The Banking Union: Towards or away from the market?

In December 2013 EU finance ministers reached agreement on the guidelines of a Single Resolution Mechanism for the banking union. The Single Resolution Mechanism is to accompany the Single Supervisory Mechanism. The Single Resolution Mechanism is to remove the burden of financial problems and bankruptcies of banks in member states from tax payers’ shoulders. The goal is to have banks shoulder the banking sector’s problems themselves and to shelter public finances in member states from financial difficulties encountered by national banks, as was the case in Ireland and Spain.

Deliberations on the guidelines on the banking union and analyses of its capability to handle problems in the EU banking sector seem, by and large, to neglect one key question. The question is whether the new policies drive the banking sector closer to the market and market laws or, on the contrary, estrange it from them?

Will the resolution fund do?

If we claimed that today banks operated under market rules, we would largely ignore the peculiarities of banking activity. The financial sector is one of the most heavily regulated sectors. If banks encounter problems, they are rescued with tax payers’ money. Banks are bailed out not only because they are a source of systemic and rapidly multiplying risk, but also because commercial banks are used in implementing monetary policy. For this particular reason, bankruptcy issues are often subjected to political rather than market decisions. Bank deposits are covered under state guarantee schemes, while the structure and amount of banking capital is closely supervised. Banks are allowed to operate under a fractional reserve system, which translates into commercial banks’ right to create money. It is precisely this right that is the source of systemic risk in banking.

If the banking union architects wish to have banks pay themselves for their mistakes and failures, they are welcome to have their way. It forces banks to operate by market laws, and market laws require that banks themselves shoulder the consequences of their decisions. Since 2008, a total of 470 billion euros raised from tax payers has been allotted to save euro-area banks from collapse. This is a huge amount of money. Just to compare, Lithuania’s annual GDP amounts to approximately 34 billion euros.

The Single Resolution Mechanism provides for a single resolution fund that will be financed by bank levies raised at the national level. The fund will initially consist of progressively growing national compartments financed by banks. These national compartments will be accumulated over a period of 10 years starting from the launch of the mechanism in 2016. In 2026 the national compartments will be merged into a single fund amounting to 55 billion euros. During the transitional phase, financial aid for the resolution of banks will come, if need be, from the national compartments of the member states where the banks are located, and as of 2026 the cost will come from the single fund.

If we compare the size of the resolution fund in 2026, the 55 billion euros, with the 470 billion euros that have been allotted to rescue banks during the recent crisis, it becomes obvious that the single resolution fund will be too negligible to finance the decision of EU governments to save banks with their own money.

It remains unclear where additional funds will come from if the single resolution fund financed from bank levies gets overdrawn. It is suggested that, during the transitional phase, lending between national compartments will be possible. In certain cases, bridge financing may be available, notwithstanding Germany’s opposition, from the tax payers’ financed 500 billion-euro European Stability Mechanism, whose primary designation is to address problems in public finances of EU member states. If bank failures occurred again, and the relatively modest single resolution fund was overdrawn, there is no assurance that banks would not be rescued with tax payers’ money again.


„Bail-in” rules: half a step ahead?

The Single Resolution Mechanism will endorse bail-in rules by which bank losses will first of all be covered not from the single resolution fund or tax payers’ money, but through allocating them to large deposit holders and creditors.

Again, one might say that this increases the proximity of banking regulation to the principle of responsibility, whereby investors themselves pay for their erroneous investment decisions with at least a portion of their assets. However, bail-in rules will only impact large shareholders, while small deposit holders will continue to be fully covered by deposit guarantee schemes. This reflects the principle of banking regulation by which small investors are not considered to be professional market participants, and, therefore, need to have full insurance coverage. This means that the deposit guarantee system will continue to cripple the choices of deposit holders and will offer no incentive to risk considerations in choosing banks.

 To rescue or to liquidate?

What the Single Supervisory and Resolution Mechanisms can do is increase the transparency of the banking resolution and bankruptcy procedure. To date all problems have been addressed on a case by case basis, without resorting to any single rule. The Single Resolution Mechanism lays down a decision-making process regarding troubled banks. Many claim that it is too unwieldy to react to problems quickly and effectively. But at least it is there. For the market to operate smoothly, a clear and effective bankruptcy procedure should be in place.

However, a lack of clear rules has not been the only problem. The biggest concern was the rescuing of banks per se. The Single Supervisory Mechanism and the Single Resolution Mechanism might still endorse policies that would lead to saving rather than liquidating failing banks. Bank bankruptcy might continue to evolve around politics rather than being subjected to market laws. This problem remains, and it is no less relevant than the transparency and clarity of the bankruptcy procedure. One might expect that after taking over direct supervision of the 130 largest banks and 200 internationally operating banks, the European Central Bank will do a better job supervising banks than member states themselves and will help prevent bank failures.

The Banking Union reflects the increasingly prevalent trend of calling for “more Europe” whenever EU member states face problems on the national level. Yet, there is ample evidence that problems, lifted onto a higher political level, get aggravated rather than diminished. Will the ECB be capable of assessing banks in different member states in a centralized, and at the same time, appropriate and unbiased manner? Concentration of power and decision-making per se will not solve problems if individual member states shun responsibility. So the banking union and its instruments and mechanisms reflect the desire of EU member states to solve problems of the banking sector at a central level, by concentrating supervision, decision making and financing of troubled banks at the ECB. This will hardly shield future tax payers from banking sector problems. With the proposed policies, the banking sector will not move towards better reflecting market principles. Rather, these policies will conserve the current estrangement of the sector from the market.