Politics has created a bank union phantom

Under scrutiny, the substance of Europe's bank union agreement evaporates. Expect nothing more than a bank-financed resolution fund too small to do the job.


The headlines on Thursday were that the EU had agreed a banking union; by Friday the news was the fiscal union will be postponed, indefinitely. A case of good news, followed by bad news?

Absolutely not. The main economic purpose of a banking union is bank resolution and deposit insurance. The first of the two is clearly fiscal in nature. Angela Merkel has made it clear that Berlin is not ready to pay for the resolution of other people’s banks. At last week’s European summit the German chancellor said she rejected a mutualisation of debt and hidden transfer payments. In other words: just as she rejected a fiscal union, she will also reject a bank resolution mechanism that does what such a policy is supposed to do – take taxpayers’ money and rescue a bank.

The most I would expect is a small resolution fund, financed by the banks themselves – something too small to do the job. Without a real resolution mechanism, there can be no banking union either. So what happened last week was the political process stalled in a very big way.

One can criticise Merkel’s position, but not her lack of clarity. She has been making those points repeatedly. I expect that whoever is going to be German chancellor after the federal elections next September will uphold that position.

What has been agreed last week is virtually cost-free – a single supervisory mechanism for about 1 per cent of the banks in the eurozone, based at the European Central Bank. To maintain the pretence of progress, the heads of state and government have asked the European Commission to come up with a proposal for a resolution regime in 2013, ready for 2014.

What matters is not whether they will reach agreement, but the substance of that deal. If you study the details of what was agreed last week, the substance evaporates. The common supervisory structure will affect only about 100 to 150 banks out of a total of 6,000 – those with assets of more than €30 billion. The ECB can usurp supervisory powers from national regulators but the rules of engagement are not clear. Wolfgang Schuble, the German finance minister, said when he left the meeting that the ECB would need to make a well-argued case. But it is not clear how this would work in practice.

The division into larger and smaller banks certainly makes no economic sense. History tells us that banking crises do not usually originate with the largest banks, but often with smaller, fast-expanding banks – US savings and loans, or more recently Spanish cajas. Small- to medium-sized banks now have an incentive to offload assets into off-balance sheet vehicles, or to split into smaller units, so they can avoid falling under the ECB’s tougher regulatory regime.

The €30 billion will become a kind of target to circumvent. The practical outcome of this agreement will be a two-tier banking system, one for large banks, one for small banks.

There is another damaging division that runs along national borders. Most of France will be inside the new union; a large part of Germany will be outside. So instead of a banking union, you have the exact opposite: a fractured banking system. If there are hardly any German banks in this new system, why should one expect Berlin to take part in a resolution system?

So how is such a fractured two-tier banking union without an effective resolution system going to work? My guess is it will work through forbearance. The ECB will deal with failing banks just as the eurogroup has been dealing with failing states. It will replace existing debt with new debt, and impose conditions. And just as the eurozone will never allow one of its members to default, the ECB will never close down a bank. Bank resolution thus becomes a euphemism for exactly the opposite.

So this will be about the pretence of resolution, not real resolution. There is a parallel with the ECB’s program of outright monetary transactions. This was intended to provide temporary support to sovereign bond markets, but it has not yet been triggered, and may never be. Its main purpose was to send a signal that the ECB accepts the role of buyer of last resort – even if it never buys. The role of the OMT and the banking union is to keep up appearances.

When Mario Draghi, the ECB president, announced the OMT, the consensus was that it would give governments time to put the policies and institutional changes in place. What happened was that the OMT has killed any appetite for a fiscal union, and has turned the banking union into a phantom.

The effect of the OMT will be negative in the long run because it has provided policy makers with a false sense of security. That was not the intention but the effect. When the crisis returns, as I expect, in 2013, Mr Draghi will be on his own, responsible for failing banks, failing states and a depression in the periphery. I am intrigued to see how he is going to do that.

Copyright The Financial Times Limited 2012.

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