24/2/2013: EU's Banking Union Plan Can Amplify Moral Hazard It Is Designed to Cure

In a recent note, Germany's Ifo Institute (Viewpoint No. 143 The eurozone’s banking union is deeply flawed February 15, 2013) thoroughly debunked the idea that the European Banking Union is a necessary or sufficient condition for addressing the problem of moral hazard, relating to the future bailouts.

Per note (emphasis is mine), "Largely ignored by public opinion, the European Commission has drafted a new directive on bank resolution which creates the legal basis for future bank bailouts in the EU. While paying lip service to the principle of shareholder liability and creditor burden-sharing, the current draft falls woefully short of protecting European taxpayers and might cost them hundreds of billions of euros."

Instead of directly tackling the mechanism for bailing-in equity and bondholders in future banking crises, "the new banking union plans may... turn out to be another large step towards the transfer of distressed private debt on to public balance sheets..."

Here's the state of play in the euro area banking sector per Ifo: ECB "has already provided extra refinancing credit to the tune of EUR 900 billion to commercial banks in countries worst hit during the crisis... These banks have in turn provided the ECB with low-quality collateral with arguably insufficient risk deductions. The ECB is now ...guaranteeing the survival of banks loaded with toxic real estate loans and government credit. So the tranquillity is artificial."

I wholly agree. And worse, by doing so, the ECB has distorted competition and permanently damaged the process of orderly winding down of insolvent business institutions, as well as disrupted the process of recovery in terms of banking customers' expectations of the future system performance. Per Ifo, "Ultimately, the ECB undermines the allocative function of the capital market by shifting the liability from market agents to governments."

The hope - all along during the crisis - was always that although the present measures are deeply regressive, once the current crisis abates and is reduced from systemic to idiosyncratic, "the European Stability Mechanism (the eurozone’s rescue fund – ESM) and the banking union plan [will impose] more [burden sharing of the costs of future crises on] private creditors".

The problem, according to Ifo is that neither plan goes "anywhere near far enough" to achieve this. "..the “bail-in” proposals suggested by the European Commission as part of a common bank resolution framework [per original claims] “should maximise the value of the creditors’ claims, improve market certainty and reassure counterparties”".

Nothing of the sorts. Per Ifo: "Senior creditor bail-ins are explicitly ruled out until 1 January 2018, “in order to reassure investors”. But if bank creditors are to be protected against the risk of a bail-in, somebody else has to bear the excess loss. This will be the European taxpayer, standing behind the ESM."

"The losses to be covered could be huge. The total debt of banks located in the six countries most damaged by the crisis amounts to EUR 9,400 billion. The combined government debt of these countries stands at EUR 3,500 billion. Even a relatively small fraction of this bank debt would be huge compared to the ESM’s loss-bearing capacity."

Ifo see this four core flaws in "institutional architecture" of the bail-in mechanism:

• "First, the write-off losses imposed on taxpayers would destabilise the sound countries. The proposal for bank resolution is not a firewall but a “fire channel” that will enable the flames of the debt crisis to burn through to the rest of European government budgets." 
• "Second, imposing further burdens on taxpayers will stoke existing resentments. Strife between creditors and debtors is usually resolved by civil law. The EU is now proposing to elevate private problems between creditors and debtors to a state level, making them part of a public debate between countries. This will undermine the European consensus and replicate the negative experiences the US had with its early debt mutualisation schemes." 
• "Third, asset ownership in bank equity and bank debt tends to be extremely concentrated among the richest households in every country. Not bailing-in these households’ amounts to a gigantic negative wealth tax to the benefit of wealthy individuals worldwide, at the expense of Europe’s taxpayers, social transfer recipients and pensioners."
• "Fourth, the public guarantees will artificially reduce the financing costs for banks. This not only maintains a bloated banking sector but also perpetuates the overly risky activities of these banks. Such a misallocation of capital will slow the recovery and long-run growth."

Note that per fourth point, the EU plans, while intended to address the problem of moral hazard caused by current bailouts, are actually likely to amplify the moral hazard. In brief, "...the proposal for European bank resolution exceeds our worst fears."

Note that the Ifo analysis also exposes the inadequacy of the centralisation-focused approach to regulation that is being put forward as another core pillar of crisis prevention. "A centralised supervision and resolution authority is necessary to address the European banking crisis. But that authority does not need money to carry out its functions. Instead bank resolution should be subject to binding rules for shareholder wipeout and creditor bail-ins if a decline in the market value of a bank’s assets consumes the equity capital or more. If the banking and creditor lobbies are allowed to prevail and the commission proposal passes the European parliament without substantial revision, Europe’s taxpayers and citizens will face an even bigger mountain of public debt – and a decade of economic decline."

I couldn't have said it better myself.