Too European To Fail? New E.U. Banking Safety Net Takes Shape

Creation of euro-zone supervisor for banks is a breakthrough, but agreement contains some big (and small) loopholes

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Yves Herman/Reuters

European Union leaders pose for a family photo during a E.U. summit in Brussels December 13, 2012. European governments reached a landmark deal on Thursday that gives the European Central Bank new powers to supervise banks, boosting confidence in the single currency bloc as it enters the fourth year of its debt crisis.

The agreement by E.U. leaders to establish a pan-European supervisory system for banks is an important political breakthrough in the drive to shore up the euro-zone’s financial stability, and by European standards it was reached relatively quickly — just seven months after the idea was first put on the table.

Starting in March 2014, the European Central Bank will begin directly supervising all banks in the euro-zone with assets above 30 billion euros ($40 billion), which in practice means about 80% of them. The aim is to provide a far more rigorous oversight for the European banking system than the patchwork of national regulators who are at times prone to domestic political influence. Indeed, the financial crisis in 2007 has exposed the extent to which banking regulation is highly politicized in countries including Spain, where the woes of a handful of savings and loans have plunged the entire nation into crisis and led to the ouster of the head of the central bank.

But, as so often in the E.U., it took laborious compromise to arrive at a deal. That means the supervision will not cover a swathe of smaller banks within the 17-nation eurozone, including Germany’s “Sparkassen”, which are regional savings and loans institutions that have been particularly weak. (The IMF took a useful look at German banking here). Countries that don’t participate in the euro have the choice of whether they want their banks to be covered by the new supervision; so far, Britain and Sweden have declined the offer. That could pose significant problems to the workings of the new system, given the size of British banks and London’s role as the euro’s most important financial center.

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The British will continue to have an important influence on banking regulation issues through a European banking authority in which it has a major voice, and which is expected to work closely with the new supervisory mechanism.

As it is, Europe’s weakly capitalized banks are a central preoccupation for many economists and policy makers: the Organisation of Economic Cooperation and Development estimated this month that euro area banks alone need to raise an additional $500 billion if they are to bring their core capital up to 5% of their total assets, a baseline level. Moreover, with the financial crisis, the relationship between government borrowing and banking has become muddied: Spain again is a good example because the government’s intervention to save its banks has driven up its sovereign borrowing requirement, spooking markets and increasing pressure on the banks, who themselves are holders of an important part of the sovereign debt. In a recent speech, ECB president Mario Draghi said that a financial union was vital to end what he and other bankers are calling this “adverse feedback loop.”

Draghi had argued that supervision of all euro-zone banks should fall within the remit of the new system, saying, “one lesson of the financial crisis is that not only large cross-border banking conglomerates have the capacity to destabilize the financial system. Due to interlinkages and mechanisms of contagion, even smaller institutions may turn out to be systemically important.”

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Still, the deal is better than no deal, which was a very real possibility given some important differences between France and Germany. The French had wanted a comprehensive accord to take effect more quickly; Germany was insistent on exempting its savings and loans, and looked to be dragging its feet on the whole arrangement before Chancellor Angela Merkel and her finance minister Wolfgang Schäuble finally signed. The upshot is that, even though the ECB won’t directly supervise the smaller banks, it will have some powers to push national regulators to step in. Nicolas Véron, an economist at the Peterson Institute, said the agreement amounted to “a big European success.”

Even with this decision, the safety net for European banks remains far from complete, and two other important decisions need to be taken for it to become a reality. The first is the establishment of a resolution mechanism that would enable the new supervisor working with national regulators to deal with failing banks, including by shunting soured loans into a new structure where they would eventually be sold off. The second is the creation of a pan-European deposit insurance scheme that would protect investors up to a certain amount. Such schemes, similar to the Federal Deposit Insurance Corp., already exist in many European nations, but there is no trans-national scheme.

At their meeting last week, E.U. leaders agreed to tackle these two issues in the first half of 2013. So far, the appetite to set up a new deposit insurance scheme looks highly limited, given that governments across the continent are looking to cut back on spending and liabilities. But an accord on resolution may now be on the cards, as the ECB gears up – and staffs up – to become the continent’s bank watchdog.

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