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If there is one major reason why eurozone bankers should be happy about the prospect of the eurozone banking union, then this is the outlook for their banks becoming too big to fail rather than starting to be viewed as too big to save. If there is one major motivation why the EMU will stay intact, then this is the fact that otherwise eurozone banks would be on a worse position to grow when compared to their U.S. and Chinese peers, all other things equal.

These are basically the two inferences of an interesting research paper "Do we need big banks? Evidence from performance, strategy and market discipline," (January 2012) written by Demirguc-Kunt, A. (World Bank) and H. Huizinga (Tilburg University and CEPR). Let me explain and show you what it means.

Too-big-to-fail banks vs. too-big-to-save banks

First of all, it is important to distinguish between the two types of big banks:

  1. Banks that are big in terms of their absolute size, and
  2. Banks that are big in terms of their systemic size, i.e. big relative to their home country's economy - even though they may be rather small in international comparison.

Banks in the first group are referred to as too-big-to-fail banks; given that their failure would cause serious disruptions on the financial markets, they have been protected by the implicit or explicit public guarantees. For example, the big U.S. banks are too-big-to-fail.

Banks in the second group are referred to as too big to save, because they are too big for their home countries to be saved. For example, Icelandic and Irish banks were too-big-to-save.

From the above referred research work of the international sample of banks over the years 1991-2009 it follows that:

  1. Bigger banks in absolute terms are more profitable even though also more risky for their shareholders due to their activities on capital markets;
  2. Bank growth will increase profitability relatively more if a bank is located in a larger country;
  3. The optimal bank size, as determined by a trade-off between risk and return, is the smaller, the smaller is the home country.

In other words: a too-big-to-fail bank located in a large country is clearly on a more advantageous position for doing business than its little competitors and systemically large too-big-to-save banks in smaller countries, this due to the implicit and explicit too-big-to-fail subsidies.

Current situation: even Germany had troubles with saving its largest bank should it come under the market attack

Currently in Europe the largest banks are big in absolute terms and operate as too-big-to-fail banks. However, given the national responsibility for bank crisis resolution and the fact that in most of the euro area countries public sector capabilities to bail out banks are zero or minimal because of the very high government debt burdens anyway, they are at the same time also too big to save.

This is not only the situation in Spain or Italy, but also in France for example where banking is highly concentrated into a few big banks and public debt is about to exceed the sustainable level.

For an illustration, see the figure below: the top 20 European banks by assets and how their absolute size compares to the economies of their home countries.

(click to enlarge)

The above is true for the "safe haven country" Germany too. It is not that Germany's largest bank, the Deutsche Bank (DB), is in the process of introducing major changes just for fun or tightening the executive pay because it very much wanted to. It is forced to do that.

Interestingly though, the largest banks in the European core have not been considered this way up to very recently. Instead, they have been enjoying all the benefits of the too-big-to-fail banks. Banks headquartered in the European "safe havens" such as Sweden are still doing this. Only now urgency for a banking union has become obvious in eurozone - because once in the union, the home country of a Spanish bank is not any more Spain, but the European Union (or the EMU, depending on how the European integration is going to progress).

Expected benefits of the Banking Union

When put simply, I see four main expected benefits arising from the introduction of the European banking union to the EU level policy makers as well as for the bankers:

  1. Weaker market scrutiny to gain time for the next policy moves as well as for strengthening banks' balance sheets - one hope is that more external creditors will put their money in, or at least re-finance their existing credits;
  2. Banks remaining trustworthy in the eyes of depositors and voters - or becoming reliable once again for the depositors when it comes to the so-called PIIGS countries, this despite the fact that far too often big banks are insolvent (if we only had the data to re-value their assets based on fundamentals...);
  3. Good basis for pushing towards the fiscal and political union faster - a banking union would not work without the fiscal backing anyway;
  4. Preserving Europe's role as important player in global finance: safeguarding competitive advantages of the European banks to grow and compete internationally.

In other words, the crucial intention is to make European banks too big to fail once again rather than leaving them being perceived and treated as too big to save by the markets. Of course, in the speeches given by the EU officials, these benefits are rarely if ever put this way. Some of the European bankers seem not having got the point either.

Will European banking union do the trick?

Ultimately the European banking union will not do the trick of saving the day for the large troubled European banks; it's just an intermediary step. Most probably the markets will first react positively or very positively to the news that the European policy makers have actually succeeded with putting everything into one pot, but…

According to my earlier assessment, the total euro area non-financial debt (public and private) would need to be reduced by more than 5 trillion euros before the economy can return to anything like normal growth trajectory. For each debtor there is a creditor; a debt crisis is also a creditors' crisis. The mentioned 5+ trillion euros in excess debt compares to approximately 2.3 trillion euros as capital and reserves in the balance sheets of the euro area credit institutions (ECB data, end of Q2 2012). Any sort of pooling or re-distribution would not change these numbers.

"Kick the can" policy is running out and the ECB's firepower, despite of its ability to "print" money, is limited in practice. In other words: the ultimate resolution of the European banking system is inevitable unless the European citizens accept 10-20 years or maybe longer zero economic growth as well as higher than normal inflation rates until banks gradually manage to write off their so far unrecognized losses on the account of the future returns (which has been part of the "solution" in several earlier financial crises).

So if you have a short term investment horizon then you might play on the rise of the DB's stock price in short term. After all, too-big-to-fail sounds better from a shareholder's perspective than too-big-to-save. In longer term, I still remain bearish on bank stocks in Europe; if the Liikanen Group does not deliver a European version of the Volcker Rule (DB is assuming that this will not happen), then eurozone citizens should be disappointed indeed.

Source: European Banks: Too Big To Fail And Too Big To Save