The nightmare scenario that haunts Europe’s incomplete Banking Union

The EU’s Banking Union is a work-in-progress, and among the lessons of the eurozone crisis so far there’s a growing awareness that harmonising the rules on banking supervision and resolution doesn’t go far enough. Before the eurozone crisis broke in 2010, national supervisors hadn’t been able to limit the build-up of risks, and ever since then national authorities’ cross-border coordination has proved ineffectual. The Banking Union may have come a long way towards addressing these weaknesses, but there remain inherent dangers that have yet to be dealt with.

The restructuring of eurozone countries’ national banking sectors has been delayed since the onset of the crisis, and the provision of liquidity by the European Central Bank (ECB) to commercial banks in member states has had to rely on national supervisors’ assessments of solvency. This created a strong incentive for national policymakers to indirectly shift risks to the ECB’s balance sheet.

The Banking Union has essentially become a gatekeeper for the ECB’s balance sheet; the transfer of powers within the Banking Union to the European level, in terms both of bank supervision and resolution, is now substantial. The bail-in framework also seems suited to enabling bank creditors to absorb losses smoothly enough to ensure the stability of the financial system isn’t put at risk. The Single Resolution Fund (SRF) will provide for a degree of operational independence of the Single Resolution Board (SRB), in effect making the Banking Union a substantial step towards full monetary union. It increases the likelihood that private risk-sharing is enforced, in sharp contrast to what happened at the height of the eurozone crisis, when large risks were transferred from the private to the public sector, which inevitably led to the overburdening of public budgets.

But saying that the Banking Union can work doesn’t necessarily mean that it will. Past experience of nationalist attitudes, political interference and regulatory shortcomings during the crisis makes it all too easy to picture a scenario in which it could fail. A not unrealistic starting point for one of these scenarios would be that in two years or so, with GDP growth sluggish and unemployment still high, banks burdened by problem loans and low buffers of equity remain weak. Up to that point, the ECB’s assessment of banks’ balance sheets may well mean that it has kept its promise that no bank under its direct supervision will have failed. The Single Resolution Mechanism (SRM) is fully operational, the SRB has been set up, and the SRF already accumulated €10-15bn.

Let us then assume that if solvency concerns about a single bank arise in a single country – let’s say a bank in Greece or elsewhere on the eurozone’s periphery – these concerns will remain the private information of its ECB supervisors. The troubled bank may not be a systemic player at the European level, but still large enough to have significant operations in other EU countries. And let us also assume that this ailing bank is domiciled in a eurozone country large enough to exercise significant political influence.

In line with SRM decision-making procedures, the ECB notifies both the SRB and the European Commission that this bank looks likely to fail. The SRB then quite quickly concludes that resolution action may be needed, and anticipating that the significant financial resources of the SRF may have to be used it calls a meeting of national resolution authorities. This confirms that the public interest would nevertheless not be served by winding down the bank under regular insolvency proceedings.

The SRB therefore decides that any further step requires Commission approval as a decision-making body within the SRM and also as the EU’s competition authority, so it decides to delay action until it has consulted Brussels. Meanwhile, the national authorities’ representatives have been in touch with their own governments, and preparations are being made for an Ecofin meeting of finance ministers. Time is running out, with the number of people involved getting larger; rumours soon start to spread that the SRB has its first ailing bank on its hands, with insiders saying the case is highly political. In the financial markets, investors are quick to spot the likely candidates for these resolution proceedings, and refrain from providing further funding. The contagion spreads, with feverish speculation about how hard the SRB will go on the bank’s creditors.

Does this scenario suggest that there is the threat of a systemic crisis? It’s hard to say, not when it remains unclear which “system” we are talking about. Is it the economy of the member state which is host to the troubled bank, or is it the member states where the bank maintains subsidiaries and branches, either in the euro area or the European Union as a whole? While these questions are being debated by the SRB, the Commission and the Council, funding conditions deteriorate further. Some banks sell assets to maintain capitalisation levels acceptable to the markets and regulators. Asset prices are in a downward spiral and in newspapers across the world headlines are warning of another eurozone crisis.

Financial authorities and politicians around Europe decide that a comprehensive bail-in of the ailing bank’s creditors would send markets the wrong signal. But to keep promises of “no more bail-outs” they agree on a bail-in of its junior creditors. To keep the eurozone’s “no more taxpayers’ money” promise is going to be hard, as the paid-in volume of the SRF is clearly way too small to recapitalise a bank of any meaningful size and provide funding guarantees. The host country’s finance minister wants funds from the European Stability Mechanism for direct recapitalisation, as promised in June 2012, but a number of northern finance ministers remind him that he will need to draw on his fiscal budget first, as was agreed in the following year. The host country minister then queries this on the grounds that the ailing bank also holds significant operations in other member states. The idea is also mooted of the Fund taking a loan and raising additional ex-post contributions from the banking industry, and although this has better chances of agreement it would require a guarantee to the Fund that no one is willing to provide.

As the struggle over bail-out money continues, serious doubts arise in the financial markets over whether this resolution procedure can ever be effective. When markets start drying up, no one can really tell whether a growing number of banks are now just facing liquidity troubles, or whether these are deeper concerns about their solvency. The ECB realises that in any case withdrawing banking licences isn’t a reasonable option so long as the SRB lacks the firepower to bring the situation under control. The ECB instead sees no other choice but to provide ample liquidity to the banking system. The outcome of this scenario is a variation of a well-known theme that institutions and politics may fail, but willing or not the ECB must stand ready to act.

The point of this scenario is to show what could go wrong in the Banking Union. Recent empirical evidence confirms that market expectations of public bank bail-outs are still high. A bail-in regime as the key ingredient of a more sustainable eurozone architecture has apparently not been successfully “sold” yet. So the fundamental question remains of how to complete the Banking Union in a monetary union of sovereign states without political union?

The SRB’s exercise of bail-in powers should first be made obligatory, with discretion reduced to a minimum. Second, politics should not be allowed to have a say in triggering resolution. Third, stricter state aid rules should be used to deter authorities and politicians from pre-emptive recapitalisations. Exceptions from a strong no-bail-out commitment should only be granted in cases of systemic crisis. For a statutory systemic risk exception to work, one does not need an exact definition of “systemic”, but instead reasonably high institutional hurdles to ensure a crisis is not labelled systemic too easily – perhaps a triple majority in the SRB, the ECB and the Council.

Fourth, to make provision for any case of systemic risk there should be ex-ante burden-sharing agreements and explicit funding commitments between member states. And fifth, a more complete Banking Union would allow for the strict separation of monetary policy and banking supervision so as to mitigate conflicts of interest and reduce the risk of overburdening the ECB, and to better integrate non-euro area members.

Completing a full Banking Union within a union of sovereign states doesn’t mean introducing more mutualisation through, say, a joint deposit insurance scheme with a common fiscal backstop. Banks’ balance sheets depend so much on national fiscal and economic policies that any mutualisation of contingent liabilities would give rise to moral hazard that cannot be addressed unless there’s a significant transfer of sovereignty, in other words, political union.

Many of the Banking Union’s shortcomings reflect the limits of European law. But for it to work, it must be able to demonstrate member governments’ strong political commitment to closer eurozone integration and the irreversibility of the euro. To avoid placing it at risk, changes to the EU treaties should be envisaged soon rather than leaving to an uncompleted Banking Union.