What Does European Banking Union Mean?

Effecting a European banking union was never going to be easy. We saw some signs of the political difficulties at last week's European summit. Disagreements between the French and German leaders, as well as Germany's refusal to use the multi-nation ESM fund to pay directly for bank recapitalizations, have grabbed the headlines. See here and here for examples. The meetings did come to some agreements, as embodied in a typically opaque communique, but they did not, in my view, resolve the fundamental issues.

Regarding banking union, the communiqué focused on the establishment of a bank supervisory arm within the ECB and the timetable for establishing that. Regarding the issues of deposit insurance, a bank resolution law, and bank recapitalization mechanisms, the communiqué was anything but clear. Regarding deposit insurance it said:

"The European Council calls for the rapid adoption of the provisions relating to the harmonisation of national resolution and deposit guarantee frameworks based on the Commission's legislative proposals on bank recovery and resolution and on national deposit guarantee schemes. The European Council calls for the rapid conclusion of the single rule book, including agreement on the proposals on bank capital requirements (CRR/CRD IV) by the end of the year."

"In all these matters, it is important to ensure a fair balance between home and host countries."

These statements suggest that the nationality of each bank will be maintained for deposit insurance purposes and that a single deposit insurance system is not envisioned, at least as part of the original architecture. Thus, all the banks are to be supervised by one central entity (within the ECB) but the deposit insurance systems will continue to be national. In my opinion, that is not workable because the decision to take over and remediate a bank must be taken centrally; to have different consequences for depositors in different countries would lead to chaotic resolutions.

On a resolution mechanism, the communiqué said:

"The European Council notes the Commission's intention to propose a single resolution mechanism for Member States participating in the SSM once the proposals for a Recovery and Resolution Directive and for a Deposit Guarantee Scheme Directive have been adopted."

Good. A single resolution mechanism is needed. Without it, banking union is not workable.

On the recapitalization issue, the communiqué said:

"The Eurogroup will draw up the exact operational criteria that will guide direct bank recapitalisations by the European Stability Mechanism (ESM), in full respect of the 29 June 2012 euro area Summit statement. It is imperative to break the vicious circle between banks and sovereigns. When an effective single supervisory mechanism is established, involving the ECB, for banks in the euro area the ESM could, following a regular decision, have the possibility to recapitalize banks directly."

Apparently this means that after the system is up and running and banks have been accepted into it, it is possible that a bank could be recapitalized by the ESM. This clearly is a hot issue for the politicians. And it is advertised as the way to break the link between governments and banks, which is a major goal of all concerned. But I wonder how the ESM recapitalization will fit into the resolution mechanism. Basically, government recapitalization is inconsistent with a sound resolution mechanism that brings in new private sector capital to support the existing deposits. And a good resolution mechanism should break one of the links without intervention of the ESM.

In reality, however, the links between banks and their home countries cannot be broken by banking union so long as the banks are seen as national in character. So long as they are seen as national in character, the banks will buy the debt of their home countries, which of necessity links the health of the banks and the economic health of the home country.

I believe that the ESM issue that gets the current headlines is a red herring. The question of Germany and other northern countries allowing their money to be used to bail out currently-insolvent Spanish banks without Spain being on the hook for repayment has nothing to do with banking union. However much Spain and other countries with insolvent banks may wish for it, it is not going to happen, and the issue will not stand in the way of banking union. A workable banking union can be formed only for banks that are healthy at the time that they enter the system. That requirement will apply to small German banks as well as Spanish, Greek and Irish banks. Banks that cannot qualify but are nevertheless subject to ECB supervision would be inconsistent with the unified system of supervision.

Fundamental Issues

I believe the uncertainties and inconsistencies that the summit revealed reflect underlying fundamental issues that have been fudged so far.

The first fundamental issue is the nature and function of a bank. I think all of us who have been involved in bank regulation and supervision on either side of the Atlantic over the last 40 years have asked the question "What is a bank?" Or "What should a bank be?" Or "What is a bank's role in society?" However we have asked the question, we have had in mind the same set of conundrums. Banks, most economic thinkers agree, should be safe places for depositors to put their money, should reliably conduct the payments system, and should be a source of capital for businesses and of financing for individuals.

To make banks safe and to lower the costs of borrowing, governments have undertaken various types of programs. These programs often include deposit insurance, a national lender of last resort, and other privileges that go with banks' role in the payments system. In some societies, including many European countries, the safety emphasis goes so far as to include in-practice guarantees that banks do not fail.

The more governmental safety benefits a bank receives, the less the market will impose effective capital requirements on the bank. If the governmental safety benefits are strong enough, the market will permit the bank to operate with practically no capital at all, permitting stockholders to leverage their meager investments 30, 40 and 50 times and managers to claim enormous bonuses for the profits that result when times are good.

It should be obvious that a bank that has leveraged its equity capital 30, 40 or 50 times over is a very fragile business. Most of a bank's assets are loans to businesses, people and governments in one form or another. And when a loan goes into default, it usually loses quite a sizable part of its value. Therefore it does not take a very large part of a highly leveraged bank's portfolio defaulting for the bank to run out of equity capital. And at that point, either the bank will have to be sold (if anyone will buy it), the government will have to provide new equity capital to the bank, or the bank will fail and its future will depend of the resolution law. Taxpayers, equity owners, bondholders and other creditors and counterparties, and even depositors at the extreme, have to take whatever consequences the form of resolution gives them.

These consequences are the reason for regulatory capital requirements. That is, regulatory capital requirements are governments' logical response to the moral hazard that they have created by giving banks governmental safety benefits. If rigorously enforced, strong regulatory capital requirements should make banks much safer for all their constituencies, including the governments that have put themselves on the hook to bail them out, equity owners, bondholders, counterparties, depositors, and even borrowers. Substantially all people involved in bank regulation and supervision agree with this formulation.

Political Realities

In Europe, however, two political realities prevent this apparent consensus from being carried out logically toward a joint banking union. The first reality is that not all European nations agree with my formulation concerning the need for rigorous enforcement of regulatory capital requirements. They fight a rear-guard action, contending, variously, that high capital requirements will make loans more expensive (possibly true), that weak banks cannot raise the necessary capital (possibly true if they are, in reality, insolvent), and that governments stand and should stand behind their banks, so rigorous capital regulations are unnecessary.

These rear-guard nations will seek to use the occasion of banking union to force other countries to bail out their weak or insolvent banks, and they will stand in the way of vigorous insolvency laws that permit-or even require-the regulator to take over and sell or liquidate insolvent banks. In effect, a number of European nations do not want to take away the banking punch bowl. Either they believe that banks are not fragile (against all historical precedent) or they hope to have other countries support their folly. This has implications both for medium-term transitional issues and for longer-term issues involved in setting up a deposit insurance system and a remediation regime.

(As I wrote several months ago, a prudential supervisor without the power to take over and remediate failing institutions would be close to worthless. A Europe-wide bank regulatory system has to begin from the resolution mechanism and work backwards in order to be successful. If it begins with a supervisor that has no resolution powers, it will quickly find itself with a toothless supervisor and an unworkable deposit insurance system.)

The second major political reality is that almost every European nation sees its banks as a national resource rather than a privately owned company that may have interests all over the world and that, therefore, has, in a sense, no nationality. Within the European Union, it should be seen that this should not pose a long-term problem. If the Union is going to flourish, then its financial institutions have to flourish as part of the union rather than as national champions. But the idea that banks are national champions is far from dead in Europe (or elsewhere), and it will bedevil those trying to form a meaningful banking union.

The major architects of banking union, including the top executives of the EU and ECB, understand this quite well, I believe. Perhaps the French and German leaders understand and merely have to posture for a few months before they give in to the realities. The realities include that neither France nor Germany is going to be able to maintain its national champions and that Germany will not accept a responsibility to bail out other nations' national champions that have been managed badly and therefore are functionally insolvent before the unified bank regulatory arrangement begins. My fear is that Germany and/or France will not be willing to embrace centralized supervision that abandons their national champions to the mercies of the ECB and that that will lead to a dangerous, unstable fudge. If that happens, then the instability may take time to become apparent, and the Europeans will have built on quicksand, which might sound familiar.

Aside from this fear, I am optimistic that these two political issues will prove to be transitional issues that can be solved by admitting to the deposit insurance system and the resolution system only those banks that the ECB will determine to meet the final capital requirements of Basel 3. The Spanish-and the Irish, I guess-are going to be unhappy about that. So will other nations with swaths of effectively insolvent banks. But they all will come along if they see Germany and France abandoning their banking champions to the more rigorous standards of the EU and ECB. I am less certain about how things will play out with the ten non-euro members of the EU. But in one way or another, I do not expect them to be able to stand in the way of the seventeen nations coming together on this subject.

There is going to be a lot of posturing, pushing and shoving along the way. It will not be pretty. But in the end I believe that Mario Draghi and the other architects of the system will prevail because the banking union is one of the necessary steps to preserve the euro and return the Continent to prosperity.

Optimism Is Warranted

Obviously, this is a very optimistic assessment that I am making. But I have been making optimistic assessments about the ECB ever since Mario Draghi took over last November, and so far I have been more right than wrong. I do not deny that there are many issues that will have to be decided along the way or that it is likely that some of them will be decided in unworkable ways. But I do not see that the leaders of Europe have any way of going backward on this set of issues.

For investors, this probably means that the euro will not weaken greatly in the near future based on fears of union or zone breakup. And that means that securities that trade in euros probably have fairly modest currency risk for American investors. I am not certain how any individual investor should utilize that. But if one agrees with my assessment, then at least the currency risk becomes a risk that is assessed as moderate when considering European investments.

Italy had a very successful bond auction last Thursday, selling 18 billion euros of 10-year debt at under 5% per annum. If one combines the progress on the banking front with the progress on the debt front in Italy and the prospect of ECB help for Spain, one might even become optimistic that the euro crisis could be over some day-perhaps even as soon as 2014. Greece will remain insolvent and the question of how to accommodate the non-euro nations in EU will come to the fore. But renewed economic growth probably will enable Spain and the others to meet their obligations with the help of the ECB.

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.