Not the banking union Europe is looking for

FT.com

A mere five years after commentators (including this one) started to call for a joint supranational backstop for the European banking system, European finance ministers are now finally closing in on a deal, now reaching a broad political agreement.

It was always clear that such a banking union for a 17-member single currency bloc would be far from perfect. It would be a complex hybrid construction. But it could still be useful in the long run because in 10 or 20 years, the eurozone would end up with a banking sector no longer predominately dependent on member states. Or so I – and others – thought.

Many banking union advocates, including me, underestimated its economic costs. With the shift from a national regime to supranational banking union comes the need, for example, to harmonise how banks account for bad loans. The European Central Bank is now conducting a review of bank balance sheets, to be followed by stress tests.

Banks have responded by deleveraging. The fewer risky assets they have on their balance sheets, the less capital they will need to raise if the stress tests come up with a surprise. This means that the banking union exacerbated, or at least prolonged, the credit crunch. In other words, it comes with a non-trivial cost.

Against the costs, one must obviously also consider the potential benefits. A detoxified, slimmed-down bank system could emerge from this process. Banking risks and sovereign risks would no longer coincide, bringing an end to the infamous 'death loop' that has plagued governments and banks across the eurozone. The bank sector might consolidate across borders and become more efficient. And a banking union would create a eurozone-wide anti-crisis insurance mechanism. If done right, this could have been a hugely important project.

But, unless we see some important shifts in the balance of the argument, the political agreement reached last week simply did not cut it. I am not holding my breath here, since the political deal is done. But unless there are important additions to what we have been told about the deal, I would not think this banking union is worth supporting.

To see this, it is important to get a sense of the scale involved. The ECB will end up as the supervisor of 128 banks. Together these banks account for 85 per cent of all assets in the eurozone’s banking system. The aggregate balance sheet of the eurozone financial sector, excluding the central banks, was €31.4 trillion ($48.112 trillion) as of the end of October. An approximate 85 per cent share translates to somewhere between €26 trillion and €27 trillion.

The bank resolution fund for this new banking union will be built up over 10 years through bank levies. At the end of that period it will have reached €55 billion – a mere 0.2 per cent of the asset base. Most of these banks have assets of more than €30 billion. In a systemic crisis, in which banks can suddenly collapse, the whole European resolution fund could easily be swallowed by a single moderately-sized bank. A reminder of the just how expensive bank resolution can be came last week from Slovenia, a small country that stretched its national resources to the limit by pumping €3 billion of new capital into the country’s three largest banks.

As Angel Ubide argued in a note for the Peterson Institute for International Economics, the resolution fund needs a credit line to cope with contingencies. There are not many obvious sources. The ECB is one – though this might stretch its legal mandate. This leaves the European Stability Mechanism, the bloc’s bailout fund, as the best-placed source to provide such a credit line.

But Germany and other creditors have resisted this – so far. If that position prevails, this is going to be a banking union without a fiscal backstop. That would leave the resolution fund, as it is conceived now, as a micro-level kitty useful for when a bank manager runs away with the till. But without a credit line it is not a crisis policy tool.

So will the benefits of this banking union outweigh the costs? If the resolution fund ended up permanently without a credit line, it clearly would not. You have significant costs in the short run, and no gain in the long run. If the banking union does not provide the minimal service of anti-crisis insurance, what is the point?

What about a banking union with a credit line? That would depend on the size of the credit line, and the rules of engagement. If the credit line were to be another €55 billion, it would hardly make a difference. You could bail out two moderately-sized banks instead of one. And if the voting rules are thus that a small group of creditors can veto a large bank recapitalisation, then this is not a really an insurance mechanism either. Would you call it insurance if the payout depended on whether the German parliament voted in favour?

So this would be my red line. With a reasonable backstop, I would say: go for it, and fix the remaining problems later. Without a backstop, there is no point. It is not a banking union, and should be rejected.

Copyright The Financial Times Limited 2013.