The European Banking Union Negotiations – Supervision

The banking union is a particularly important item in the long term reform agenda of the EU/Euro-Zone, and one that has often been neglected. In a crisis that is characterised by the linkages between public finances and the banking sectors, as intermediated by financial markets, the banking union in all its components offers a sterelisation mechanism which stops a shock to the balance sheet of financial institutions from migrating to the balance sheet of the sovereign that they are domiciled in. This is a point which is clear to the ECB’s Draghi who said as much at the latest post ECB Governing Council Meeting press conference:

The main aim is to break the link between the sovereigns and the banks. It is to make the banks basically reliable, trustworthy, regardless of the place where they have their headquarters and where they exercise their business

Adding this to the protection from public finance shocks that the OMT has offered banks, would be a leap on the way to a permanent solution to this Euro-zone crisis.

Bank-Sovs Connection - Bank Un and OMT

Given the protracted duration of the banking union negotiations, and its aforementioned relevance, I believe that it is only appropriate to review the relevant issues and positions as they stand at the end of 2012. In a sense this post is a continuation and a consolidation of the post I wrote back in September.

Limited Field of Negotiations – So far, only  Supervision 

The first thing to notice is that it is sad to see that the ongoing negotiations are focusing on the supervision aspect of banking union at the detriment of insolvency resolution and the debt guarantee scheme.

What is under consideration

The Negotiating Battlefield – Scope, Credibility and Voting

The considerations underlining the banking union negotiations can be broadly grouped under 3 groups, pertaining to fears that the intended scope is too wide, that the addition of financial stability will conflict with the priority of price stability and that banking regulation will be dominated by the Euro-Zone, whose members constitute a large majority of the EU.

Banking Union Negos Battlefield

Scope: I dedicated a previous post to an earlier discussion of this issue, which pits small regional (German) banks to their global brethren and the regulatory ambitions of the EU. German local banks are the epitome of this position that recycles the traditional view that regulation can be detrimental to small businesses. The FT has an insightful article on this issue where Michael Huber, chief executive of the Karlsruhe Ettlingen savings bank argues that

“You don’t impose the safety rules you’d need for a 2,000-passenger cruise ship on a yacht taking five people up the coast,” he says. “There would be enormous administrative costs that I would have to pass on … it would hit Mittelstand companies and the local economy.”

Meanwhile, as I articulated in that previous post, the German government staunchly took up that flame and appears to have succeeded in getting its way. Although the details are still vague, the ECB and other Euro-Zone member states have agreed to take a two layer approach where the ECB would only directly regulate those banks whose balance sheets are large enough, following the USA example.

Although I can see the argument behind Mr Huber’s claims, I find it somewhat biased in the favour of the industry that he works for. Far from me to be the advocate of markets as the beacon of freedom that will save western society, but clearly a little bit of competition helps. If regional banks have to decrease the number of loans and probably the relevant rates at which they make them, this may open up room for other institutions to come in. Alternatively, if this does not happen, presuming that there is no friction in the market, the n the conclusion is that there is no business to be made there and that the loans that these regional banks are making are already inefficient, in which case good ridance. Of course this is very simplistic. There is always friction, the market takes time to react and local banks are protected in such a way that it is (rightly) quite difficult for anyone to open up a new bank that may compete. Moreover, big global banks don’t make their business from the small loans or the depositors money, so a gap in the market won’t necessarily be synonymous with efficient market allocation, which is only a theoretical idealisation.

The other issue I have has to do with the quality of banks balance sheets and the safety of regional banks which supposedly arises from the aforementioned conservativeness of their investments. The problem is not the operations they engage in but the fact that they do invest in bad assets, be it bad loans to small businesses or complex financial products sold by well-spoken investment bankers. Whether it is the Cajas in Spain, the Irish banks or the German local banks, all these small public institutions have a very bad reputation. While the public might be aware of the problems that Bankia and Caja Catalunya (among many others) face, they may have forgotten that WestLB and Hypo Real Estate Group were some of the first European banks to face difficulties in 2008, leading to the transfer of their bad assets to the the EAA and FMS Wertmanagement bad banks. As a Roberto R’s comment in a tangentially related post illustrates, these institutions are prone to accusations of nepotism or at the very least bad management from weak management, who own their position to political appointments.  As a Deutsche Bank Research note into the framework of a European Banking Union puts it,

“Such plans appear odd given the insights gained during the latest financial crisis which clearly point to the fact that smaller, regionally active banks are at least as likely to be the cause of systemic crises as large ones. This is unsurprising as these institutions tend to have higher risk concentrations, are more likely to be involved in local lending booms, especially in real-estate finance and are often more interlinked at the local political level. Spanish cajas and German Landesbanken are cases in point.”

Clearly Deutsche Bank has a vested interest, so you may question the impartiality of their argument. I for one agree with them. If landesbanken don’t want the regulation, then they’ll have to accept a limited scope to the assets that they can hold.

Credibility and Conflicting Policies: While monetary stability does not necessarily conflict with financial stability, the active pursuit of the first through monetary policy can be achieved at the detriment of the second. Notwithstanding long run money neutrality, Christiano, Eichenbaum and Evans 1998 and Bernanke and Gertler 1998, inter alia, show how monetary policy affects a wide array of economic variables in the short run. Approximating the mandate of central banks to a Taylor Rule that legally specifies the variables to be considered and their hierarchy of responsiveness clarifies the possible dilemmas faced by monetary authorities. Equating financial stability with low asset price volatility and monetary stability with low consumer price growth, it is clear that if the first responds faster to economic developments than the second, monetary policy may react too slow to financial developments and potentially fuel asset price bubbles. Moreover, while in demand shocks variables will move in parallel, during short term aggregate supply shocks, that is not the case, as GDP growth falls and inflation increases. Attempts to lower inflation by raising interest rates may create unsustainable funding environments for businesses which in the absence of credit will shed more workforce. As balance sheets shrink, liquidity decreases further and asset prices fluctuate due to rising insolvency risks. The present policy of the ECB is a good case-study. Its unwillingness to embrace the role of a lender of last resort, for fear of inflation, feeds sovereign default risk, which feeds back into the private sector leading to the downward spiral described previously.

Voting Rights: The banking union, while most relevant for the safety it would give the Euro-zone economies, particularly the Spanish banks, is not a Euro-zone project, but rather a broader EU one.

The banking union would be regulated by the European Banking Authority (EBA) where central banks would be represented and whose voting rights would be allotted by their size (population, economic and or geographical). This has led to a fear that the ECB as the representative of most EU member states (the Euro-Zone) would be able to side-line the Bank of England and the Riskbanks of Sweden and Denmark. Ironically, the increasingly Euro-sceptic British conservative party is worried about the potential risk of irrelevance while continuing to argue for a referendum on the continuation of British EU membership that would only result in less influence…

Timing: Formal or Political Constraints

The FT’s Brussels blog, as always, has a very interesting post considering the dynamics at play and how the conclusions of Monday’s and Tuesday’s meetings might inform us as to the relevant time horizon of a banking union deal. On the one hand it might be a constitutional issue where the banking union stretches beyond the limitations of the present EU treaty framework, in which case next week’s meetings are inevitably doomed. Alternatively, the ongoing German vacillations may be a bargaining tactic that creates uncertainty ahead of a crucial decision in order to allow Germany to leverage its position and get a more favourable agreement. It is not as though we have forgotten the manner in which Germany positioned itself with radical demands ahead of the December 5 2011 and Deauville (October 8th 2010) agreements where its demands were largely watered down. In this case either Schaeuble on Monday or Merkel on Tuesday would get what they are looking for by then. Last I heard, Schaeuble sounded like he was willing to compromise.

Either way, we’ll know which it is by Wednesday, which is comforting, I guess…

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