The last good thing to happen to the euro zone was the ECB's announcement of OMT in August 2012. Although no country has yet taken up the offer of assistance through the OMT mechanism, the offer itself gave confidence to bond buyers that Europe would not let Spain and Italy default. As a consequence, the rates on those nations' bonds declined, and the declines have stuck, even in the face of adverse publicity regarding the Cyprus bailout mechanism.
In my article immediately after the Cyprus event, I said I thought the way that Cyprus was handled would help Mario Draghi and the ECB to implement the proposal for a euro-zone-wide banking system. In his news conference on April 4, Mr. Draghi confirmed my belief and explained how he thought the Cyprus event had strengthened the move toward a euro-zone-wide system.
Mr. Draghi faced several questions concerning Cyprus. One of them (asked more than once) was how the proposal (not implemented) to tax the insured deposits in Cyprus banks had come about. Mr. Draghi responded by saying that the tax had not been a part of the ECB-EU-IMF proposal but that in the course of a night's bargaining with Cyprus, the tax became part of the deal. Mr. Draghi opined that was "not smart" and noted that it was reversed the next day.
Mr. Draghi also used the Cyprus event to put banks in other nations on notice that the ECB will not lend to banks that are not solvent and viable. That is what the Treaty requires, and that is what the ECB did in Cyprus and will do elsewhere. It was the ECB's unwillingness to extend further credit to the two largest Cypriot banks that led to their restructuring. (If there is a plan in place to recapitalize a bank, it may not be regarded as insolvent and non-viable, Mr. Draghi clarified.)
But the way Cyprus was handled was not, Mr. Draghi repeated more than once, a "template". The way Cyprus was handled was "disruptive" because there were no rules to apply. If there are no rules, then each crisis will be chaotic. That is why there must be clear rules for how bank restructurings take place and for the pecking order of what classes of securities and debts get bailed in first, second, third, etc. That a European framework for restructuring banks is needed is the "lesson from Cyprus". In this regard, the "single supervisory mechanism" is "absolutely essential". It is needed to shed light on the banking systems of all countries and to unify the system of bank resolutions in all countries.
Mr. Draghi talked also about the timing of the single supervisory mechanism. He does not want to wait until 2018 or any such year. It should begin in 2015. The ECB already has a draft of law prepared by the European Commission and will be considering it. The proposed framework would not require mutualization of losses (meaning that losses due to bank failures would not be borne by taxpayers but instead by junior securities and loans). Mr. Draghi referred to the U.S. FDIC as an example of how failing banks should be handled.
Mr. Draghi said he would view favorably any measure that "cuts the links between sovereigns and banks." He regards cutting those links as essential.
My view of this situation is that Cyprus was the necessary demonstration that the single supervisory mechanism is essential to the success of the euro. Countries with weak banks are now going to see that they cannot look to Europe as a whole to recapitalize their banks. They must do it themselves or engage in tough resolutions in which junior security holders and creditors, not taxpayers, pay the costs. The single supervisory mechanism almost certainly will come into being in 2015, along with the single resolution mechanism. This is good news for Europe and for European investors-longer term. But some eggs will be broken in order to get to well-capitalized European banks. I think a lot of stockholder dilution is in the cards in 2014.
One thing that Mr. Draghi did not mention is a euro-zone-wide deposit insurance system. I believe he knows that a single supervisory mechanism that depends on national deposit insurance systems to back up insured deposits is not workable. I am guessing that the deposit insurance system will be discussed at a news conference in the next few months. I explained how a deposit insurance system for all Europe could be established in my last article, linked above.
For investors in European banks, I think this means caution: If the bank is not well capitalized, dilution of stockholders is likely. If the bank is well capitalized, then I believe the stock price will go up when undercapitalized competitors falter under the new regime. The problem is how to tell which banks really are well capitalized. At this point, I cannot make the distinction with any confidence.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.