Banking Union: Another Step on the European Journey
The start of the Single Supervisory Mechanism (SSM) in the euro zone adds an important element to the euro’s financial ecosystem. It should help to restore trust in the system and, by reducing frictions in the monetary transmission mechanism, may also contribute to growth. Recent additions to the monetary framework of the euro zone have not changed the fact that there is no traditional quasi-default-risk-free sovereign debt, but have reduced the sovereign-financial nexus to the minimum of what has been observed in fiat money systems.
The European Monetary Union (EMU), which was conceived in the 1980s and started in earnest in 1999, has been a journey into a previously uncharted monetary territory. While it was clear from the outset that something entirely new was to be created and that there would be problems with it, it was not until the outbreak of the great financial crisis that it became clearer what the problems actually were: the lack of a lender or guarantor of last resort, the lack of a sovereign issuer, and the realization that without a credible single supervisory standard-setter it would be difficult to maintain a level of trust in banking systems required for a functioning cross-border (re-)financing of financial institutions.
Historically, currencies had been backed by the full faith and credit of a sovereign. When neither was enough, the sovereign always had the option to print more money and cover its nominal debts and at least technically avoid default. This ability to resort to seigniorage supported the general assumption that domestic debt of a sovereign issue has generally been considered to be free of default risk. For domestic creditors—including holders of money—this amounted to an extraordinary wealth tax, while foreign creditors would be “bailed-in” via devaluation of the domestic currency. The existence of a nominally independent central bank changed little at the availability of this nuclear monetary option, as changes in governance are a simple legislative act away. The ability to thus tax away debt, paired with sufficient leverage to coerce the domestic financial sector to cooperate in a cycle of printed money and subscription to government debt issues, has always made sovereign debt practically as good as the money it was issued in, but also contributed to the sovereign-financial nexus. After all, in a closed domestic system, taking over a bank that may have come into trouble because it held too much of the weakened domestic sovereign is relatively easily done, as it can be financed with freshly printed “equity.”
The initial presumption in the EMU had been that all member states are domestic sovereigns when issuing their new domestic currency, the euro, and all are effectively of the same quality, with just small differences attributed to relative liquidity. This was best evidenced by yield spreads between German and Italian ten-year government bonds which, at the introduction of the euro, had diminished to about 25 basis points (bps) from more than 400bps just three years earlier. The sovereign illusion lasted until February 2008, when spreads broke out of their previously established range. In the crisis it became clear, although rarely formulated, that the euro zone has no true sovereign debt, that sovereigns could indeed face a liquidity and credit crisis when no buyers for their bonds turn up, and that even domestic banks cannot be coerced into picking up new issues.
The ECB managed to overcome this situation by providing liquidity on government collateral, and thus performed the classical central bank role of liquidity provider of last resort—indirectly also to governments. The Greek default, though, showed the limits of this strategy, as boundaries could be stretched, but not broken. Before the establishment of the European Stability Mechanism (ESM) there simply was no guarantor of last resort who could anchor a fiat monetary system. Pre-euro, it had been relatively easy for governments to nationalize banks. While 100 percent debt-financed, it was easy to place the additional debt in the financial sector at modest inflationary effects, and avoid the political backlash of a banking crisis. Maastricht budget criteria have effectively closed this path: taking a bank on a Maastricht balance sheet is highly inefficient, as all its liabilities count to public debt, which are not offset by the asset side of the bank’s balance sheet. A striking example of this effect could be observed when the nationalized Hypo Real Estate in 2011 found a netting potential of €55 billion in its derivatives positions, resulting in a reduction of the German debt/GDP ratio by two percentage points.
While governments usually are the ultimate leveraged hedge fund, financing equity injections with 100 percent debt, euro zone governments now face a hard limit. Despite the fact that the political enforcement of the Maastricht criteria has always been tame, most recently apparent in the lenient position of the EU Commission toward France, markets have clearly shown that at a certain point governments will lose market access, and domestic banks find it increasingly difficult to finance themselves. The point of pain set by investors is not fixed in stone, unlike the rather randomly set 60 percent Maastricht ratio; volatility, credit ratings, and overall perception play a critical role. The creation of the ESM has provided a means to extend this point and give a state more room to breathe. However, it is clear that despite a generous equity cushion and a significant ability to raise additional debt in the markets, it is not an infinite source of liquidity, as would be the case in a “classical” closed sovereign—central bank—bank system.
As a result of the banking restructuring and resolution directive and the Single Recovery Mechanism (SRM), a non-sovereign back-stop has been added to the system in the form of the pre-financed Single Resolution Fund (SRF), and similar funds in the non-euro zone countries. The SRF can now underwrite the equity of troubled banks in a resolution scenario and thus help to prevent dominos from falling to create a potential chain reaction. In its final form, it will have some €55 billion in equity, corresponding to a significant borrowing capacity if required, and allowing it to carry even a very large financial institution through a crisis. The firepower of the SRF will be augmented, although only indirectly, by pre-financed national deposit guarantee funds (NDGF), which in their aggregate should reach in excess of €80 billion. The NDGFs would indemnify the SRF for avoiding a bail-in of covered deposits. These mechanisms together significantly reinforced the stability of the monetary anchor. Psychology plays an important role in this, as aptly described by Arthur Hailey in “The Moneychangers” where he shows the effect money piled on the cashier’s desk had on the mood of a concerned crowd.
Perception also matters when it comes to trust. Actions by governments to window-dress their debt ratios probably created more, and a longer-lasting, damage in this respect than a break of the actual ratios would have done. Increased attention had been paid therefore to the financial-government complex, and bank balance sheets are increasingly scrutinized for sovereign exposure, also because they provide a mirror image and thus validation for officially reported numbers.
The creation of a single regulator by the Single Supervisory Mechanism provides a credible answer to the issue of transparency and divergence in regulatory standards and counters suspicions of issues and risks, in particular in the sovereign-bank relationships, to be willfully neglected. The decision to establish this single regulator within the ECB allowed the new regulator to start its activities with a strong reputation for independence and ability to enforce rules. The stronger confidence in the accuracy of reported numbers and efficiency of governance frameworks created by the SSM should contribute to a return of the EU inter-banking market to its pre-crisis state once the liquidity distortions caused by the present central bank policy have been removed.
In total, the latest pieces added to the EMU construction site have clearly made the system more stable. It cannot be denied that lacking a significant change to the power balance in Europe, which would see a transfer of taxation and hence also financing mandates directly to the center, the EMU is not going to become a traditional currency area. Instead it now is probably the financial system with the smallest dependency on sovereign credit that has ever existed. Admittedly, the mix thus created is complex: an independent, although not apolitical, lender of last resort; pre-funded sources of bridge assistance in the form of the ESM for sovereigns; and the SRF for banks, involvement of NDGFs, a credible arbiter, and a conditional involvement of national sovereigns in addition to bail-in rules. The resulting waterfall is complex, but ultimately a lot more credible than the traditional reliance on the good will of a benign sovereign.
While it seems unlikely that the creation of the SSM, which went live on 4 November 2014, will magically revive the economy of the euro zone, or prevent any and all (in)conceivable forms of financial crisis, it is an important contribution to a more stable financing and hence economic environment in Europe and should enable the euro zone countries to continue on their journey of close cooperation.
Gunnar Stangl is the Head of Regulatory Coordination at Commerzbank AG. The views expressed here are solely those of the author in his private capacity and do not necessarily represent the views of, and should not be attributed to, Commerzbank AG or any of its units.