European agreements seem to always be compromised formations. The agreement struck several hours ago on the handling of failing banks is no exception to this generalization.
One side, that included Germany, the Netherlands and Finland, wanted clear uniform rules that would allow investors and creditors to understand a transparent process. On the other side were countries that wanted to preserve greater national discretion. This camp included France and a couple of non-EMU members, such as the UK and Sweden.
First, there was an agreement that creditors in order of seniority would have to cover the first 8% of the distressed institutions' liabilities. Then national authorities can offer greater exemptions, regulatory forbearance and turn to national backstops. There was also some room for greater national discretion, simply requiring EU notification.
The first part of the national backstops are the resolution funds that are financed by a tax on banks. The agreement calls for their national resolution funds to be the equivalent of 1.3% of the country's insured deposits and the European Commission must approve their use. The agreement also limits the role of these resolution funds to 5% of the troubled bank unless unsecured senior bond holders are wiped out.
European officials also agreed in principle that shareholders, bond holders and large depositors (in excess of 100k euros) should bear costs before taxpayers. The idea that uninsured depositors are on the hook was controversial, but after the Cyprus fiasco earlier this year, the die appeared cast. The idea that uninsured depositors should be treated as insured made little economic sense. In the US, the resolution of a troubled bank does not often require hitting uninsured depositors, but it has. In the Indy Mac case, for example, uninsured depositors lost about 50%. This did not trigger a wide run by depositors at other banks.
In Cyprus, where banks depended almost exclusively on deposits for funding, insured depositors were ultimately protected (albeit with capital controls), but large depositors were not. It is this part of the Cyprus program that is now generalizable.
Recall that the European Union had already committed a third of its annual GDP to aid banks between 2008 and 2011. European officials want to break the link between banks and the sovereigns. The banking union is seen as a necessary step in this direction. There is a role for the ESM to aid banks. However, and this is important, the agreement struck does not come into effect until 2018.
In some ways, the agreement, as arduous as it may have been to achieve, may prove easier than the next steps. It is not yet clear whether national leaders or a central European authority will have the final say on closing or restructuring a troubled financial institution. National officials in Europe, unlike the US, are loath to shutter banks. The US had a market centric model of capital distribution. Europe remains more bank centric. Several EU countries are reluctant to support a central resolution authority.
And therein lies the key tension and why compromise will remain the order of the day: integration means the surrender of sovereignty. Understandably, national officials are reluctant to give up sovereignty unless there is no alternative. Yet, if the EMU is to be sustained, greater integration is necessary. What is ultimately being negotiated is how much sovereignty is to be surrendered and how much control countries will be able to exert over that supranational entity (Brussels).
In the US the shift from state sovereignty to a federal system may have largely taken place when the Constitution replaced the Articles of Confederation. However, a true monetary union was not achieved until the Federal Reserve Act in 1914 and as the Supreme Court decision this week demonstrates, the tension between states' rights and federalism has not been fully resolved. European states, of course, enjoyed more sovereignty and for longer than US states.
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. I have no business relationship with any company whose stock is mentioned in this article.