Mis­con­stru­ing Ger­many will prove to be death of the Euro

The Pak Banker - - Front Page - Me­gan Greene

WHEN I go from one Euro­pean cap­i­tal to an­other, talk­ing to of­fi­cials and se­nior politi­cians about the fu­ture of the euro, Ger­many feels less like an­other coun­try than a dif­fer­ent planet. In Madrid and Dublin, a euro-area bank­ing union -the pre­req­ui­site for bail­ing out banks di­rectly -- is dis­cussed as if it were a fore­gone con­clu­sion. Both Spain and Ire­land are hop­ing their gov­ern­ments ul­ti­mately won't have to fi­nance the res­cue of their banks alone.

Top of­fi­cials in Ger­many work on the as­sump­tion that a mean­ing­ful bank­ing union will never hap­pen.

I re­cently spoke, for ex­am­ple, on a panel about the pro­posed bank­ing union at a con­fer­ence in Lon­don that was hosted and at­tended by se­nior Ger­man busi­ness­men, politi­cians and Fi­nance Min­istry staff. Af­ter my in­tro­duc­tion, one se­nior of­fi­cial ex­plained the Ger­man po­si­tion on a bank­ing union in just five words: "We do not want it." I looked around to see a sea of heads nod­ding in agree­ment.

This cog­ni­tive dis­so­nance within the euro area is po­ten­tially fatal, lead­ing to mis­in­ter­pre­ta­tion of the in­ten­tions of the cur­rency bloc's in­dis­pens­able na­tion: Ger­many.

Take the last Euro­pean Union sum­mit, in Oc­to­ber. EU sum­mits are rit­u­al­ized events at which mem­ber states' na­tional lead­ers sign joint state­ments and then rush off to their as­signed rooms in the build­ing to hold sep­a­rate news con­fer­ences. There, they try to de­fine what the deal re­ally means. Ger­man Chan­cel­lor An­gela Merkel signed the Oc­to­ber sum­mit's con­clu­sions, which com­mit­ted to start build­ing parts of a bank­ing union, and then started to dis­tance her­self from it be­fore she had left the build­ing.

This raised a few eye­brows, but it should have raised the alarm. Most com­men­ta­tors as­sumed that any back­track­ing was just about elec­tion sched­ules. Merkel was keen to push off po­ten­tially con- ten­tious is­sues un­til af­ter Ger­many's 2013 elec­tions, they ar­gued.

That as­sump­tion was prob­a­bly false. Ger­many isn't in­ter­ested in tak­ing the steps re­quired to es­tab­lish an ef­fec­tive bank­ing union, not now and not ever. With­out a bank­ing union -- and, by ex­ten­sion, some de­gree of fis­cal union -the euro project stands lit­tle chance of sur­vival. To ex­plain why, you have to go back to the start of the cri­sis. By 2007, euro-area bank bal­ance sheets bal­looned so much that the to­tal as­sets of the bank­ing sys­tem reached more than 300 per­cent of gross do­mes­tic prod­uct, com­pared with less than 100 per­cent of GDP for banks in the US Given the in­ter­con­nect­ed­ness of Europe's fi­nan­cial in­sti­tu­tions, it was feared that the fail­ure of one lender might bring down the en­tire sys­tem. So a de­ci­sion was made to avoid the in­sol­vency of any ma­jor bank in the euro area at all costs.

As banks were re­cap­i­tal­ized by their gov­ern­ments, a neg­a­tive-feed­back loop de­vel­oped be­tween lenders and their sov­er­eigns. In some coun­tries, states stepped in to prop up their ail­ing banks, while in oth­ers the banks stepped in to prop up their ail­ing sov­er­eigns.

This was most ob­vi­ous in Ire­land and Greece. The bot­tom­less pit that was the Ir­ish bank­ing sys­tem sank the state, as bank debt was foisted onto the Ir­ish sov­er­eign's bal­ance sheet. In Greece, banks were hit hard, first by de­posit flight as savers wor­ried that the coun­try might leave the euro, and then by a hefty "hair­cut" -- or write­down in value -- im­posed on pri­vately owned Greek gov­ern­ment bonds, with which Greek banks were stuffed to the gills.

The main ob­jec­tive of a bank­ing union is to break this neg­a­tive-feed­back loop by al­low­ing banks to fail and to be liq­ui­dated or re­cap­i­tal­ized with­out con­ta­gion to other lenders or to sov­er­eigns. In or­der to work, the union has two min­i­mum re­quire­ments. The first is a sin­gle su­per­vi­sory mech­a­nism to over­see all banks in the euro area. The sec­ond is a bank-res­o­lu­tion plan, which would put pro­cesses in place for re­cap­i­tal­iz­ing sys­tem­i­cally im­por­tant banks that get into dif­fi­culty, and for liq­ui­dat­ing their non­sys­tem­i­cally im­por­tant coun­ter­parts.

Some progress has been made on es­tab­lish­ing a su­per­vi­sory mech­a­nism. At the EU sum­mit in Oc­to­ber, euro-area pol­icy mak­ers agreed to leg­is­late one by the end of 2012, and to im­ple­ment it in 2013. Once this has been done, pol­icy mak­ers agreed that the EU bailout fund, the Euro­pean Sta­bil­ity Mech­a­nism, will be able to re­cap­i­tal­ize banks di­rectly.

Ger­many only wants the mech­a­nism to su­per­vise sys­tem­i­cally im­por­tant banks. It's no se­cret that this is be­cause Merkel doesn't want euro-area su­per­vi­sors pok­ing around Ger­many's sick Lan­des­banks and high­light­ing that Ger­many's bank­ing sys­tem hasn't been im­mune to the cri­sis. This hur­dle is prob­a­bly sur­mount­able.

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