Scholz gives ground on banking union, but will Rome cede too?

The lack of a common eurozone-wide fund to dole out deposits when a bank fails is one of the biggest stumbling blocks to a regional banking union. It impedes not only public trust in the euro, but also — if you ask most bankers in the region — cross-border mergers too.

The big reason it hasn’t happened yet is that two of the EU’S big players, Germany and Italy, have failed to agree on what needs to be done before a European Deposit Insurance Scheme, or EDIS, is set up. In short, Germany thinks Italian banks are too risky because they have made too many bad loans and hold too much government debt. Specifically, Germany wants a reassessment of the zero risk weighting attached to sovereign bond holdings, so that banks must hold some capital against them.

Earlier this week, some touted a breakthrough after Germany’s finance minister Olaf Scholz launched a media blitz to restart the debate on banking union -including advocating EDIS.

A proposal by Germany’s finance minister to end the stalemate over the eurozone’s banking union has revived hopes in Brussels of making progress on its most ambitious integration project since the creation of the single currency…

Olivier Guersent, the European Commission’s director-general for financial stability, said at an ECB event on Wednesday that Mr Scholz’s intervention was “a bold move and very welcome”.

Others were sceptical, noting that this could be cynical quid pro quo for Germany getting its way on tax harmonisation. And it would still seek to punish banks that have big portfolios of their host country’s debt through “risk-based concentration charges”. This is from the German finance ministry’s confusingly titled “non-paper” (our emphasis):

This type of model would be based on the introduction of base risk weighting for different qualities of loans, measured using ratings, for example. This would include a certain allowance for sovereign debt, which would be exempt of the capital, requirements irrespective of the rating (e.g. up to a concentration of 33% of the Tier 1 capital of the individual bank). This type of exemption for a “base concentration” would reflect the need for banks to maintain, due to regulatory requirements and for refinancing purposes within the central bank system, a certain quantity of safe, liquid assets, which generally consist of sovereign bonds.

The size of the degree of concentration of sovereign debt issued by a single country on banks’ balance sheets could then be addressed using a concentration factor, which would increase with increasing concentration. Multiplying the concentration factor by the base risk weighting would give the risk-based concentration charges, based on the rating and the degree of concentration. Hence, the lower the quality of the loan and the higher the concentration of the liabilities from individual countries or borrower units on the bank’s balance sheets, the higher the applicable risk-based concentration charge would be.

This type of model can be calibrated in such a way that it would not involve excessively large additional capital requirements for Eurozone banks in comparison with the status quo. Nevertheless, in this case there would already be an incentive for banks to more intensively diversify their sovereign bonds portfolios and hence function better as a buffer in crisis situations. In addition, challenges resulting from the transition could be mitigated by having an appropriate phase-in period (5 to 7 years).

This is progress for euro federalists in the sense that Germany now recognises that at least some portion of government debt holdings need to be exempt from risk weighting. A transition period of up to seven years is also a decent amount of time for banks to diversify their sovereign bond holdings.