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.

11/12/2013: Will Europe Have Any Firepower for Banks Bail Outs?

The Banking Union debate drags on and on and on and the further we travel in time into this debate, the more apparent is the pathetic nature of the undertaking, and with it, the pathetic state of leadership across Europe... Here's the latest instalment:
http://blogs.ft.com/brusselsblog/2013/12/eu-bank-bailout-fight-more-leaked-documents/

Key quotes in this latest instalment:

"Both the European Commission and the European Central Bank – along with most eurozone finance ministries – believe a “break in case of emergency” backstop needs to be in place to provide a safety net for the bank rescue fund since, even when it’s completely full, it will only have €55bn in it. Given the recent crisis experience, that might only be enough to bail out two or three mid-sized European banks."

Laugh! or Cry! or both. The entire circus is about EUR55 billion. Not enough to backstop another Ireland (based on the 2008-2010 crisis dimensions). Not enough to backstop the retail division of the Deutsche Bank alone (based on 5% loss over capital cushion). Not enough to backstop anything, really. Administration, compliance, enforcement and other bureaucratic functions associated with this backstop (and the necessary Banking Union spoking it to the ECB and the eurosystem) will be running at somewhere around 5-10 percent of the entire fund, annually. If this is a form of insurance, you might getter better quote on insuring Titanic in its current state for passenger traffic.

"In addition, the fund will take 10 years to completely fill through levees on European banks, meaning some kind of backstop needs to be in place in the interim. The “SRF Backstop” paper basically says: we need a backstop, but we’re still not sure what it should be or how it would work."

Two things. Unless euro area hopes to remain in the Great Stagnation for the next 10 years, we shall see growth in banks balancesheets. Over 10 years horizon (even if balancesheets grow at 1.5% = real GDP growth expectation for euro area + HICP target, so 3.5% nominal growth pa in balancesheets), the banking assets side (covered liabilities from the SRF perspective) will have expanded by 41 percent. In other words, to provide the same cover as today's EUR 55 billion the fund will require EUR 78 billion. Forget the idea that in its current vision SFR will only be sufficient to bailout two or three mid-sized European banks. We'll be lucky if it can bailout 1 or 2 of mid-sized European banks in 10 years time.

15/5/2013: What IMF assessment of Malta has to do with Ireland?

Here's an interesting excerpt from the IMF Article IV conclusions for Malta, released today (italics are mine):

"In the longer term, regulatory and tax reform at the European or global level could erode Malta’s competitiveness. The Maltese economy, including the financial sector and other niche services, has greatly benefitted from a business-friendly tax regime. Greater fiscal integration of EU member states and potential harmonization of tax rates could erode some of these benefits, with consequences on employment, output, and fiscal revenues."

Now, Ireland is a much more aggressively reliant on tax arbitrage than Malta to sustain its economic model and has been doing so for longer than Malta. One wonders, how come IMF is not warning about the same risks in the case of Ireland?


Another thing one learns from the IMF note on Malta: "The largest banks will be placed under the direct oversight of the ECB from 2014. The MFSA should work closely with the ECB to ensure no reduction in the supervisory capacity of these banks."

Wait, we've all been operating under the impression that direct oversight from ECB is designed to increase quality and quantity of oversight. Quite interestingly, the IMF is concerned that it might reduce the currently attained levels of supervision.

7/7/2012: Banking union - a bit of a folly

Daniel Gros makes a cogent argument on banking union at vox.eu : http://bit.ly/L0tmUR

However... his argument is partially self-defeating.

Unified banking operations for an Italian bank with german subsidiary he uses as an example, by allowing transfer of liquidity (funds / deposits) from German subsidiary to cover Italian parent's liquidity demand that arises from Italian bank's overall elevated riskiness would be, in effect, a case of mis-pricing risk for German customers of the Italian bank. Should these customers re-price risk post-banking union, the customers will walk out of the subsidiary and the Italian parent bank will still be short of liquidity.

Thus, unless Italian bank is made a German bank (or until), the problem will remain. The only way for the supervisory authority to avoid the problem arising in the short run is by deceiving German customers of the Italian bank.

In addition, in order to make an Italian bank into a German bank, common supervision will require full convergence of all banking models to a common denominator. Whether such a convergence yields a better Italian bank (by the standards of the day) and / or a less safe German bank is a matter of more than supervision, but of a full regulatory convergence.

21/6/2012: IMF Article IV on euro Area: a massive miss, but loads of passion

So having penned the G20 response to the euro area crisis (see post here) last night, tonight, IMF decided to issue another missive on the topic (here). Which makes you wonder if the IMF has become so frustrated with the euro area's lack of real leadership, it has now resorted to the tactic known as blanket bombing the EU with gloomy assessments.

Here are some interesting extracts [comments and emphasis are mine]:

"Downward spirals between sovereigns, banks, and the real economy are stronger than ever. 

As concerns about banks’ solvency have increased—because of large sovereign exposures and weak growth prospects in many parts of the euro area—the effectiveness of liquidity operations has diminished. [It is clear that the IMF is seeing the entire euro area response policy as a set of liquidity supply measures, rather than solvency and structural reforms set of measures.]

Sovereigns, in turn, are struggling to backstop weak banks on their own. Absent collective mechanisms to break these adverse feedback loops, the crisis has spilled across euro area countries. Contagion from further intensification of the crisis—including acute stress in funding markets and tensions involving systemically-important banks—would be sizeable globally. And spillovers to neighboring EU economies would be particularly large. 

A more determined and forceful collective response is needed."

So far so good. In the nutshell, the IMF is saying that the euro crisis is now threatening the EU itself. In other words, were some nut eurosceptic to invent a tool for undermining the EU, he couldn't have done much better than inventing the current euro zone.

So what are the IMF proposals for the euro area more forceful collective response? Why, of course it is integrate more and grow.

"Completing EMU: Banking and Fiscal Union to Support Integration

A strong commitment toward a robust and complete monetary union would help restore faith in the viability of EMU. This should encompass a credible path to a banking union and greater fiscal integration, with better governance and more risk sharing. However, achieving this goal will take time and hence requires a clear timeline, with concrete intermediate actions to set the guide posts and anchor public expectations."

Err... Mr IMF, I have a question: suppose we have a banking union. Which means all banks will be regulated under singular umbrella. Note - this does not mean having a proper regime for shutting down currently insolvent banks, nor does it mean a unified system of banks assets workout. It means, however, joint deposits protection scheme. Good thing, deposits protection. Confidence improving. Alas, last time I checked, Greek banks are sick because of the sick sovereign, bonds of which they hold & of the sick economy. Spanish and Irish banks are sick because they made bad loans. In all cases so far, banks are sick not because they lack regulatory unification, and not because they lack deposits protection, but because they have bad assets. How can a banks union make these assets any better?

Good news, IMF says: "The proposed EU framework for harmonized national bank resolution processes is a necessary first step. But it needs to go further. ...A common bank resolution authority is also needed. It should be backed by a common resolution fund to ensure burden sharing and to limit fiscal costs. These efforts should be supported by a common supervisory and macro-prudential framework to forestall further financial fragmentation. While a banking union is desirable at the EU27 level, it is critical for the euro 17."

Bad news: there are absolutely no proposals even discussed yet to cover banks resolution mechanism. IMF is exceptionally silent on what should be done to achieve such 'resolution' and EU has shown no willingness to allow shutting down of a single bank. Thus, common resolution mechanism in the IMF parlance means preciously little, but in the EU vocabulary it means simply 'burden sharing'. In other words, 'banks resolution' mechanism is more about shafting bad banks debt onto all of the euro zone collectively. While this might help individual countries, e.g. Ireland, it does nothing to change the reality that euro area combined Government debt is going to be 90% of GDP this year alone. In other words, relabeling, for example, Irish banks debt an EA17 debt, instead of the Irish Government debt, will not achieve any net improvement in terms of breaking the links between banks and sovereigns (the sovereign here, thus becomes EA17 instead of national) and it will do absolutely nothing to restore functioning banking in EA17. 

My suggestion would be for IMF to be more forthright and tell exactly what this 'resolution mechanism' should look like.

IMF goes on with lofty dreamin: 

"More fiscal integration, with risk sharing supported by stronger governance, can reduce the tendency for economic shocks in one country to imperil the euro area as a whole. Ultimately, this could mean sufficiently large resources at the center, matched by proper democratic controls and oversight, to help insure budget shortfalls at the national level. Getting to this endpoint will take time. But the process can start with a commitment to a broad-based dialogue about what a fuller fiscal union would imply for the sovereignty of member states and the accountability of the center. This should deliver a schedule for discussion, decision, and implementation."

Wait, aside from the desirability of such a solution (which is open to a debate), the IMF says that the solution will take time. Lots of time. And yet, this is supposed to be a response to the ongoing acute crisis? Or does IMF honestly believe that 'a commitment to a broad-based dialogue' will do anything to compensate for the fact that euro area peripheral states are currently insolvent? How? By telling the markets that they are 'broadly-speaking talking to each other'?

I do note that the IMF is clearly stressing the need for democratic systems reforms in line with integration. I wonder, however, what they have in mind, exactly. Are they saying EU is currently not democratic enough? After all, if EU is democratic, then 'proper democratic controls and oversight' would exist already and would simply need to be deployed to a new structure...

The IMF also offers an interesting insight into its perception of the euro bonds ideas: 

"Introduction of a limited form of common debt, with appropriate governance safeguards, can provide an intermediate step towards fiscal integration and risk sharing. Such debt securities could, at first, be restricted to shorter maturities and small size and be conditional on more centralized control (e.g., limited to countries that deliver on policy commitments; veto powers over national deficits; pledging of national tax revenues). Common bonds/bills financing could, for example, be used to provide the backstops for the common frameworks within the banking union."

Interesting, isn't it? On one hand, IMF foresees limited common debt issuance. On the other it foresees this common debt being used to 'backstop ... banking union'. Now, wait - I thought banking union backstop would have to be enough to deal with current acute problems in Greece, Ireland, Portugal, Spain and Italy. That would be what? €300 billion? €500 billion? And that would have to be 'cheaper' and 'more stable' source of funding than ECB already provides. So it cannot be 'limited' and it cannot be 'short-term' (LTROs are already €1 trillion-large and 3-years long and they are not working).

In short, I see loads of frustration from the IMF side, but no real tangible solutions to the euro are crisis.