Europe must break free of banking doom loop
The next 12 months are make or break time for the struggling eurozone economy, writes Colm McCarthy
‘WE affirm that it is imperative to break the vicious circle between banks and sovereigns.” With these words, the well-remembered EU summit of June 29, 2012, committed Europe's leaders to fixing the failing eurozone, the dysfunctional and ill-designed common-currency area launched in 1999.
They have been backsliding on this commitment in the period since, with creditor states, led by Germany, intent on frustrating efforts to build a durable monetary union.
The backsliding has taken concrete and dangerous form in the course of recent weeks.
The European crisis is a banking crisis first and foremost and will not be fixed without a proper banking union. This requires a Europewide system of bank resolution; that is a pre-agreed system for dealing with banks that go bust.
To date, the costs have fallen mainly on taxpayers in whatever country the bust banks' headquarters happened to be located, with the result that numerous national treasuries are over-burdened with debt. As sovereign debt escalates, lenders to governments take losses — dramatically so in the case of the massive Greek default.
Lenders to banks have been favoured over lenders to governments. It is universally acknowledged that the doomloop linking bust banks to indebted sovereigns cannot continue. But on present indications it remains the preferred policy of the European leadership, including the leadership at the ECB.
Taoiseach Enda Kenny circulated his fellow summiteers with a reminder that they had committed to breaking the doom-loop and that retrospective European assistance with the costs of the Irish bank rescue remained on his agenda.
It now appears that he is alone in this: the communique of June 29, 2012, appears to be a dead letter. It is even possible that bust sovereigns, such as Ireland and Spain, could be faced with yet more pressure from Europe to borrow even more money to bail out bank creditors, incredible as that may seem.
The ECB is about to commence an ‘asset quality review' for 124 of the largest European banks, including five in Ireland. This will lead, about a year from now, to the publication of definitive stress tests on each of these banks and some may be judged short of adequate capital. That is to say, they could fail the test.
If they do and are unable to raise market capital, it is ECB policy that the host government should pony up yet again to protect bank creditors, regardless of how bust the national treasury may be or of how much it has already been forced to borrow for bank rescue. So much for “breaking the vicious circle”.
On two previous occasions, before the ECB got involved, the European stress tests were conducted by an organisation called the European Banking Authority. The EBA concluded (twice) that everything was just fine and that no European bank was bust, or in any danger of going bust.
Several banks which received the EBA all-clear subsequently went under, one within weeks of the thumbsup. The list of banks deemed stress-free included AIB, which cost the Irish taxpayers a cool €20bn. Not surprisingly, European stress tests do not enjoy any credibility in the market.
A well-functioning monetary union needs a banking union with three components — centralised bank supervision, a system for winding up banks that fail without bankrupting sovereign states and a credible scheme of insurance for retail depositors.
The failure to put such arrangements in place in 1999 is at the heart of the common currency disaster. It has now been decided that the ECB should become the central supervisor of eurozone banks and it released last week limited details about the methodology it will follow in the next round of stress tests.
More important, ECB president Mario Draghi was quoted to the effect that some banks will likely fail the test next year. He clearly appreciates that the credibility of the ECB is on the line and that it cannot self-destruct like the EBA. The latter body has not been scrapped — perish the thought. Even though its essential function of supervisory oversight has passed to the ECB, it will survive as a kind of zombie euro-quango.
If and when the ECB pronounces that some banks have failed the stress test, those banks are effectively and publicly bust. If Europe ran its financial affairs seriously, there would be an automatic resolution process, allocating
‘The State has bankrupted itself through bailing out bust banks’
the losses first to shareholders, then to bondholders and finally to unguaranteed depositors, if that proves necessary.
Five years into the banking crisis, no such arrangements have been put in place at eurozone level. Proposals along these lines, which had been brought forward by the European Commission, have been blocked by Germany, which is opposed to the completion of a banking union. Germany's opposition to a banking union is consistent with keeping open the option of eventual eurozone break-up, which German politicians pretend to be unthinkable.
With no agreed resolution process for banks which are failing, the ECB's Draghi has been squaring this circle by insisting that each eurozone member must have “national backstops” in place, which means that each country must be willing and able to bail out any further bust banks with more borrowed money.
Five Irish banks are to be stress-tested by the ECB next year. Two are not our problem: Ulster Bank, which belongs to Royal Bank of Scotland and ultimately to the UK taxpayers; and the Irish unit of the American firm Merrill Lynch, Uncle Sam's problem.
But three are effectively wards of the Irish State. One of these, Bank of Ireland, is expected to pass the test. But nobody knows for sure whether the other two, AIB and Permanent TSB, might not need more capital, on top of the enormous impositions already inflicted on the Irish taxpayers.
Under ECB policy as enunciated by Mario Draghi during the week, if either of these needs more capital, they must raise it in the market (impossible) or get it yet again from the (bust) Irish Exchequer.
When unwelcome charity collectors call to the house, the standard response in the US is “we have already given at the office”. This should also be the reaction of the Irish Government should Mario Draghi conclude that any Irish bank needs more capital. The Irish State has already bankrupted itself, partly due to its own errors, through bailing out bust banks. But the current excess public debt in Ireland is also due to the machinations of Draghi's predecessors at the ECB. It is simply unconscionable that the Irish taxpayers should be exposed to any further liabilities for Europe's banking mess. We've already given.
The banking systems of both Spain and Italy will also be under the ECB spotlight and it is entirely possible that some banks will be deemed to be short of capital. The governments of Spain and Italy have no remaining borrowing capacity to bail out bust banks and there are several other eurozone countries in the same position.
The ECB stress tests cannot credibly be concluded until the second leg of a banking union, a pre-agreed resolution process for bust banks, is in place. It is the expressed wish of the ECB that this should be done before March, when the European Parliament, whose assent is required, dissolves for elections in May.
Given German opposition to the completion of a proper monetary union, this is not going to happen. That is to say, on current indications there will be no eurozone bank-resolution agreement.
The next 12 months will make or break the eurozone project. If there is no agreement on bank resolution, the stress tests will have to be fiddled, the central bank's credibility will diminish further and the sovereign debt market will face renewed turmoil.
In the circumstances, it would be reasonable to expect some degree of urgency at political level.
Instead, the European summit which concluded on Friday in Brussels took not a single decision of consequence about the continuing crisis in the eurozone. The meeting discussed, amongst other matters, eavesdropping by American spooks (felt to be bad), the digital economy (good) and corporate tax avoidance (also bad). The communique studiously avoids any substantive discussion of the real and present danger created by the paralysis over banking union.
It is time for the overindebted countries to explain to the ECB that further ‘national backstops' for failing banks are inconsistent with state solvency.