Blowing the cover off Europe's bank crisis

A new round of ECB stress testing will finally expose the extent of the eurozone’s bad bank problems, and fan the flames of dissent on how to address them.

The European crisis plays itself out on different levels: some clearly visible, others less so. What dominated the headlines of the past four years was Europe’s sovereign debt crisis. The fiscal crises in countries around the Mediterranean and Ireland were obvious and had to be contained by several bailout packages.

What makes this sovereign debt crisis so palpable is the fact that the sums in question are easy to ascertain. Although one may have some doubts about their reliability, at least official debt figures are in the public domain. Their development can be measured and forecast with reasonable accuracy. All it takes are a few clicks through to the website of the European Commission or the European Statistical authority, Eurostat.

Europe’s other crisis is an altogether different beast. I am talking, of course, about the crisis facing Europe’s banking sector. Though it is known that there are problems with financial institutions across the continent, their size is far more difficult to ascertain. The stress tests that had been conducted over the past years were really exercises in hiding unpleasant facts rather than revealing them. Hardly anyone really took them seriously.

To restore credibility in Europe’s financial sector, the European Central Bank is now preparing yet another stress test. This time, however, it is meant to be a genuine analysis of the real state of European banks. The ECB certainly has an incentive to paint a more realistic picture now. It will be in charge of policing the continent’s financial sectors once plans for Europe’s banking union are implemented.

So how large are the holes in the financial system? That is the multi-billion euro question to which there are no answers yet, just guesswork. Closely linked to it is the question of how these holes can be plugged. On this latter question, at least we are now seeing some plausible scenarios developing.

On Monday, ECB director Yves Mersch told the Frankfurter Allgemeine newspaper that the ECB would be pressing for tougher capital adequacy rules for those 130 banks that are to be monitored under the new so-called Single Supervisory Mechanism. Asked how these rules should be met, he responded that it could be through raising capital or shrinking the banks’ balance sheets. Well, yes, one might say. What else?

More interestingly, he pointed out that for those banks which fail to implement either measure, there was a “cascade of safety nets”. First, there should be a ‘bail in’ of depositors and shareholders. The model for this would be Cyprus, where depositors lost part of their savings beyond €100,000.

If such a ‘bail in’ were not sufficient, then as a second step it should be decided whether the bank were sustainable at all or whether it should be liquidated. Third, public money would be required to stabilise banks that would not or could not be liquidated. This should first be provided by national governments, and if national governments were unable to do so then international bailout mechanisms should take over.

If this sounds reasonably nebulous that’s because it is. All of Mersch’s three steps are hard to imagine on a European scale. Even the small-scale ‘bail in’ of two Cypriot banks was an operation so delicate it almost triggered bank runs elsewhere. How would such a ‘bail in’ work for larger banks in larger countries? And how could their impact be contained?

Liquidating banks would essentially face the same challenges. The added complication there would be which organisation should be tasked with the implementation. EU Commissioner Michel Barnier had suggested that this task might fall to the European Stability Mechanism. Unfortunately, ESM director Klaus Regling quickly made it clear that his authority had no interest in getting involved in this business. The ESM is busy enough bailing out governments, in any case.

The real problem, however, would be to use taxpayers’ money to save struggling banks. Naturally, Europe is divided on how this should be organised. On the one hand, there are those countries that are already struggling with their public finances. They are obviously not keen to also shoulder the burdens of their financial sectors, and they probably could not afford it anyway. On the other hand there is Germany, which resists mutualising the responsibility for Europe’s banking sector. Instead, Berlin insists that national banking crises should first be dealt with at the national level before asking institutions like the ESM for assistance.

These different positions are hard to reconcile. In the end, it is a rather academic question. If, say, Greece had to stabilise its banking sector by billions of euros, how likely would it be that Athens could raise the money? Even if it did, it would need to be backed up by international institutions on which it relies for its public finances.

For other struggling countries aiming to bail out their banks, there is at least some good news. According to a letter by European Union Commissioner Olli Rehn, leaked to the Welt am Sonntag newspaper, any bank bailout would not count towards EU deficit rules. In a strange kind of way, this makes sense. Faced with the choice of incurring higher deficits or risking a bank run, most governments would gladly pick the former. Now, with the backing of the EU Commission, there is no reason why they would not.

It is bad news nonetheless in Europe’s crisis. While the ECB’s Yves Mersch is still trying to convince the public that taxpayers’ support would only be the ultima ratio in dealing with undercapitalised banks, the European Commission is already signalling its support for such policies.

There remains too much speculation around the planned banking union. Some of it may become clearer once ECB President Mario Draghi announces the details of the new stress test on 23 October. However, the main problems remain political in nature, and they can be summed up in the questions “Who pays?”, “How much?” and, just as an aside, “Would the ECB’s own balance sheet survive a proper stress test?”.

As the sovereign debt crisis lingers, we should pay more attention to the complex and obscure issues facing Europe’s banking system. It will be one of the main battlegrounds of the euro crisis for the coming year.

Dr Oliver Marc Hartwich is the Executive Director of The New Zealand Initiative.

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