of private sector involvement should be required. The decision of the extent of private creditor participation should best be taken by the ESM itself because this institution will be able to weigh the benefit from having to inject less capital against the potential for a destabilization of the Eurozone banking system. Once this has been done and the ESM is satisfied that the restructured cajas are sound, they could be immediately admitted to a European deposit guarantee scheme. A decisive intervention of the ESM should thus be sufficient to re-establish confidence in the Spanish banking system and stem the deposit flight which has already reached alarming proportions.