A WEAK EU BANKING UNION RISKS DEFLATION / THE FINANCIAL TIMES MARKETS INSIGHT

Markets Insight

December 9, 2013 6:20 am

A weak EU banking union risks deflation

By Gene Frieda
 

Barely one year after agreeing to build an integrated banking union, Europe is on the verge of meeting its promises to create a single supervisor and rule book for banks, a common resolution fund and harmonised national deposit insurance mechanisms.
 

But it has failed miserably in its primary objectives: to sever the vicious link between sovereigns and banks, to protect the European Central Bank’s independence, and to jump-start a genuine process of cross-border mergers and acquisitions to create a single European banking market.
 

The outcome, which resembles a weak confederation rather than a strong union, increases the odds that the euro area slips into deflation.

Banking union will fail to break the sovereign-bank feedback loop. In the event of resolution, banks will remain dependent almost entirely on national funding sources. The first port of call will be equity and subordinated debt holders (and eventually senior unsecured creditors under the new Bank Recovery and Resolution Directive).
 

Domestic creditors, a subset of domestic taxpayers, will still probably have to pick up the tab, not least because most national resolution funds will not be pre-funded. Sovereign loans from the European Stability Mechanism (ESM) will be next in line, but there is little euro area capital set aside as a backstop: at the end of the rainbow lies a paltry €60bn in ESM funds dedicated to direct bank recapitalisation.


For a group of 130 banks that carry a mountain of €25tn in assets, the common backstop looks like a pebble. Meanwhile, common deposit insurance is nowhere in sight.


The result? With sovereign and private sector debt levels high and growth low, foreign creditors will stay away from any whiff of a capital problem.


Entrenched fragmentation


This will force banks to be “national in life as well as in death”, entrenching fragmentation in the European banking system.

Banks will continue to hold primarily national assets and their size will be constrained by their resident deposit bases. Any reconvergence of funding costs comes not as a function of greater confidence, but from the forced reimposition of national financing constraints.

Loan pricing, on the other hand, will remain highly differentiated amid elevated periphery default risk, as highly indebted economies will be unable to grow their way out of a debt trap. A complete banking union would remove these national financing constraints and promote a greater flow of credit to viable entities.

Fragmentation along national lines is reinforced by myriad regulatory changes – designed to make the global financial system safer – that create powerful financial disincentives for cross border acquisitions.

Basel III and related regulation generally work against building scale. Larger capital charges based on size, leverage and complexity, and a bias toward ringfenced subsidiaries, may make for a safer global banking system, but applied across euro area countries, and in the absence of a strong banking union, they constitute a recipe for less efficiency and greater fragmentation.


Independence compromised

Finally, given the lack of common fiscal backstops for the banking sector, the ECB’s independence is compromised. Indeed, without a credible backstop, supervisory responsibilities cannot be separated, giving rise to conflicts between monetary policy and financial stability objectives.

The likely agreement on a weak Single Resolution Mechanism echoes a broader banking union theme that eschews centralisation of powers in favour of one where national governments and regulators still have significant veto power. The link between persistent fragmentation, unstable periphery debt dynamics and corresponding risks of deflation draws the ECB ever closer to quantitative easing policies that are indistinguishable from the underwriting of fiscal policy.

 

The optimistic view of Banking Union 1.0 is that a confederation regulated by a single supervisor marks an irreversible step towards fiscal integration.

In Banking Union 2.0, all countries might belatedly accept stronger supranational authority over resolution and recovery as the price of a healthy, growth-enhancing single market for European banks. But by then, it may be too late.

The risk is that weak confederations create more, not less, conflict, and delay allows deflation to seep through the cracks in the current configuration. A stronger union is needed now as the price of a healthy, growth-enhancing single market for European banks.


Gene Frieda is a global strategist for Moore Europe Capital Management

 

Copyright The Financial Times Limited 2013.