European banking: Two cheers for banking union

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A chorus of commentators is urging speedy progress towards European banking union.

Christine Lagarde, managing director of the IMF, sees it as key to resolving the uncertainty besetting the global economy – a move that could extend the bounce in confidence after Mario Draghi’s unveiling of potentially unlimited bond-buying into a sustained rebound, and a way to break the vicious cycle between sovereign and bank debt problems in the eurozone.

The large global banks want to bring it on. The Institute of International Finance points out that the ambitious plan unveiled by the European Commission last month to turn the European Central Bank into a single supervisor of European lenders is a crucial prerequisite for allowing the European Stability Mechanism directly to recapitalize banks without first loading more liabilities on to straining sovereign balance sheets.

The IIF calls for speedy implementation, saying that together with ECB bond buying, banking union would give troubled sovereigns much-needed headroom to complete essential reforms. It sees banking union as part of a move towards closer fiscal integration.

The ratings agencies are on board. Fitch says a single supervisory mechanism would be a positive both for banking sector credibility and for stability in the euro sector, and that giving the ECB early intervention powers as part of this – and so lining up possible ESM support for temporarily troubled but fundamentally sound banks, for example in Spain – might reduce bank default risk by a factor of eight over a five-year period.

For now, however, it remains unclear how the ECB’s intervention and supervisory powers will stack up against national authorities handling final resolution of failed banks. The EC wants the European parliament and the European Council to agree on this by the end of 2012, a short timetable requiring discrepancies between national and EU authorities to be resolved quickly. However, it’s unlikely they will be.

Making the ECB a single supervisor is only a first step to banking union and a relatively easy one, even though it has pitted the German government, which wanted the ECB to take this role, against the EC, which initially favoured the London-based European Banking Authority.

It’s hard to see what incentive non-eurozone sovereign members of the European union will have for simply handing supervisory authority over their banks to the central bank for the euro. And even within the eurozone, arguments have quickly surfaced. The EC’s draft legislative proposal is that the ECB should supervise all leading banks in the eurozone by July and all banks from 2014.

Germany might be happy for large banks to be supervised by the ECB but not the hundreds of savings and cooperative banks that are a distinctive feature of that country’s banking system.

The German finance ministry does not welcome the idea of an EU authority imposing its prudential standards on these banks, while German politicians are equally suspicious that a rush to take the next two steps in a banking union after a single supervisor – establishing a single resolution authority and pooled deposit insurance – might open a backdoor for Europe’s periphery to drain German taxpayers’ money.

So, even as the EC’s draft proposals were being applauded, analysts were warning not to expect too much too soon on European banking union. Bernhard Speyer, analyst at Deutsche Bank, offers four predictions: the timetable for troubled banks to come under EU supervision in January 2013 will be pushed back; direct ESM transfers of money to Spanish banks won’t happen quickly; EU supervision will remain weak and dependent on support from ambivalent national regulators with no incentive to offer early disclosure of problems within their banking systems; and a half-baked system will emerge.

If Speyer is right, and instead of a fully fledged banking union, we get a big box of euro fudge, it remains to be seen whether Europe can halt the balkanization of its banking system.

By effectively capping peripheral sovereign bond yields, the ECB is helping Spanish and Italian companies that can only borrow at punitive rates compared with their northern European competitors. However, if the peripheral banks cannot fund in the wider interbank market, the transmission channels remain fragile.

This year has seen eurozone banks in the still-healthy north come under pressure to reduce parent funding to their subsidiaries in the periphery. National regulators are pressing banks to hold capital and liquidity in their home countries and to lend domestically, including to governments. This is the exact opposite of banking union in progress.

It will take more than a hasty plan to establish the ECB as an EU-wide supervisor to reverse it.