Financial markets responded positively to the European summit on June 28-29, but how much progress was made?
Before this crisis is over, there will be huge losses to be absorbed. These losses have already been incurred through poor bank lending and excessive government debt in countries without capacity to repay. The allocation of these losses – between countries, between institutions, between current and future generations and between the private and public sectors – is yet to be determined.
Perhaps the summit's biggest step forward was in teasing apart the hitherto closely intertwined problems of bank weakness and government debt. Governments have to stand behind their banks, so weak banks are a contingent liability of governments, a nexus demonstrated by Ireland.
When the EU decided it would lend €100 billion to the Spanish government to help recapitalise the Spanish banks in mid-June, the market reacted badly, more concerned about the increase in Spanish government debt (and the likelihood that the new EU debt would rank ahead of existing debt) than about any good this might do for the Spanish banking system. Now this issue has been addressed at the summit: in future, banks will be able to get assistance directly from the soon-to-be-established bailout arrangements, the European Stabilisation Mechanism.
In the overall picture, this is scant comfort. While the Spanish banks could be helped without adding to the Spanish government's debt total, this just shifts some of the potential loss from Spain to Europe. If you were holding Spanish government debt, you would like this outcome. But there is only €500 billion in the stabilisation fund and around €200 billion has already been allocated to Greece. And the ESM is supposed to support government debt markets as well.
To put this problem in perspective, outstanding Spanish government debt is €800 billion while Italy has a €2 trillion debt. Of course these figures don't represent the likely losses. But while it remains unclear how any losses will be absorbed, government debt-holders will be concerned that they are the fallback absorption option.
Thus the ESM decision, in itself, doesn't change much. But by shifting some of the responsibility for Spanish banks towards Europe and requiring a new banking union with a unified banking supervisor, the European Central Bank may have become more involved.
This holds out some hope. The ECB's balance sheet is the only ready source big enough to match the enormity of the sums involved. Unified supervision might make the ECB more ready to act as lender of last resort to troubled banks. But this is not, of course, costless or unlimited. While the ECB has very great capacity to provide short- or medium-term funding, it has almost no capacity to absorb losses: its capital is €5 billion. Thus losses go back, sooner or later, to the constituent governments. The deeper involvement of the ECB will buy time, but won't solve the underlying issues.
If Europe is going to pick up some of the losses, it will certainly want a greater say on how the Spanish banks are run. Europe would want to ensure, for instance, that the first line of defence for Spanish banks would be the shareholders and probably the bond-holders as well. Beyond this, Europe is sure to want to get more closely involved in the ongoing detailed prudential supervision of Spanish banks (and, given the precedent that this sets, of all euro area banks).
This is politically sensitive and much harder to achieve. No sovereign government is going to readily cede the detailed supervision of its banks. Europe's banking is so heavily cross-border that overall European supervision makes a lot of sense. But this is the sort of change negotiated over years rather than months and preferably in good times when countries can agree without feeling the gun pressed to their head.
This predicament is typical of the current fraught climate. Proposals which give a bigger role to Europe, at the expense of member sovereignty, are being put forward as solutions to the pressing problems of the immediate crisis.
It is possible that greater banking centralisation (and greater fiscal centralisation) might be further steps along the path the continent has been on for 50 years: towards a unified Europe. But unification objectives are usually achieved at an evolutionary pace. Financial markets, mainly concerned about the exigent issue of how they will be repaid, are looking for some early assurance that losses will fall elsewhere. On this, the summit offered little comfort.
Originally published by The Lowy Institute publication The Interpreter. Reproduced with permission.