Banking union instead of Eurobonds – disentangling sovereign and banking crises

Thorsten Beck, Daniel Gros, Dirk Schoenmaker, 24 June 2012

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Most observers have realised by now that a core problem of the Eurozone crisis is the close interconnection between banking and sovereign fragility (Gros 2010). Unfortunately, recent policy actions have exacerbated this interconnection. 

  • The use of the additional liquidity provided by the ECB through longer-term refinancing operations (LTRO) operations by some banks to stock up on government bonds of their own country has tied the fate of sovereigns and banks even closer together (Wyplosz 2012).
  • The use of the EFSF or ESM to recapitalise Spanish banks via a loan to the government bank support agency (FROB) has exacerbated the Spanish sovereign debt crisis rather than helped to alleviate it. The loan adds another heavy burden to the Spanish debt-to-GDP ratio.

Matching supervision and resolution frameworks to the geographic perimeter of larger cross-border banks has been on the reform agenda since the start of the Global Financial Crisis.  Today the issue is coming up again under the heading of banking union, at the top of attempts to save the Eurozone from demise. Some see the banking union with a joint resolution fund to recapitalise failing banks across Europe simply as first step to Eurobonds and an indirect means to mutualise sovereign debt.  However, we argue that the establishment of a pan-European border resolution framework and fund is critical to disentangle banking and sovereign debt crises in the short term and provide the Single European market in banking with a sound and effective regulatory framework.

Moreover, once the banking system and the sovereign debt crises have been disentangled, there may be no need for Eurobonds anymore.  Losses in the banking sector will no longer endanger the solvency of otherwise solid sovereigns as in Ireland and Spain.  With a stabilised banking system there will also be no longer any need to bail out irresponsible sovereigns, such as Greece.  Moreover, with a solid banking system it is much less likely that fundamentally sound sovereigns would be subject to crippling risk premia.

A long-term reform agenda…

The lesson of this crisis is that a stable Single European Market in banking is not possible with national supervision, something also referred to as the financial trilemma (Schoenmaker, 2011). One could of course argue that the problems of Spain (and Ireland) are due to local banks engaging in a classic real estate lending binge.  This is true, but the problem would only remain local if the failure of mid-sized local banks did not endanger the stability of the entire Eurozone banking system.  Large cross-border Spanish banks and indeed banks elsewhere have considerable exposure to these banks (and the Spanish economy in general).  Failures of the Spanish local banks could thus set in motion a domino chain affecting the entire Eurozone banking system. In addition, national supervision of cross-border banks gives rise to distortions, as shown by Beck, Todorov, and Wagner (2012), since home-country supervisors might intervene in a weak bank too early or too late. Finally, the recent experience across Europe has shown political and regulatory capture of national supervisors resulting in underestimates of losses and delayed intervention.

The three of us have therefore – in different combinations and with different co-authors – repeatedly called for a supranational framework for the supervision of large pan-European banks (Allen et al, 2011; Schoenmaker and Gros, 2012; Schoenmaker, 2012).  While different institutional solutions are possible, a European-level framework for deposit insurance and bank resolution is critical in order to enable swift and effective intervention into failing (cross-border) banks, reduce uncertainty, and strengthen market discipline. Critically, a central resolution authority needs the necessary resources to resolve large cross-border banks in an efficient manner. That is why a combination of the resolution authority with a deposit insurance scheme for cross-border banks might be necessary (Schoenmaker and Gros, 2012). Industry-based funding for such a scheme is also called for to reduce concerns of moral hazard, where the downside risk of banks’ risk-taking is borne by taxpayers. Since deposit insurance, even if financed by banks themselves, always faces limitations in case of systemic bank failure, however, a back-stop by national governments, possibly through a European institution, such as the EFSF and the new ESM, is necessary. This is especially important in the early phases as the fund is being built up.

…but short-term needs

While the institutional reforms outlined above are necessary for the long-term sustainability of the Eurozone and a Single European Market in Banking, the Eurozone is facing immediate needs in fighting the ongoing crisis. There is still a significant capital shortfall in many European banks, not yet fully recognised. As just one example, Acharya, Schoenmaker, and Steffens (2011) calculate a recapitalisation need of 200 to 500 billion euros.   The increasing weight of sovereign debt on bank balance sheets weighs down banks, especially in the periphery.

The US sorted out its banks in 2009. It did a very strong stress test, coupled with the availability of TARP funds for immediate recapitalisation (though most fresh capital was raised in the market). Since then, US banks are no longer a source of weakness of the US economy. Europe has muddled through, with semi-strong stress tests and much leeway for recapitalisation (up to 9 months!). Most importantly, European leaders did not make the EFSF available for bank recapitalisation.

A European Resolution Authority

To turn the European banking system from a source of fragility into a source of strength, we argue for bold steps and a stop to forbearance.

  • We call for the establishment of a temporary European Resolution Authority, for which the ECB can make staff and offices available.

This Resolution Authority will sort out fragile bank across Europe, both small and large; strongly capitalised banks go ahead, and weak banks are either recapitalised or (partly) liquidated.

  • Where possible banks should be recapitalised through the market; if not feasible, the Resolution Authority recapitalises by taking an equity stake in the bank (by straight equity or hybrid securities).

It is important that the Resolution Authority also receives the upside if the banks are getting on the right track, with even a possibility to make gains as happened in previous crises. In addition, the use of debt-equity swaps should be considered, as well as restrictions on divided and possibly salary payments imposed.

  • The Resolution Authority would need a fiscal backstop from the EFSF/ESM to gain the necessary credibility not only with the banks it is tasked to restructure but also with the markets.

Addressing the restructuring needs of Europe’s banks on the European level has the additional advantage that it will also reduce political pressure and interference on the national level and will enable a more transparent and cost-effective process.

Conclusion

Restructuring and recapitalising banks across Europe will not only help disentangle sovereign and bank fragility, but it can also help Europe grow out of the crisis by turning the financial sector from a drag on sovereigns’ balance sheets to a motor for private-sector growth. Such a European Resolution Authority is thus not only a crisis resolution tool but also a critical part of the growth compact that is currently so high on the political agenda.

References

Acharya, Viral, Dirk Schoenmaker and Sascha Steffens (2011), How Much Capital Do European Banks Need? Some Estimates. VoxEU, 22 November.

Allen, Franklin, Thorsten Beck, Elena Carletti, Philip Lane, Dirk Schoenmaker and Wolf Wagner (2011), Cross-border Banking in Europe: Implications for Financial Stability and Macroeconomic Policies, CEPR, London.

Beck, Thorsten, Radomir Todorov, and Wolf Wagner (2012), Supervising Cross-Border Banks: Theory, Evidence and Policy, Tilburg University Mimeo.

Gros, Daniel (2010). "Eurozone crises left to fester", VoxEU.org, 21 December 2010.

Schoenmaker, D (2012), “Banking Supervision and Resolution: The European Dimension”, Law and Financial Markets Review, 6:52-60.

Schoenmaker, D and D Gros (2012), “A European Deposit Insurance and Resolution Fund”, DSF Policy Paper, No. 21, Duisenberg school of finance, Amsterdam.

Schoenmaker, D. (2011), “Financial Trilemma”, Economics Letters, 111:57-59.

Wyplosz, Charles (2012). "The ECB’s trillion euro bet", VoxEU.org, 13 February 2012.

Topics: EU policies
Tags: banking regulation, banking resolution authority, Eurozone crisis

Comments

European Resolution Authority

An important question would be the political independence of the European Resolution Authority. As actually visible, the ECB is not that. Your statement “Where possible banks should be recapitalised through the market” is a theoretical wish, already refuted by the market.
 

Thorsten Beck
Professor of Banking and Finance, Cass Business School; Professor of Economics, Tilburg University; Research Fellow, CEPR
Director of the Centre for European Policy Studies, Brussels
Dean of the Duisenberg School of Finance and Professor of Finance, Banking and Insurance at the VU University Amsterdam

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