17/4/2014: Toothless Shark? EU's Banking Union

EU has been pushing hard on the road toward the Banking Union (BU) with recent weeks seeing completion of the agreement and vote in the EU Parliament on SRM and other aspects of the BU (see: http://trueeconomics.blogspot.ie/2014/04/1642014-eu-parliament-passes-bail-ins.html). But beyond the facade of all this activity, there is a nagging question of the BU's structural effectiveness. This question is yet to penetrate the thick sculls of investors seemingly obsessed with new issuance of debt and equity by the European banks.

The latest BU shape is much improved on the previous versions: gone are national discretions and in is a new streamlined process with ECB and EU Commission in the driving seat. SRM got an efficiency push with new deadline for completion of funding pushed to 8 years from previous 10 years. The fund will be 60 percent mutualised by the end of year two of its operations. Which further reduces potential for national authorities picking at it while bickering with the EU regulators and supervisors. The SRF will have access to ESM while the funds are being accumulated. And the new version cuts the time required to deploy the Single Resolution Mechanism and the Single Resolution Fund, should the banks run into systemic tight spot. All good.

The bad bits are, however, still there.

1. The SRF is still only EUR55 billion at maximum capacity. Which is peanuts for a systemic crisis, give euro area banking system has EUR30.5 trillion worth of assets (which means that SRF can cover just 0.18 percent of the euro area assets).
2. There is no defined mechanism by which banks will be contributing to SRF. Will banks be liable on the basis of their deposits base? If so, the BU will be a de facto mechanism for rewarding less deposits-rich banks and penalising banks that are funded using greater share of deposits. Not a good idea, since alternative to deposits is… err… interbank markets. And a bad idea, because deposits-rich banks are in the euro area's core and in particular - Germany. Alternatively, contributions to SRF can be based on assets. In which case, French, Spanish and peripheral banks are crunched. 
3. There is little in terms of SRF / SRM promise of breaking the contingent liabilities spilling from the systemic crisis in banking sector onto sovereigns. The only way of doing so is to reduce the rate of crisis spread and probability of crisis becoming systemic. 

The break between taxpayers and banks can only be achieved by creating a highly competitive system of diversified, smaller and better capitalised banks (see: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2329815).

Step one would be to hike minimum leverage ratio (core capital to total assets) to the US standard. Currently we have 3% standard in the EU (http://www.bis.org/publ/bcbs251.pdf) and in the US the ratio is set at minimum 5% for eight biggest bank-holding companies and 6% for the rest of the banking system (http://www.cnbc.com/id/100880857). Given weakness of euro area SRF (pre-funded and capped) compared to FDIC (pre-funded and backed by a stand by loan from the Treasury of USD30 billion, plus a further US Government guarantee to cover any excess obligations) and the heavier reliance of the European system on bank lending, this means leverage ratios of close to 6.5-7% or more than double current minimum.

Step two would be to test the banking system to identify larger banks that will require splitting up and smaller banks that will require capital raising. This will have to be facilitated by forcing new deleveraging targets and supporting equity issuance and forcing mergers in some cases.

Step three will be removing implicit and explicit barriers to new banks entry into European markets and actively promoting emergence and development of alternative banking institutions.