The Eurozone banking supervisory mechanism (AKA FDIC in the U.S.) is something that has been talked about for years, but can never get off the ground. One of the reasons has to do with the question, who will pick up the tab for recapitalizing the European banking system?
Unlike the U.S., European politicians do not understand how to deal with financial markets. As a result, Europe relies much more on banks and the banking system than the U.S.
By relying more on markets, the U.S. has the edge, for losses are passed on to investors who want to undertake risk. In Europe, there is no one who wants to undertake risk, hence, banks, governments (local and federal) and the industrial complex have all gotten together in bed in one big fat financial orgy. Nowhere is this more true than Germany.
But when something goes wrong, then someone has to pick up the tab. In the case of General Motors (NYSE:GM) for example, the tab was picked up by the market. Shareholders paid the price for their incompetence and their shares went to zero. General Motors' Bondholders suffered as well, because they loaned money to a company that was overburdened with debt. As a result, almost anyone who ever invested in GM has suffered a 100% loss.
But God forbid if the General Motors incident happened on European soil! It is a moral sin to wipe out senior secured bondholders in Europe! God also forbid, if in order for a company to become solvent, we have to exchange debt for equity!! God forbid if we have to restructure a company and lay off workers. What? Close down productions plants? We don't do these things in Europe. And because the stockholders in many cases are governments themselves, stockholders don't get wiped out in Europe … that's a no no.
But things in Europe are changing. And they are changing because they cannot go on any further as is. It so happens that Europe has woken up to the reality that you need a mechanism similar to the FDIC in order to recycle failed banks. For those who don't know, that's what the FDIC does, besides guaranteeing deposits.
Below I reference a paragraph from a new European directive that is still in the works - "Directive of the European parliament and of the council establishing a framework for the recovery and resolution of credit institutions and investment firms."
As you can see, the framework aims to copy paste the FDIC:
The bail-in tool (articles 37 to 51)
The bail-in tool will give resolution authorities the power to write down the claims of unsecured creditors of a failing institution and to convert debt claims to equity. The tool can be used to recapitalise an institution that is failing or about to fail, allowing authorities to restructure it through the resolution process and restore its viability after reorganisation and restructuring. This would allow authorities greater flexibility in their response to the failure of large, complex financial institutions. It would be accompanied by removal of management responsible for the problems of the institution, and the implementation of a business restoration plan.
So Europe indeed has a plan to follow the footsteps of the U.S. The only problem with this plan is that it is scheduled to go into effect in 2019. And while the official Eurozone banking supervisory mechanism, which will come into effect sometime in 2013 or 2014, will simply be a recapitalization mechanism, in due time, it will more than likely have full fledged powers to conduct forced bail-in's as the directive above states.
But who is against giving such powers to either the European Banking Authority or the European Central Bank? Germany and France of course. And the reason is that Germany and many other European governments don't want to admit that their banking systems are insolvent and that European banks need massive deleveraging.
Conflict of interest issues also prevent change because European politicians have always had their foot in bank boardrooms, thinking they can fix anything via banking mechanisms. As a result, they routinely mistakenly take equity for liquidity and vice verse and made a mess of things.
Top it all off, no one wanted to pay for anything and kicking the can down the road was the preferred option, which delayed the inevitable, meaning an FDIC type bank recycling mechanism. As a result, there is a huge backlog of bank-fixing that needs to be done. And the amount of money that is needed to fix the system is beyond what governments have. Just three French banks have more assets than the entire French GDP.
I have outlined a way to fix the system in this article here - How To Solve The Greek Debt Crisis Without Taxpayer Funds. It requires central bank creative financing and yes, plenty of money printing. I am sorry folks, I don't like my option either, but I see no other choice where we stand.
So what are the investment implications for the European banking complex? Well if I am correct, as I have outlined in this article here - Operation Bank Twist: Sell European Banks, Buy U.S. Banks - European banks will need massive write-downs, deleveraging and massive capital injections in the future. That will translate into massive dilution and even more losses for shareholders of European banks.
So in my opinion, the entire European money-center banking complex is still a long-term short play, including, but not limited to, Deutsche Bank (NYSE:DB), Commerzbank (OTCPK:CRZBY), Credit Agricole (OTCPK:CRARY), UBS AG (NYSE:UBS) Credit Suisse Group (NYSE:CS) and BNP Paribas (OTC:BNOBF).
By the way, speaking of deleveraging (AKA smaller asset footprint), Credit Suisse and UBS are about to downsize by about 7,000 jobs.
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.