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What will the banking union be for and will it ever happen?

Background paper of the European Values Think-Tank, 2013-09-06

On the tenth day of July Germany significantly influenced preparations of the European Banking Union project. German government rejected the final draft of the second pillar proposed by the European Commission. The second pillar founds mutual Eurozone fund into which the European banks would contribute (1 % of insured deposits) and it also counts with the Commission’s right to accept the final decision about which bank should be restructuralised from the fund or, on the other hand, which should be left to bankrupt.

The so-called Single Resolution Mechanism should be the second step after the approval of unified supervision over approximately two hundred banks active in the Eurozone (Single Supervisory Mechanism which should be broadened up to 6000 banks in the future). Such passing of supervision authorities on to the European Central Bank is due in the second half of 2014. The third pillar of the Banking Union was supposed to be the Single Deposit Guarantee Scheme which, however, after the German government came out against the draft, is far from the reality.

The German government represents an opinion that a change of the European Treaties is necessary for the fully-fledged Banking Union due to the fact that the legal base is currently too weak to bear such extensive change of the Eurozone architecture. However, the legislative worries are mainly concentrated on the usage of the internal market, sometimes known as the single market (formerly the common market) law base towards vindication of extensive rights of the Commission. Moreover, these rights do not apply to all 28 states but serve only the purposes of the states which share the common currency. The issue of a very little say of the member states when it comes to deciding about commencing a saving process of a particular bank raises doubts. However, it is the depoliticising of the basic decision to save a particular bank that is the bottom line of the SRM. According to the current draft the states should be represented only in a resolution executive board that supervises the national regulators, elaborates on bank liquidation plans and then submits it to the Commission for the final decision on whether and when to put a bank into resolution.

Due to the German “no” the whole process will most probably be delayed and it is not yet certain that the potential future compromise will be strong enough to break the doom loop in which the banks and the state finance got caught. If the bank gets into troubles and it has to be saved at the state cost, it increases the state debt and thus increases the riskiness of the state bonds held mainly by domestic banks. When the state bonds interest rates grow, it increases the interest rate for which domestic banks take loans – it worsens their solvency and closes the deadly loop. This can even lead to the necessity to save the whole state (like in the case of Cyprus).

The Banking Union project is already delayed and there are various doubts that it will be ready to smooth transition of the banking supervision (SSM) to the European Central Bank in 2014. Furthermore, Germany requires that the strong authority deciding on the bank restructuring is created after the primary European law (meaning the Treaty of Lisbon) is changed. As we know the change of the primary law in all the 28 states requires a long and laborious process full of referendums, which usually takes from one to three years. The European debt crisis will probably prolong.

The main European commentator for the Financial Times, Wolfgang Münchau, claims that the European approach to the crisis is characteristic for timewasting and there is a significant risk that all the arrangements and precautions will be good for nothing. However, something like a truly European approach does not exist. In fact it is mainly about two different perceptions of the crisis by two different groups of states which call for different arrangements: one proclaims the consolidation of public finance should take place as soon as possible, while the other wants to encourage the economic growth by stimulus policies (austerity vs. growth). The first group is led by Germany and promotes the so-called austerity policy. Naturally, it disagrees with this process being pernicious for economic growth. It is willing to provide emergency loans and majorly contribute to saving mechanisms; however, in exchange it asks structural reforms and rapid consolidation of public finance of the periphery countries. The main reason is the wish to prevent moral hazard and the need to vindicate the expenditures for saving another state in front of the German voters.

The second group supports the current draft of the Commission, while the first group hesitates, doubting that the expenditures will not be transferred to their taxpayers. According to the currently applied bail-out principle the creditors are untouched except for the shareholders which lose their investment. The trouble is that in the times of big financial crisis the equity of the shareholders is not enough to cover all losses and the state has to introduce an additional capital in order to cover them. Although, in the case of the common Eurozone fund banking sector means are involved, most of the restructuring funds are due to the lack of “firepower” backed up by the credit lines and by the implicit guarantees of the national Ministries of Finance or of the central banks. Potentially, the mediated impact on the taxpayers does exist, indeed, and the German worries are well-founded.

Germany prefers the bail-in approach towards the restructuring to the bail-out one. Contrastingly to the bail-out approach, the bail-in one would also include (apart from the shareholders) the creditors (bond-holders, short-term interbank loans holders and deposit holders) that have not yet been affected in the present perpetuations (apart from in the case of Cyprus).

The individual creditors would be haircut according to a certain “pecking order” – i.e. the order in which they would lose their claims. The basic argument here is the ability to break the doom loop between banks and state finances. The cons of this bail-in principle lie in the projection of the new risk for creditors onto an increased riskiness of the bonds and thus an increased interest rate required by the creditors. This would eventually lead to higher expenditures on financing of the banks (and their transfer onto their customers) and worsening of solvency. Furthermore, the threat of spreading the contagion in the times of crisis is self-explanatory.

In connection to the political reactions to the crisis, Aleš Chmelař deals with the issue of European solidarity between the individual states; he argues that there is none. Solidarity without concurrent strictness not only does not bring positive domestic political results, it is indefensible in front of the domestic audience. Again, this is about different perceptions of the seriousness of the situation and different estimates of the European crisis depth. Germany puts forward the risk of moral hazard and prevention of possible future abuse of rescue mechanisms by the periphery states. Judiciousness of institutional reconstruction of the Eurozone is in place and the German approach makes sense. The other side of the coin is that if this is a structural crisis of the entire Monetary Union, in which the survival of the common currency is in stake and in which only one group of states is currently standing on the safer shore, it can only be solved by strong actions. Ideally, such actions should include those which would lead to the correction of the imbalance on both sides. However, courageous actions within the current EU are rare goods and so the threat is that the Banking Union will not match the targets for which it is being founded.

Despite all the doubts Germany is aware of the fact that a strong overall Eurozone system is in its best interest and in the long term it will be rather money-saving. The European representatives also perceive the German “no” as a strong negotiator’s tactics rather than as a blocking position. Even more so because the federal election in Germany is due in autumn and the sensitive topic of “paying debts of irresponsible states” (as the Germans perceive it) needs to be vindicated by showing stricter approach towards the states that are benefiting from the help. Among the representatives of the EU a progress in the question of the Banking Union is expected after the election. The analyses dealing with the schedule of Banking Union creation also expect that the next steps in the issue will be possible in the end of 2013 – after the German elections.

The periphery states are currently in serious trouble and it is not certain for how long the European Central Bank will be able to calm the situation. On the other hand, the Banking Union project will change the functioning of the entire continent so vastly that it is necessary to properly think it through and not to rush it (like it happened with the European Monetary Union). In the long term it is necessary to balance all the interests and consider the impacts on taxpayers (especially those who pay most of the costs). It is also crucial to avoid possible future doubts of the project and its deconstruction.


Jakub Janda, Deputy Director of the European Values Think-Tank

Jan Famfule, Analytical team member, European Values Think-Tank