Banking Union or Bait-and-Switch?

When the Council of Economics and Finance Ministers (ECOFIN) meets informally on Friday, 22 April, one issue on the table will be the reduction of bank exposure to the sovereign debt of their home governments. This issue was laid out in a note from the Dutch Presidency that was leaked on Wednesday. The response of the Italian government in particular was immediate and strongly negative. Italian banks are heavily exposed to Italian sovereign debt and any attempt to reduce that exposure would impose unacceptable costs on an already fragile Italian financial system. To some degree this is the case for other peripheral countries as well. The Dutch Presidency note argues that Europe’s banking union needs to be strengthened with some kind of European Deposit Insurance Scheme (EDIS) and ‘a common backstop for the Single Resolution Fund (SRF)’. Before the Dutch Presidency can flesh out its position on these key support mechanisms, however, it needs to tackle the ‘bank-sovereign nexus’ so that ‘risk sharing and risk reduction go together’. Intellectually, this is a coherent argument.

Politically, it looks more like a bait and switch. The Europe-wide deposit insurance and common resolution backstop is the bait. All the peripheral countries have to do is reduce the exposure of their banks to their home-country sovereign debt. Unfortunately, once they make the adjustment, the risk to the banks will be reduced and so the creditor countries will argue that there is no need for Europe-wide deposit insurance and common resolution backstop on the grounds that markets and national self-discipline can solve any remaining problems. That is the switch.

That is a pretty harsh accusation to make but it is consistent with the short history of Europe’s banking union. That history starts with the Spanish banking crisis in spring 2012. The cause of the crisis was an ever widening hole in the balance sheets of Bankia and its holding company BFA. The Spanish government discovered to its dismay that any debt it raised to fill the gap would only undermine its own finances. Since the other large Spanish banks had large exposures to Spanish sovereign debt, the fall in Spanish sovereign bond prices only threatened to widen the pool of losses. Loans from other governments or European institutions offered no solution: so long as they passed through the Spanish state, they only added to the government’s debt problems and hence weighed down its creditworthiness. What Spain needed was some form of foreign-sponsored direct recapitalization. Spain’s creditors were willing to offer that, but only on condition that Spain and other European countries subject their banks to a ‘single supervisory mechanism’ (SSM). The logic was simple: risk sharing should be matched by credible efforts at risk reduction. Institutionally, that is how Europe’s banking union was born.

The point to note, however, is that the direct recapitalization never came to pass. Spain did get European resources but the Spanish government remained responsible for their repayment. Meanwhile, crisis was averted by actions at the European Central Bank (ECB). ECB President Mario Draghi promised to do ‘whatever it takes’ and effectively put a floor under Spanish sovereign debt prices through the introduction of outright monetary transactions. This might have been a happy coincidence. Certainly as this SSM developed it was possible to imagine a future where emergency bank recapitalization would not have to pass through member state finances.

Nevertheless, events in Cyprus revealed something altogether different. The trouble with the Cypriot banks started alongside the Spanish crisis. They continued through the creation of the SSM. When that crisis came to a head the solution was to bail in the creditors and not to rely on European resources. In an interview with the Financial Times, Eurogroup President and Dutch Finance Minister Jeroen Dijsselbloem made it clear that he believed reliance on private sector bail-ins should set the pattern for future bank rescues: ‘We should aim at a situation where we will never need to even consider direct recap.’ In other words, now that there is risk reduction, there is no need for risk sharing.

There is a powerful logic to that position as well. Moreover, it is a logic that pairs nicely with financial market regulation within many of the creditor countries. Just look at the situation with regard to deposit insurance in Germany, where the savings banks, regional banks, and commercial banks all pay into separate funds. If they cannot find the political will to create common deposit insurance within their own country, why should anyone expect them to support a common deposit insurance system at the supranational European level. Instead, the Germans have to hope that the different parts of their financial system will not have to rely on a cross-subsidy. Otherwise the German government will have to foot the bill. There is clear historical precedent for that as well from the most recent European financial crisis.

The challenge with relying solely on risk-reduction is managing the transition from a high-risk situation. Here the Dutch Presidency note suggests a market approach that is likely to be inadequate. Italian banks that are overexposed to Italian sovereign debt can unload their positions in the hopes that banks elsewhere will find the notes attractive, particularly given that they must also diversify their sovereign debt exposure. What is less clear is what those Italian banks are meant to purchase. Much of the universe of creditor-country debt is already negative-yielding. Moreover, some banks might try to offload their holdings ‘faster than required’ which might ‘exacerbate potential price dynamics’. In other words, they will be selling into a declining market.

Fortunately, the ECB will set a floor. That is ‘risk sharing’, albeit of a different form. The Presidency note includes a footnote that suggests the ECB will be able to pick up any slack through its large-scale asset purchasing program, which includes both significant repurchases and the reinvestment of proceeds from assets that mature. What the note fails to mention is that the ECB can only purchase according to fixed proportions – currently in line with the ECB’s capital key. The reason for this proportionality is to prevent unnecessary risk sharing. The implication is that the ECB will be competing with the Italian banks for creditor country paper while ignoring what the Italian banks have to sell. If so, the ECB may also play a role in exacerbating potential price dynamics. This means there is no risk sharing on the table. Instead there is just adjustment on the periphery (but not in the core) – followed, perhaps, by resolution and recovery. That is what the Italian government fears most.

The Italian government is right to be fearful. The proposal to reduce bank exposure to their sovereigns is not a formula for linking risk reduction to risk sharing. It is a bait and switch.

This essay was originally published on MNI Euroinsight. You can find the edited version here.