Banking union: big bang or damp squib?

Eurozone needs package of interrelated measures to prevent project going backwards

The Bulgarian government, after assuming the rotating presidency of the Council of the European Union in January 2018, became the latest in a growing line to pledge it would prioritise completing the eurozone’s banking union.

Progress has been made: the single supervisory mechanism at the European Central Bank (ECB) and the Brussels-based single resolution board already exist. In theory, the third leg of the stool is a single European Deposit Insurance Scheme (Edis) and then the job is done.

In reality, banking union is a set of much more complex interactions between different European institutions and pieces of legislation, with the overarching aim of removing barriers to a single banking market. These obstacles are more widespread than they appear, including the need for a single, pan-European pool of high-quality collateral to replace the current dependence on home sovereign bonds, and the prudential treatment of eurozone banks’ subsidiaries in other eurozone countries.

This complexity has stalled the European Commission’s draft Edis legislation, originally published in November 2015. Several members, led by Germany, want meaningful risk-reduction measures in the banking sector before the mutualisation of risk implied by guaranteeing other countries’ depositors.

The risk-reduction plan includes tackling high non-performing loans (NPLs) in certain national banking sectors, ensuring bank debt can be bailed in instead of recapitalising banks with a government bailout, and breaking the doom loop created by high home sovereign-debt exposures on bank balance sheets.

The EU seems to be changing its own approach: instead of arguing over the exact sequence of events to finalise the banking union, it is pursuing everything at the same time

Efforts to break the doom loop received a setback in December 2017, when the Basel Committee failed to agree even to consult on reforms to the standardised approach for calculating credit risk capital to be held against banks’ sovereign exposures. The EU had left the project to Basel in the hope of overcoming internal rifts and avoiding any competitive implications if Europe moved on sovereign risk while the rest of the world stayed still.

So the EU seems to be changing its own approach: instead of arguing over the exact sequence of events to finalise the banking union, it is pursuing everything at the same time. The Bulgarian presidency has promised to move on with Edis this year. The ECB and European Commission have joined forces to accelerate the clean-up of NPLs on bank balance sheets. And the commission is set to unveil another proposal intended to reduce home sovereign exposure while also developing a pan-European safe asset – the sovereign bond-backed security.

Meanwhile, the European Parliament has begun advocating concentration charges on banks’ sovereign-credit risk exposures to help break the doom loop and incentivise the uptake of SBBS. There are also council discussions on upgrading the European Stability Mechanism to provide proper backstop funding with which to tackle major national or cross-border banking crises, which threaten to exhaust the single resolution fund.

If all of these measures are worked on simultaneously to form a single, big-bang package, it could break the deadlock to completing the banking union. But the drawn-out process of finalising Basel III last year suggests another possible outcome. The giant package of reforms was delayed by a year because its progress slowed to the pace of the most controversial item on the agenda.

Complex engineering

In the meantime, there are several risks that could throw the entire project off the track.

Former German finance minister Wolfgang Schäuble let fly a parting broadside at the SBBS project as he departed last October, warning: “We must be able to create real stability through reforms, not through complex and expensive financial engineering.” As coalition talks are still ongoing, Schäuble’s successor has not yet been appointed – if they hold a similarly negative view of SBBS, it could scupper the idea before it sets sail.

The credibility of the single resolution board is under fire in a lawsuit over the resolution of Spain’s Banco Popular. Any upward trend in NPL ratios for specific countries would further undermine the appetite for risk mutualisation. The European Banking Authority’s third-quarter 2017 Risk Dashboard report showed NPL ratios continuing to improve. The proportion of banks with NPL ratios lower than 3% is at 51.4%, compared with just 38.1% for the third quarter of 2015. But this improvement could be reversed as the ECB curbs its ultra-easy monetary policy and interest rates rise.

So, time is of the essence. While it is important for new rules and institutions to be carefully designed, the status quo is not necessarily stable and there are inherent risks in allowing the banking union to persist in its current, incomplete form. This year, the leaders of the eurozone are likely to have to choose between big bang and damp squib.