In her first interview since becoming the head of the new Single Supervisory Mechanism (SSM) in Europe, Danièle Nouy talked a big game about letting European banks fail. Policymakers in Europe have been busy agreeing on a road map for how to save banks and, when necessary, how to resolve them. The progress that has been made on establishing a banking union was unthinkable only 12 months ago. However, the road map that policymakers have agreed to is flawed and fails to achieve the primary goals of banking union.
Breaking the Doom Loop
The ECB is currently gearing up to look under the hood of Eurozone’s 128 largest banks in an asset quality review and stress test before taking over supervision of the biggest banks. There is immense political pressure on the ECB from national supervisors to not find any big capital holes in the banks. If big capital holes were discovered, there is no cash available to fill them. Consequently the ECB is likely to err on the side of leniency in its inspection of European bank balance sheets.
However, banks cannot avoid crystallizing losses for NPLs forever. Now that the SSM has been established, the second step towards banking union is to determine what to do when losses are accepted and a bank gets into trouble.
European policymakers have agreed on a roadmap for what to do when a bank has a capital hole, to come into effect in 2016. First, banks are encouraged to raise their own capital in the markets. If this is not possible, banks must impose a loss on their creditors amounting to as much as 8 percent of the bank’s liabilities. This bail-in rule is the single most important developments so far in the banking union. It means that banking debt no longer necessarily gets foisted onto the state’s balance sheet by an immediate bailout. Consequently, the doom loop between banks and sovereigns has been weakened.
However, it has not been broken. If a bail-in is insufficient to fill the capital hole, a bank can dip into national resolution funds (once they exist) or state resources for a bailout. Bailouts going forward will be capped at 5 percent of the bank’s total liabilities. The second half of the doom loop, whereby failing states bring down their banking sectors, has not been addressed at all. In fact, Eurozone bank exposure to domestic sovereign bonds is currently higher than at any time since the Eurozone crisis began. If sovereign debt is written down, the banks will take a bigger hit than ever before.
If a country cannot afford to bailout its bank, then as an absolute last resort around 50 billion euros of the European bailout fund, the European Stability Mechanism (ESM) can be accessed by the state for bank bailouts.
Gone are the days of banks as bottomless pits for taxpayer money. If a bail-in and bailout are insufficient to save the bank, it must be wound up. European policymakers agreed on a Single Resolution Mechanism (SRM) to achieve this, but it will be extremely difficult to actually implement.
A resolution board comprised mainly of national supervisors can decide to wind up a bank. This decision is then sent to the European Commission, which can accept or reject it. If the decision is rejected, it gets bounced back to the finance ministers of member states for a vote.
There are two problems with this decision process. First, it will take days if there isn’t immediate agreement on closing down a bank, and given how politically unpopular bank resolution is, agreement is unlikely to be immediate. Winding up a bank must be done over a weekend, or else bank runs and market panic will ensue. Second, the final word on bank resolution remains with the member states. This means bank resolution will continue to be subject to domestic political pressures, which is partly how Europe’s banks got so sick in the first place.
Leaving the decision-making process aside, there are problems with how to fund bank resolution as well. The first port of call is national resolution funds that are built up by imposing a levy on the banks. These funds will gradually be merged over the course of ten years to create a Single Resolution Fund (SRF) with 55 billion euros in it. There are two problems with the SRF. First, it will only exist in a decade and consequently will not help in the current financial crisis. Second, no one knows quite how it will be used or accessed. Those details are to be hashed out later. It seems likely that Germany (as the largest contributor to the SRF) will resist access to the common fund. If that is the case, the banking union will have failed to achieve one of its other main goals: burden-sharing across Europe’s banks.
The next step in Europe’s banking union is for the member states to hammer out a compromise deal on bank resolution with the European Parliament. The latter has been heavily critical of the deal already agreed and favors a more streamlined, centralized approach. The Eurozone would be better off if the European Parliament rejected the current deal and policymakers were sent back to the drawing board. That is their best chance of establishing a real banking union rather than the loose banking federation currently agreed.