The EU's banking union: a recipe for disaster
In its original intention, the banking union was supposed to ‘break the vicious
circle between banks and sovereigns’ by mutualising the fiscal costs of bank
resolution. This was the result of a belated acknowledgement by European
decision-makers, various years into the crisis, of the non-fiscal – namely,
banking and monetary – nature of sovereign distress in the EMU. As the
‘sovereign debt crisis’, in 2012, engulfed two countries that in the pre-crisis
years had registered among the lowest deficit/debt ratios in the EMU – Spain
and Ireland – European policy makers were forced to recognise that leaving the
responsibility to deal with the post-crash banking crises in the hands of
individual member states – essentially leaving national policy makers with no
choice but to finance their bank-rescue operations (or bailouts) with national
fiscal resources – had ended up saddling certain countries (especially those of
the EMU’s periphery, which had experienced massive speculative capital inflows
and a huge build-up of private debt in the years leading up to the crisis) with
unsustainable levels of public debt, and leading to dangerous imbalances that
now threatened the financial stability of the euro area as a whole. As the
governor of the Bank of England Mervyn King had argued early in the crisis,
‘global banks are global in life but national in death’.
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Hence, even though the focus on austerity as the main policy response remained unchanged (for political rather than economic reasons, as I argue in depth in my book, The Battle for Europe), there was a recognition of the need for substantial changes in the European policy stance on bank resolution, aimed at relieving individual countries of the fiscal responsibility for bank-rescue operations and putting an end to the fragmentation along national lines of banking and monetary conditions. The establishment of a joint public funding mechanism – a so-called common ‘fiscal backstop’ – for the whole euro area was considered essential for this purpose. The prerequisite for a mutualisation of bailout costs, however, was the centralisation of the responsibility for banking supervision and resolution in the euro area, so as to preclude the externalisation of the fiscal costs of regulatory failure by countries with lax regulatory regimes. Such were the considerations that drove European leaders on 29 June 2012 to explicitly affirm the need to break the ‘vicious circle between banks and sovereigns’, adding that ‘when an effective single supervisory mechanism is established, involving the ECB, for banks in the euro area the ESM could, following a regular decision, have the possibility to recapitalize banks directly’.
In the course of constructing the banking union, however, something remarkable happened: ‘the centralization of supervision was carried out decisively; but in the meantime its actual premise (that is, the centralization of the fiscal backstop for bank resolution) was all but abandoned’, Christos Hadjiemmanuil writes. Within a year, Germany and its allies had obtained:
a) the exclusion from the banking union of any common deposit insurance scheme;
b) the retention of an effective national veto over the use of common financial resources;
c) the likely exclusion of so-called ‘legacy assets’ – that is, debts incurred prior to the effective establishment of the banking union – from any recapitalisation scheme, on the basis that this would amount to an ex post facto mutualisation of the costs from past national supervisory failures (though the issue remains open);
d) most importantly, a very strict and inflexible burden-sharing hierarchy aimed at ensuring that (a) the use of public funds in bank resolution would be avoided under all but the most pressing circumstances, and even then kept to a minimum, through an application of a strict bail-in approach; and that (b) the primary fiscal responsibility for resolution would remain at the national level, with the mutualised fiscal backstop serving as an absolutely last resort.
‘The policy choices made on these occasions locked in a requirement of extensive bail-in of private stakeholders and the avoidance of public assistance in all but the most extreme circumstances as principal characteristics of the European approach to bank resolution’, Hadjiemmanuil notes. In short, when a bank runs into trouble, existing stakeholders – namely, shareholders, junior creditors and, depending on the circumstances, even senior creditors and depositors with deposits in excess of the guaranteed amount of €100,000 – are required to contribute to the absorption of losses and recapitalisation of the bank through a write-down of their equity and debt claims and/or the conversion of debt claims into equity.
Only then, if the contributions of private parties are not enough – and even then, at very strict conditions – can the Single Resolution Mechanism’s (SRM) Single Resolution Fund (SRF) be called into action. Notwithstanding the banking union’s problematic burden-sharing cascade – for reasons that we will examine shortly – the SRF presents numerous problems in itself. The fund is based on, or augmented by, contributions from the financial sector itself, to be built up gradually over a period of eight years, starting from 1 January 2016. The target level for the SRF’s pre-funded financial means has been set at no less than 1 per cent of the deposit-guarantee-covered deposits of all banks authorised in the banking union, amounting to around €55 billion. Except if all unsecured, non-preferred liabilities have been written down in full – an extreme measure that would in itself have serious spillover effects, for reasons that are easy to imagine – the SRF’s intervention will be capped at 5 per cent of total liabilities. This means that, in the event of a serious banking crisis, the SRF’s resources are unlikely to be sufficient (especially during the fund’s transitional period).
If a bank remains undercapitalised even after all the aforementioned sources of resolution financing have been exhausted – and even then, at very strict conditions – countries may request the intervention of the existing European permanent bailout fund, the ESM, through its new direct recapitalisation instrument (DRI). The way in which the instrument has been implemented, however, raises doubts as to its practical significance. As Hadjiemmanuil notes, the DRI’s rules ‘raise significant barriers to the activation of the DRI even in situations where recapitalisation with public funds appears justified’. Most importantly, the country eligibility criterion takes explicitly into account the alternative of indirect bank recapitalisation by the ESM, by way of a loan to the relevant national government; unless this form of assistance is bound to trigger by itself a drastic deterioration of the recipient country’s fiscal prospects, it should be preferred over the DRI. In other words, the DRI is only available in situations where a country is unable to finance on its own account a bailout without thereby undermining its fiscal prospects; in all other cases, the national government must provide itself financial support to the troubled bank(s), either by raising the requisite sums in the capital market or, in the worst case, by accessing the ESM for a loan. In the latter case – reliant upon the approval of the Commission, in liaison with the ESM’s managing director, the ECB and, wherever appropriate, the IMF – requesting member states will not be spared the troika’s dreaded conditionalities, ‘including where appropriate those related to the general economic policies of the ESM Member concerned’. In other words, those states whose banks (not governments) run into trouble and thus require financial assistance by the ESM will likely be forced to implement the same kinds of austerity and structural adjustment programme – public-sector cuts, wage reductions and so on – as the recipients of sovereign loans have been forced to implement in recent years.
Oddly, even in the unlikely event that a bank is granted access to the DRI, before it can receive direct injections from the shared fund, the requesting government must either provide the capital needed to raise the bank’s minimum capital ratio to 4.5 per cent of its assets, or if the institution already meets the capital ratio, make a contribution ranging between 10 and 20 per cent of the ESM contribution. As noted by Hadjiemmanuil, what this means is that under the present arrangements, national governments will be saddled the primary financial responsibility in relation to publicly assisted bank bailouts:
"Even where a government finds itself in the unenviable position of needing to finance the recapitalization of systemically important banks, while being fiscally too weak to do so without external support, the recapitalization will take place, as a rule, on the government’s own account, with the ESM providing only indirect assistance, in the form of a loan. In contrast, in view of its very strict preconditions and terms (not least, the need for unanimity in the ESM’s Board of Governors for its activation), the DRI is unlikely to be used in other than wholly exceptional circumstances. Even then, the country will need to share a considerable portion of the financial burden – and this, despite the fact that it is no longer in charge of the troubled bank’s supervision!"
More in general, even the IMF has openly expressed doubts about the planned backstop, noting that ‘centralized resolution resources may not be sufficient to handle stress in large banks’. The overall amount that the ESM will be allowed to disburse for all bank recapitalisation has been capped at a relatively puny €60 billion (though the limit is allegedly flexible), more or less the same amount expected to be raised through the privately funded SRM. Though a large sum, it is a drop in the ocean compared with the balance sheets of Europe’s massive banks. The euro area is home to a very large banking sector, with total assets amounting to more than three times the region’s GDP, concentrated for the most part in the hands of large systemic banks, including a number of global systemically important banks, whose recapitalisation could conceivably require huge resources. To get an idea, the average balance sheets of the European Union’s 30 and 15 largest banks (€800 billion and €1.3 trillion respectively) are 13 and 21 times larger than the proposed recapitalisation limit. Not only are these banks too big to fail – they are too big to bail. The failure of any of them – even assuming that it would take place in isolation, rather than as part of a wider systemic crisis – would require the mobilisation of huge financial resources. This is also proven by the recent crisis, with certain large banks receiving public assistance in excess of €100 billion.
With all this in mind, one could still argue that the bail-in mechanism represents a step forwards vis-à-vis the bailouts of recent years, by limiting the burden placed on sovereigns and thus the ‘socialisation’ of banking crises. The crucial point to understand here is that the bail-in is indeed a great tool to have at one’s disposal, as there are undoubtedly numerous cases where a bail-in might be preferable to a bailout. But this has to be decided on a case-by-case basis. The problems arise when member states are forced to resort to the bail-in as the primary method of bank resolution, regardless of the potential consequences of such a move, of the nature of the bank’s problems, of the wider macroeconomic context, etc. – which is precisely what the banking union prescribes. This is especially true in light of the extreme disequilibrium between banking systems in the EU, itself a reflections of the wider social and macroeconomic imbalances between core and periphery countries. As the ECB’s recent stress tests have revealed, the banks with the largest capital shortfalls are all located in the countries of the periphery, which have been hit the hardest by the crisis: Italy, Greece, Portugal, Ireland and Cyprus. This is not surprising: various studies have shown that there is a clear pro-cyclical link between a country’s negative macroeconomic performance and the capital adequacy of its banks. This is evident from the dizzying and rapidly-growing volume of non-performing loans (NPLs) in these countries – a direct result of the austerity policies pursued in recent years and, of course, the main reason why periphery banks failed the ECB’s stress tests.
Which leads us to the paradoxical situation in which Italy finds itself in today. The country’s banks fared relatively well during the financial crisis and therefore didn’t require almost any government aid at the time; since then, as a result of the country’s unprecedented socioeconomic collapse, itself a result of EU-sanctioned austerity, the balance sheets of Italian banks have severely deteriorated, and today – after a seven-year-long build-up of non-performing loans – are facing a system-wide crisis. For this reason, the Italian government has been in talks with the Commission for months over its plan to create a ‘bad bank’ to help offload some of the banks’ bad debt; at the time of writing, though, the Commission – the same Commission that by mid-2009 had approved €3 trillion in guarantee umbrellas, risk shields and recapitalisation measures to bail out Europe’s banks – continues to block the government’s plan, on grounds that it would amount to a violation of state aid and banking union rules. (Even if the Italian government finally has its way, it would still amount to little more than a Band-Aid, and one that the Commission is unlikely to grant to other countries).
As a result, Italy – and any other country that faces a similar situation – will have little choice in dealing with its ailing banks than to (a) force losses on the banks’ bondholders – often amounting to small savers/taxpayers, as we have seen in the case of the recent resolution of four medium-sized crisis-hit banks – or (b) accept a take-over of Italian banks by foreign capital (given the limited availability of national capital). Viewed through the lens of the unresolved inter-capitalist struggle between core-based and periphery-based capital, as argued most notably by Emiliano Brancaccio, we can posit that this will almost certainly lead to an increased ‘centralisation’ of capital, characterised by a gradual concentration of capital in Germany and the other core countries of the monetary union, through mergers, acquisitions and liquidations, and to the relative ‘mezzogiornification’ – otherwise known as ‘southification’ or ‘Chinesification’ – of the weaker countries of the union. In this sense, the banking union is likely to exacerbate, rather than reduce, the core-periphery imbalances.
The new bail-in rules also make countries susceptible to bank-run-style
self-fulfilling panics. There is reason to believe that this process is already
underway: by looking at the ECB’s TARGET
an excellent measure of intra-EMU capital flows, it would appear that periphery
countries are experiencing massive capital flight towards core countries,
almost on par with 2012 levels. It wouldn’t be far-fetched to imagine that this
is due to depositors in periphery countries fleeing their banks for fear of
confiscations, capital controls and bank failures of the kind that we have seen
in Greece and Cyprus. Almost 8 years on, the European nightmare continues.