Europe’s new ‘liability’ union

Published in Business Spectator (Melbourne), 25 July 2013

Last week, I wrote about how the euro crisis had been put on hold until the German federal election (A euro crisis on German ice, July 18). One of the policies affected by this crisis deferral is the European Union’s so-called banking union. If implemented, it could turn out more costly than previous bailouts for periphery governments. No wonder German politicians don’t like to talk about it prior to the election.

‘Banking union’ is a bit of an Alice in Wonderland term. It means just what EU politicians and central bankers choose it to mean, neither more nor less. For naïve observers, it is primarily a technical shift of financial supervision to the European Central Bank – and that’s certainly part of it. But it is also a pan-European deposit insurance scheme and a mechanism to deal with insolvent financial institutions. And this is where the supposed ‘banking’ union quickly turns into a liability union.

If the union were only about introducing consistent supervision standards for Europe’s banks, there would be little opposition to it. In fact, such a policy would probably aid a single European financial services market. The only question would be whether the ECB is really the best-placed institution to provide oversight. The conflict of interest between the ECB as both a lender to Europe’s banks and their regulator is quite obvious, especially when some banks already depend on the ECB for their survival.

However, the desire to push through plans for a banking union has little to do with such considerations. It is mainly driven by fears about nine trillion euros of debt on the books of commercial banks in the crisis countries, a substantial part of which may be toxic.

Estimates about the amount of bad loans vary but the best estimates are somewhere between €500 billion and €1 trillion. At some stage in the future, these loans will have to be written off. If (or rather when) that happens, someone will have to foot the bill – and the whole discussion around banking union is really about who that someone will be.

Over the course of the euro crisis, the main concern has been with the solvency of sovereigns. When yields for government bonds started to rise in the euro periphery, concerted efforts by the European Union and the ECB aimed to drive them back down again. Part of these efforts was the provision of large amounts of central bank credit to the banking sector in the hope that these low-interest loans would be used to soak up higher-yielding government debt.

As is now becoming clear, while these operations may have had a calming effect on sovereign bonds, they also increased the vulnerability of financial institutions. Soaked full of bonds of their own national governments, European periphery banks are arguably in a worse state than at the beginning of the euro crisis.

It is clear that sooner or later Europe’s banking sector, widely regarded as too large, will shrink down to a healthier size and that this process will force some struggling banks to close or be nationalised. Proponents of a European banking union, particularly from the euro periphery and the European Commission, are trying to make the European Stability Mechanism absorb most of the losses. This solution has moral hazard written all over it and could turn out to be expensive for core euro members like Germany.

Under these plans, national governments would not be required to save their own banks if doing so would threaten their own solvency. So in practice, great contributions from periphery countries to their banking sector are unlikely to be forthcoming. Crucially, the plans would also exempt different categories of deposits, for example loans from the ECB but also private deposits of up to €100,000.

As Professor Hans-Werner Sinn, president of Munich based Ifo research institute, warns in a column for Germany’s business magazine Wirtschaftswoche this week, struggling banks would react to these incentives by shifting around all their liabilities until, in the end, they only had protected liabilities on their balance sheets. This would then force the ESM to pay for all the costs of bank failures and restructuring operations.

The bailout of Cyprus earlier this year for the first time had bailed in bank depositors in order to protect taxpayers. At the time, this was presented as a model for future crises. However, if taxpayer protection is still the goal then the planned banking union is not the way to achieve it. On the contrary, it will leave (mainly German) taxpayers vulnerable via the ESM.

Unfortunately, the Germans may also be required to pay for banking union in another way. If plans for a joint European deposit insurance scheme are passed, savers in Euro core countries will be affected. Germany’s many co-operative banks are especially opposed to such a scheme. Because their own form of deposit protection is well capitalised, they have little desire to pay for Spanish, Italian or Greek savers.

For the time being, however, plans for a European banking union are on hold. As Malta’s prime minister Joseph Muscat explained in an interview with Bloomberg last week, the reason for the delay is the German elections: “The EU is in the waiting room until the vote.” After that, he expected banking union to be created.

It could be quite a rude awakening after the September 22 election. An unsuspecting German public will quickly find out the real state of the euro, how much saving it will cost and what share of banking losses Germany’s savers and taxpayers will have to take in the euro periphery.

And they will also learn that the seemingly harmless term ‘banking union’ could be of the most costly projects for Germany ever to be forced into.

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