EU Takes Critical Next Step in Banking Union

The European Union has at last proposed what it calls the “second pillar” of its banking union. The first pillar, unveiled last December, consists of proposals for banking reform, aimed at reducing risk in the financial system. This next step proposes a mechanism should those reforms fail and the authorities have to deal with bank failures. Some, including Michael Barnier, the EU commissioner in charge of regulation, have referred to this proposed Single Resolution Mechanism (SRM) as a “revolution” on a par with the adoption of the euro. That characterization surely overstates, as does use of the word “pillar.” Matters on either proposal are far from settled. Still, there is no denying that Europe has taken significant steps toward financial security.

Both pillars aim to avoid a repeat of the 2008-2009 financial crisis. Like its American equivalent, Dodd-Frank, and national reforms already proposed in the U.K., France and Germany, the bank reform agreed to in December would reduce risk by prescribing how banks can dispose of their assets and insisting on protections for their depositors and their balance sheets. The reforms aim at the union’s 30 largest banks and the large subsidiaries of foreign banks operating in Europe—those that are “systemically important,” in the evolving jargon of financial regulation. Though highly complex, their most dramatic provision would forbid these banks from proprietary trading in securities and commodities. This is far from straightforward. Because the reform allows banks to continue trading on behalf of their customers, banks would have to own securities for periods of time, making it difficult for the regulators to distinguish for whom the bank is trading. Recognizing this, the proposals further insist that trading for clients happen in a separate entity from the banks’ other activities. Aiming at other forms of risk reduction, these proposals would also forbid banks from owning or having large exposures to aggressive investment operations, such as hedge funds.

The proposed SRM, the second “pillar,” constitutes a refreshing recognition that even the best rules and regulations can fail, and markets will need calming when that occurs. The proposals under the second pillar would create a clear procedure for dealing with weakness in any one of Europe’s 130 biggest banks and 200 so-called cross-border banks. The SRM would not concern itself with smaller financial institutions and those largely contained within a member nation, which would come under the control of national bank regulatory authorities. To give the new mechanism the liquidity needed to calm markets in the face of trouble at one of these banks, especially the fear of failure, it would have at its disposal a roughly $76 billion resolution fund, raised from levies on the banks under its supervision. Initially, most of the fund would remain in national compartments. Only 40 percent of it would have a mutual pan-European character, though the whole fund would gradually be mutualized over the next eight years. To further enhance the SRM’s ability to calm market disruptions during a bank resolution, the proposals would give it broad authority to borrow.

Though the proposals are a considerable improvement over the past, many claim that they are insufficient. Bankers, including the regulators who framed the proposals, readily admit that $76 billion is too little to calm markets in the face of a serious problem at a major, that is, systemically important, bank. It is true the SRM can borrow, but doing so could roil markets, since a resort to borrowing would constitute an admission that the system lacked sufficient resources to begin with.

Still more concerning is the proposal’s remarkably complex decision-making structure. It is largely a reflection of the need to compromise between national interests, and many bankers claim that it is too cumbersome to deal with a burgeoning crisis. A simple description of how it works bears out their argument. As envisioned now, the European Central Bank would initially determine if a bank is in trouble. It would then notify the SRM Board, the European Commission, Europe’s Council of Finance Ministers and national regulatory authorities. The SRM Board would then determine if a systemic threat existed and whether there was the chance of a private resolution. If the board were to decide to use the mechanism, it would then have to make a recommendation to the commission. Any objection from the commission would send the board back to square one. Should the commission and the board agree but want to modify resources drawn from the SRM fund, the council would have to approve. Only after complete agreement at each contingency could the SRM system proceed.

Even the enthusiastic Barnier has admitted to these problems. Still he insists, quite rightly, that the creation of the SRM is an important step, indeed a critical one. Actually, given the divergent national positions on these issues, it is remarkable that the framers reached agreement at all. After all, the French, the Spanish and others were determined to create an overriding, top-down pan-European institution with pan-European funding, while the Germans, who necessarily would bear the greatest cost, were just as determined to protect their taxpayers and their economy from burdens imposed by what they see as the profligacy of others. Both the gradual mutualization envisioned for the SRM fund and the complex decision-making procedures surely reflect compromises between these positions.

As big a step as this is, however, matters are far from settled. The SRM proposal still has to win the approval of the European Parliament and each member nation, as do the bank reform proposals. Even once settled, these rules and procedures would fail to offer either depositors or markets the thorough assurances they and the regulators would like. When the next financial crisis comes—and another one will surely come—the best this system, or any system, can do is mitigate the strain. With that fact of financial life in mind, these steps still are no small thing. When they are adopted, Europe and the world will have considerably more financial security than previously.

Milton Ezrati is senior economist and market strategist for Lord, Abbett & Co. and an affiliate of the Center for the Study of Human Capitol at the State University of New York at Buffalo. He writes frequently on economics and finance. His new book, “Thirty Tomorrows,” is just out from Thomas Dunne Books of Saint Martin’s Press.

Photo: Sculpture of the euro symbol, Frankfurt, Germany (photo by Flickr user maveric2003, licensed under the Creative Commons Attribution 2.0 Generic license). 

http://www.worldpoliticsreview.com/articles/13673/eu-takes-critical-next-step-in-banking-union