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The EU's SRM banking pact to be finalized December 18: new beginning, or beginning of the end?

Part 2 of 3: Key terms of the SRM deal: Summary, Problems, Dangers

In our weekly fxempire.com analysts' meeting, in which we share thoughts and conclusions about the weekly outlook for global equities, currencies, and commodity markets, we noted that the results for past week's Euro group and ECOFIN meetings', which hammered out all but a few final details of the SRM deal, were far too underreported relative to their importance.

The following is part 2 of a special feature on the coming a single resolution mechanism (SRM - get to know this acronym) for dealing with troubled EU banks. It will be used to handle banks that fail the coming ECB banks stress tests in 2014, and other problem banks thereafter.

Its success or failure could well determine the fate of the EU and global economy in the coming years. Thus while its impact in the near term may be limited, its long term impact is far bigger than the start date of the Fed's taper or US retail sales in November.

Here's a summary of the key terms, along with some brief analysis of their benefits, problems, risks and dangers.

At least some of the following details could change in the final version after the December 18 meeting. We've tried to point out areas of ongoing disagreement most likely to change, as well as flaws or future problems these terms create.

Who Decides If Banks Are Closed Or Recapitalized?

After months of opposition to a single centralized authority to shutter banks, Germany has now agreed that the main executioner will be the European Commission, the EU's executive arm, because giving any other institution such power it would require full-scale EU treaty revision.

Germany still wants to limit the commission's power, so the compromise was that a resolution board comprised of member representatives would make the proposals for dealing with the problem bank, and the commission would only have a veto power, which could be overruled by a majority vote of banking union member states.

Meaning: Thus control over troubled banks remains mostly in the hands of the member states, particularly the wealthier ones with the financial power to coerce others, rather than the Brussels based resolution board, which only has a veto power that can then be overridden by the council of individual states.

Who Pays For Bank Bailouts? Private Investors First, Then National Fund, Then, Perhaps, The Common EU Fund

· Member states remain liable for most of the costs, especially in the coming years when they may be most needed and GIIPS may well be unable to afford the cost.

· The common fund will be dangerously underfunded for years to come given that only 10% of its ultimate size is to be funded each year.

· Even when fully funded, it isn't likely to be big enough to calm markets and prevent the capital flight and higher bank borrowing costs due to the new bail-in rules. Speaking of which…

· Private depositor and lender bail-ins officially alive, along with risks of depositor flight and higher bank borrowing costs due to higher risks of lender losses.

· Taxpayer bailouts not dead, but limited.

· Bail-ins and national bank rescue funds must be exhausted before common EU funds can be used, and even then subject to EU approval controlled by wealthier states

Originally, the SRM was to be funded by a common single resolution fund (SRF) paid for by annual levees on all European banks, but this was opposed by Germany because it already has Europe's biggest national bank bailout fund, and deems it sufficient for its needs. Any additional payments into a common fund would be unpopular with German taxpayers, as these funds would just go to pay for others' mismanagement and corruption.

Germany dropped its objection to the eventual establishment of a single resolution fund . However in return the SRF would not be funded right away, but rather it would be phased in over the course of 10 years. There is some disagreement about its ultimate size, but it appears to between €55 - 70 bln depending on how one estimates the size of annual member contributions.

Under the compromise, during that transition decade, a hybrid fund would be established that would be European, but made up of separate national bank bailout funds that would remain segregated under an EU umbrella.

However in return the SRF would not be funded right away, but rather in a decade's time. Each year 10% of the total common SRF fund would be paid for by a bank industry levy. The SRF would be phased in during that period, with each year each nation adding 10% of its ultimate contribution via that levy on its banks.

Thus when the fund is first established, a member's own national resolution funds would provide most or all of the funding for the recapitalization or closing of its own banks. During a decade-long transition period, as the SRF fund grows, so too would the potential for SRF funding to help troubled EU banks subject to a vote (more on how that vote works below).

Member states would have to exhaust their own national bank bailout funds before they could access the common EU SRF funds, and even then there would be limits and conditions concerning how much of the SRF any one member nation could get. Member nations' would be responsible for filling any additional funding needs.

It seems that Germany and its fellow funding nations are hoping that during the 10 year period most or all of the bad banks can be recapitalized or closed mostly with their own nations' funding, with each member state paying for its own mistakes long before the SRF has grown and absorbed funding nations' cash. Debtor nations wanted the SRM to be phased in faster so that more of their own burdens could be offloaded onto the common fund.

Cypress Was Indeed A Precedent

The deal includes rules to impose "bail-in" losses. Large depositors would be the first to be hit, along with bank bond holders, before a member's national bailout fund can be accessed, and only after those options have been tapped can the bank be eligible for the common SRF money. Also, rules for imposing losses on senior bondholders in failing banks are brought forward from 2018 to 2016. This was another key German demand designed to shrink the capital gap for rescue funds to cover. Debtor nations wanted these rules pushed off in order to minimize the risk of higher yields on their banks' bonds due to this added risk of loss.

Problem 1: The 10 year phase-in period, along with other conditions and obstacles mentioned above and below, make it very difficult for a bank access the common EU rescue fund. That seriously undermines the original goal of breaking the link between bank and sovereign debt. Cash strapped GIIPS nations are still saddled with their own bailout costs that they cannot afford. [REWORD/CLARIFY]

Problem 2: From this moment forward, EU banks are increasingly vulnerable to:

· Bank Runs: the bail-in rules that make large depositors subject to losses in troubled banks means these that any hint of trouble could send depositors fleeing. Regardless of how the final deal looks, the mere fact that the option is under serious discussion will be noted by any large depositor.

· Higher Borrowing Costs: Lending to EU banks, especially those in weaker economies or those that are less systemically important, has just become riskier. Higher risk means creditors will want higher yields on their bonds.

Problem 3: The SRF is underfunded from the start. The €55-70 bln may sound impressive at first glance, but for perspective, consider the costs of some of the EU's prior bank rescues of:

· Spanish banks: €40 bln.

· Greek banks: €40bln.

· Ireland: Anglo Irish alone cost nearly €30bln.

Ratings agency Standard & Poor's forecasted this month that the stress tests will reveal a capital shortfall that may total a bit over 1 % of EU GDP, which comes to anywhere from 55-95 bln euros depending on the source and its method of calculation.

So even if, after 10 years the SRF remains untouched (possible given the obstacles Germany is imposing though unlikely), the fund does not appear big enough to inspire confidence that the SRM will be able to do whatever is needed, even if it actually has the time to overcome all the bureaucratic obstacles. As we learned in 2010-2012, bailout funds need to be big enough to convince investors, lenders, and depositors that they can handle any eventuality.

Underfunded bailout funds undermine EU credibility, as the EU learned when its first attempts at common bailout funds in the spring of 2010 (Greek) crisis were clearly too small to handle the full range of other potential bailouts coming, and so only increased fears and market turmoil.

Who Controls Disbursements And Access To The SRF Bailout Funds

· Even if the common fund has enough cash when needed, in practice, access to common funds still controlled by funding nations

· Doom Loop Alive And Well: That leaves GIIPS and other weak economies right back where they were still responsible for banks they may not be able to afford to recapitalize or close

Not surprisingly perhaps the biggest obstacle to reaching an agreement is reaching a compromise deal over who controls disbursements of the SRF.

While Germany has agreed to support a common bailout fund, in practice it may be very difficult for a failed bank ever to access money beyond its own nation's separate bailout funds, and even harder to access it quickly in an emergency.

To ease concerns of Germany and other wealthier members that they might get stuck paying for the mistakes or corruption of others, the richer countries have greater voting power in the resolution board. Each member's vote is weighted by the "ECB capital key", the proportion of each nation's contribution to total ECB capital, rather than having one vote per member. That vote weighting, combined with a requirement for a two-thirds majority approval needed to disburse SRF funds, would give Germany, the Netherlands and Finland a blocking minority to any disbursement of SRF cash.

How Is The SRF Bailout Fund Replenished If Exhausted?

· Good question

· No plan or funding in place

· Most though ESM could be used, but Germany still blocking that option

As of this writing there is no backup fund. Germany remains opposed to allowing the Eurozone's €500bln European Stability Mechanism (aka the ESM, which was created solely to bail out countries) to also offer an emergency credit line to banks during the transition decade.

There are no other details available for adding to the SRF during the transition decade or at any time beyond that.

Problem: As noted above, even when fully funded the SRF is already too small to provide enough comfort to prevent bank runs or spiking bank borrowing costs. That risk is higher still during the transition years ahead, before even that funding exists and the burden is on the individual member nations. There is nothing in this agreement that covers what happens if both a member state's own bank bailout fund, and the common fund, are inadequate to cover what the stress tests reveal. In the early years neither the separate national funds nor the common SRM fund is likely to have much funding.

If there is another national banking crisis like that of Spain's in 2012, the SRM does not provide a solution.

What will?

How To Create The SRM: Its Legal Basis

· As yet undecided

· Dispute is a variation on the theme of who controls access to wealthy nations' money

Germany differs with the EU authorities on the legal basis for the entire SRM.

Germany wants it based on Article 352 of the EU treaty because it is arguably a better basis for placing burdens on individual national budgets than Article 114, the favored legal basis by most everyone else including lawyers of the three EU institutions, the commission, the council of ministers, and the ECB. They argue that use of article 352 creates practical difficulties such as giving all countries the right of veto and also requires votes in each member's national parliament.

Problem:

· This is an ongoing point of disagreement that has yet to be settled

· If Germany prevails and article 352 is the basis for the SRM, then the practical difficulties such as giving all members a veto and requiring votes in each member's national parliament would greatly complicate the SRM's ability to respond quickly, if at all, to crises needing fast response to calm markets.

How To Create The SRM Bailout Fund : Its Legal Basis

Germany also disagrees with the EU bureaucracy about how exactly to create the fund.

Berlin holds that at least some of the new fund's powers fall outside current EU treaties, so the SRF should be created by a separate intergovernmental treaty (outside of current EU treaties) to give it a unassailable legal standing.

Problem: However that could create problems when negotiations begin on final legislation with the European parliament, which dislikes pacts outside existing EU treaties.

Which Banks Are Covered?

· Details not yet finalized

· Coverage may be limited to larger banks, even though small ones can also present systemic risk, especially when multiple small banks need aid at the same time

All Eurozone countries are required to participate in the resolution scheme; non-euro countries can opt into the system.

However Germany wanted its smaller regional banks excluded from the plan, and preferred to retain supervisory and financial responsibility for them.

On a theoretical level, Germany justified its position by arguing that only globally systemic banks needed the EU safety net. Behind this theoretical difference were two practical considerations:

· As noted above, Germany already had its own bank resolution fund which it deemed sufficient, making involvement of the EU an unnecessary bureaucratic

· Germany's small, regional savings don't want to be part of the plan. They not want to pay into both a German and an EU fund that they aren't likely to use. Also they prefer dealing with their own domestic regulators, with whom they have a cozy relationship.

The likely compromise plan, still unsettled as of this writing, would once again follow the wishes of the EU's largest paymaster, Germany. The largest banks would come under the direct authority of the new resolution system, leaving smaller banks to the national authorities. But the European agency would be consulted on decisions regarding smaller banks.

Problem: As Michel Barnier, the EU's top financial regulator, frequently points out, it has been the smaller banks - Anglo Irish in Ireland; regional cajas in Spain; Laiki in Cyprus - that have dragged down their countries with them, not the big systemic banks. While small German banks present less of contagion threat because they've already got a strong national rescue fund, the same cannot be said for small banks in the weaker economies.

Click here for part 3 (summary and conclusions)

Disclosure/disclaimer: No positions. The above is for informational purposes only. All trade decisions are solely the responsibility of the reader.

Source: December's Real Top Event, By Far, Happens This Week: Part 2