What next for Europe’s banking union?
Thu Nov 21 2019
Ray Pierce (785 articles)

What next for Europe’s banking union?

ACCORDING TO AN analogy popular in Brussels, the euro zone is a house that needs fixing. Everyone frets about its ability to withstand a gale. But the builders are nowhere in sight. The owners cannot agree on the repairs that are needed, much less on how to do them. When Olaf Scholz, Germany’s finance minister, cautiously accepted the idea of a common deposit-insurance scheme on November 5th, that removed one point of contention. But as one row is resolved, another—on the regulatory treatment of banks’ holdings of sovereign debt—has reopened.

An infamous feature of the sovereign-debt crisis in 2009-15 was the “doom loop”, through which weak banks and sovereigns dragged each other down. In 2012 members agreed that the doom loop needed to be broken, and the monetary union backed by a banking union. A common supervision and resolution framework for large banks has since been set up. But barely any progress has been made on common deposit insurance, because northerners are terrified that their taxpayers would be liable for risky loans made by southern banks, to their home governments among others. Now Mr Scholz seems amenable—provided other reforms happen. The most contentious would penalise banks for holding heaps of their home countries’ sovereign debt—long a non-starter for Italy and other heavily indebted states.

Supporters of such regulatory penalties say they would lead banks to scale back home exposures, and perhaps to diversify into other members’ sovereign debt. Critics worry about the effect on bond markets of losing banks’ captive demand. Regulations on liquidity and capital encourage banks to hold sovereign debt. Banking sectors in Europe typically hold 15-30% of their home country’s debt stock.

New rules could take two forms. Banks could be forced to increase their capital buffers if their holdings of any particular security exceed a certain threshold—a “concentration charge”. Or they could be forced to back their holdings of risky sovereign debt with extra capital by increasing the risk score—known as the risk weight—attached to some sovereign bonds, which all regulators now treat as risk-free.

Risk weighting is more contentious because it is more potentially destabilising. In the worst case, it could mean that a downgrade by a credit-rating agency leads banks to dump some holdings, bringing about the very turmoil the reform was supposed to prevent. Germany’s finance ministry seems to prefer a hybrid approach, setting a concentration threshold above which holdings would be subject to a charge based on both concentration and credit risk.

This would have significant effects on banks—and not just in Italy. Nicolas Véron of Bruegel, a think-tank, points out that Germany has some of the most concentrated exposures to government debt: the public-sector Landesbanks are big creditors of local governments.

As important as the choice of end-point will be the path to it. Mr Véron estimated in 2017 that if the concentration threshold were set at 33% of Tier 1 capital, large French and German banks would each be deemed to have excess home exposures of around €250bn ($ 280bn), and big Italian lenders would be deemed to have €145bn. Predicting whether and how banks would diversify—into other, similarly rated euro-zone bonds, or into foreign debt—is difficult. It would depend on how much extra capital banks were asked to set aside, and their willingness to take liquidity and exchange-rate risk. Banks wanting to sell off southern, lower-graded bonds might struggle to find buyers. (A common safe asset, proposed by the commission, would ease the transition. But French and German leaders put the idea on ice last year.)

As Mr Véron puts it, “subgroups of working groups of groups” have been beavering away on technical fixes. But the decision to go ahead rests with politicians. Opponents of sovereign-exposure regulation would need first to accept the need for it in principle, and then spot a trade they are willing to make that is acceptable to the others—say, by conceding ground on sovereign exposures in return for a deposit-insurance scheme that offers more risk-sharing. Reports suggest that Italy’s government might seek instead to trade reforms to the euro zone’s bailout fund for common deposit insurance.

Officials in Brussels want to prepare a “roadmap” for reform that leaders can rubber-stamp when they meet in mid-December. But the bar is low. Even concluding negotiations on whether or not to begin negotiating on reforms could be considered a victory. If fixing the house up were easy, it would have been done by now.

Ray Pierce

Ray Pierce

Ray Pierce is a Senior Market Analyst. He has been covering Asian stock markets for many years.


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