Banking reform must be high on ECB agenda
The well has run dry and winding up bust banks without involving EU taxpayers is overdue, writes Colm McCarthy
Ireland's ability to survive without EU and IMF bailout loans, no longer available from January next, will be determined by the Government's willingness to keep the budget deficit falling. It will also be affected greatly by the stress tests on the banks to be undertaken in tandem with the European Central Bank (ECB) over the winter. If it needs further capital, the State is in no position to provide it and it is not alone.
European banks shown to be bust should no longer expect rescue from sovereign states, several of which have reached the limits on what they can borrow. Even France and Germany have limited capacity to provide further rescue funds to bust banks.
If the stress tests are done rigorously and reveal capital deficiencies in banks, there will be a crisis, since no eurozone policy has been agreed to deal with that situation. If the stress tests conclude that everything is just fine, there will be a serious credibility problem: previous stress tests have given the thumbs-up to banks that subsequently went bust and were rescued by taxpayers.
The eurozone recession, now in its fifth year, will continue until the intertwined banking and sovereign debt crises are addressed. The European banking crisis is not resolved and many banks are still struggling to finance themselves in the markets on a sustainable basis. They are still borrowing heavily from the ECB and only the strongest banks can sell unsecured bonds. The banking system remains undercapitalised, with no obvious source of fresh capital for most. The result is a banking system unwilling to lend and pressure from regulators for a further contraction in bank balance sheets. That means a squeeze on credit to the productive sector.
While budget deficits are closing gradually many governments are still overspending and several have limited market access, in a few cases none at all. The impact is uneven – the supposed monetary union has fragmented and the peripheral members, including Ireland, are worst affected.
The source of the glacial response to the financial crash of 2008 is the unwillingness to allocate losses once and for all. The eurozone lacked from the beginning a proper banking union, with centralised supervision of banks and pre-agreed rules for bank resolution, that is, for the allocation of losses to bank creditors when banks go bust. Losses were instead imposed on national treasuries and the bank creditors were spared. It is now acknowledged that this was a mistake, since spiralling public debts have forced sovereign default in the case of Greece and bailout programmes in Cyprus, Greece, Ireland and Portugal.
Europe's political leadership has failed to agree on the terms of a banking union, without which the eurozone is just a common currency area and not a monetary union. Common currency areas are prone to regional banking bubbles and to market perceptions that they might break up in disorderly fashion. This has been avoided only through a series of ad-hoc, sticking-plaster measures, including a drip-feed of central bank lending to banks in need of closure or recapitalisation.
There has been political agreement only on two facets of the necessary eurozone redesign. The first is better harmonisation of budgetary policy, with centralised oversight under the fiscal compact agreed by referendum here in May 2012. The new rules are intended to curtail excessive deficits and debt build-up, but the countries that got into trouble include two, Ireland and Spain, that stayed well within these limits in the years preceding the crisis. For them, and for the eurozone as a whole, this is essentially a banking crisis. It would not have been prevented even had the new budget rules been in place. Avoiding the next crisis needs banking reform.
A banking union requires centralised bank supervision, a limited form of which has been agreed. More critically, it also requires common rules for bank resolution (winding up bust banks without involving taxpayers) but there has been no agreement. Finally it requires a common system of insurance for retail depositors. Again there has been no agreement. The lack of agreement is due mainly to German obstructionism. The German political establishment appears to will the end (a proper and stable monetary union) without willing the means (a banking union).
This suits immediate German interests as perceived by politicians of all parties. The recent election revealed no serious plan from any of the political parties to address the crisis of the common currency. In that sense the outcome of the coalition talks which begin next week matters little. German complacency, exemplified in the obstruction of the European Commission and the ECB in their push for a bank resolution regime, was further illustrated last week in a Financial Times article from Jens Weidmann, president of Germany's central bank, the Bundesbank.
He argued disingenuously that the doom-loop between banks and bust treasuries could be broken if banks were discouraged from holding dodgy government bonds. He made no mention of the traffic in the opposite direction, the imposition on bust treasuries of payouts to holders of dodgy bonds issued by failing banks. In Ireland's case, Herr Weidmann's silence on this issue is understandable, since the Bundesbank was complicit in forcing unsecured bank debt on the Irish taxpayers.
With politicians unwilling to face the necessary re-engineering of the common currency, the ECB has been left to carry the can. Last Thursday in Paris its president Mario Draghi was queried by journalists about the next round of stress tests on the eurozone banks. There have been three sets of Europe-wide stress tests to date, the most recent in 2011 undertaken by a new euro-quango called the European Banking Authority. Banks which received the thumbs-up in these exercises include the Bank of Cyprus (went bust), AIB (went bust) and the Italian bank MPS, currently being rescued by the Italian treasury (almost bust).
For the first time the ECB will be involved in the next set of stress tests. This is important, since it is not an unknown quango, it is an actual central bank and cannot blow its credibility lightly. It will announce in the next few weeks the procedures for an 'asset quality review' of the 130 or so largest eurozone banks. The same transparent measurements will have to be applied to all banks, including banks in France and Germany where dodgy assets may lurk unrecognised in bank balance sheets.
The problem facing Draghi is acute and straightforward. There is no bank resolution mechanism in place. If a proper and thorough review of bank assets is conducted and it reveals capital deficiencies in some banks, how can the results be published without the simultaneous announcement of resolution measures? It is perfectly reasonable to announce that 'We have assessed Bank XYZ, it is bust and the government has injected capital to make it sound'. Alternatively, '. . . Bank XYZ is bust and the bondholders and large depositors are taking a bath'. Either statement works. But try this: 'We have assessed Bank XYZ, it is bust and we have no plans to do anything about it.'
Unless the eurozone governments have agreed to a credible resolution process for bust banks, the asset quality review will have to announce, once again, that every single bank is doing just fine. Alternatively the ECB will hold out, refusing to announce the results until there is some movement from governments on bank resolution.
At his press conference last Thursday, the ECB president was asked whether he expected the bank resolution regime to be agreed before the European Parliament was dissolved in March for elections next May. Draghi said: "Well, I definitely expect that."
He is being optimistic if he believes that the politicians will agree any bank resolution process in that timescale. There is no apparent willingness to agree a process that will work. Any regime involving further exposure of national taxpayer funds for bailing out bust banks, as envisaged by many German politicians and by the banking industry, will make things worse, for the simple reason that the well has run dry.
If heavy bank re-capitalisation costs arise in countries including Spain and Italy, there can be no more contributions from empty national treasuries. It is past time for creditors of bust banks to take their losses.