European Banking Union: Small Steps

European finance ministers meet Wednesday to try and agree on common rules for resolving a failed bank, after failing to do so this past weekend.  If agreement is reached, and it appears far from certain that will happen, it’s likely to involve only limited flexibility for a country to bailout the bank without imposing losses on creditors.  Following on last week’s decision allowing the European Stability Mechanism (ESM) to directly recap banks, we are seeing the outlines of banking union.  That’s progress, but is it likely to draw a line under the financial crisis? It’s looking less and less likely.

A Disappointing Agreement

Last week’s agreement on terms under which the ESM could directly recapitalize banks was in line with expectations.  Up to 60 billion euros can be used for direct recap; countries must first ensure the bank is brought to minimum core capital levels. The host country must share in the cost of the rescue.  The rest of the money must come from bail-ins of investors and/or depositors.

Guntram Wolff points out that this deal isn’t closed until governments have approved, and for Germany this means changing the law implementing the ESM. To defuse opposition at the time, the German law allowing the ESM explicitly excluded direct recap. Wolff suggests it’s unlikely that the changes will be approved ahead of German elections, meaning further delay and uncertainty.

The size of the recap fund, like the overall ESM, is woefully inadequate for the scale of the banking system hole.  Looking at the countries that have already restructured their banking system, losses of 10 percent or more are common; apply that to Europe’s roughly 27 trillion euro balance sheet, as others have, and it’s easy to be pessimistic in the downside scenario.  Not all countries will have a crisis, but all are exposed heavily to the periphery.  This probably overstates the losses, but how will we know? The European Banking Authority (EBA) lacks the authority to make the upcoming stress test credible and broad regulatory forbearance masks losses.

To be optimistic, therefore, is to conclude that European leaders understand the math, and in order to protect the euro would expand the fund when (and only when) needed--an unwritten commitment to do whatever it takes. But the desire of Germany and others to put off that day as long as possible, to exhaust all the other options, hardens their line when it comes to bail-ins. That makes this week’s showdown important.

Allocating Losses in Failing Banks:  Rules Versus Discretion

The core of the bail-in dispute is the degree of discretion national authorities should have when dealing with a failed bank. According to reports, one faction, led by Germany, want bail-in rules to provide national authorities little discretion when it comes to forcing losses on owners and creditors after a bank collapses, as well as limited room to choose the kinds of liabilities that are included.  Other countries, including periphery countries and non-euro countries, want national authorities to have more discretion.  Non-euro countries, in particular, argue that their inability to tap the European Central Bank (ECB) in times of panic requires a different set of rules.  One possible compromise (floated by the Commission) would allow flexibility once the bail-in reached eight per cent of total liabilities–after which countries would be allowed more freedom in “exceptional cases” and “subject to strict criteria”.  Of course, most periphery countries would have little fiscal space to finance any such exception.

The likely outcome is a further move towards a bankruptcy-like resolution mechanism in which bank owners, creditors and potentially deposit holders are bailed-in.  From this perspective, Greece and Cyprus restructurings, notwithstanding idiosyncratic features, have become powerful precedents for the broader reform.  Wealthier, non-credit rationed countries will have some capacity to use public money for bailouts.  Periphery countries, absent the fiscal space or debt capacity to do so, will have an incentive to practice forbearance to delay failure, but when that day comes they will have little alternative but to follow the new rules.