Via Naked Capitalism

The lead story in the Financial Times tonight is that Germany’s finance minister Olaf Scholz is pushing for an EU-wide deposit scheme…of sorts. Even though Scholz’s plan appears to be more modest than the headlines indicate, even a halting move towards EU-level fiscal commitments would be a significant departure from Germany’s traditional stance of barring EU or Eurozone-level financial commitments like Eurobonds.

Readers will recall that one of the glaring deficiencies of the Eurozone is the lack of Eurozone-level fiscal spending. Member states are not currency issuers and over time can only spend what they raise from taxes and borrowings.

If that weren’t enough of a straitjacket, the EU under so-called Maastrict treaty rules limits how large a deficit a country can run even in bad times when serious deficit spending is needed.

But another glaring set of problems that hasn’t gotten as much attention is the failure to have a sensible bank regulatory scheme. Europe still lacks a credible deposit insurance regime (deposit insurance is on a national basis and most schemes are seriously underfunded). It has also embraced bad ideas like bail-ins (which are certain to create bank runs; instruments consistent with bail-ins like “co-co bonds” have increased rather than decreased bank risk) to keep the pretense alive that governments don’t need to stand behind the banking system. 1 The EU made this bad situation no better and arguably worse with the adoption of a half-assed bank regime in 2016 called the Bank Recovery and Resolution Directive. We’ll turn the mike over to Italian economist Thomas Fazi from a 2016 article:

On 1 January 2016 the EU’s banking union – an EU-level banking supervision and resolution system – officially came into force….In its original intention, the banking union was supposed to ‘break the vicious circle between banks and sovereigns’ by mutualising the fiscal costs of bank resolution….

In the course of constructing the banking union, however, something remarkable happened: ‘the centralization of supervision was carried out decisively; but in the meantime its actual premise (that is, the centralization of the fiscal backstop for bank resolution) was all but abandoned’, Christos Hadjiemmanuil writes. Within a year, Germany and its allies had obtained:

  1. the exclusion from the banking union of any common deposit insurance scheme;
  2. the retention of an effective national veto over the use of common financial resources;
  3. the likely exclusion of so-called ‘legacy assets’ – that is, debts incurred prior to the effective establishment of the banking union – from any recapitalisation scheme, on the basis that this would amount to an ex post facto mutualisation of the costs from past national supervisory failures (though the issue remains open);
  4. critically, a very strict and inflexible burden-sharing hierarchy aimed at ensuring that (i) the use of public funds in bank resolution would be avoided under all but the most pressing circumstances, and even then kept to a minimum, through a strict bail-in approach; and that (ii) the primary fiscal responsibility for resolution would remain at the national level, with the mutualised fiscal backstop serving as an absolutely last resort.

Bailing In For Distressed Banks

In short, when a bank runs into trouble, existing stakeholders – shareholders, junior creditors and, depending on the circumstances, even senior creditors and depositors with deposits in excess of the guaranteed amount of €100,000 – are required to contribute to the absorption of losses and recapitalisation of the bank through a write-down of their equity and debt claims and/or the conversion of debt claims into equity.

Only then, if the contributions of private parties are not enough – and under very strict conditions – can the Single Resolution Mechanism’s (SRM) Single Resolution Fund (SRF) be called into action. Notwithstanding the banking union’s problematic burden-sharing cascade (see below), the SRF presents numerous problems in itself. The fund is based on, or augmented by, contributions from the financial sector itself, to be built up gradually over a period of eight years, starting from 1 January 2016. The target level for the SRF’s pre-funded financial means has been set at no less than 1 per cent of the deposit-guarantee-covered deposits of all banks authorised in the banking union, amounting to around €55 billion. Unless all unsecured, non-preferred liabilities have been written down in full – an extreme measure that would in itself have serious spillover effects – the SRF’s intervention will be capped at 5 per cent of total liabilities. This means that, in the event of a serious banking crisis, the SRF’s resources are unlikely to be sufficient (especially during the fund’s transitional period).

Fazi had a lot more to convey but you get the idea. Germany and the northern surplus countries weren’t willing to provide anything dimly resembling meaningful support. This is why the shift in the German position is significant.

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But as we indicated at the outset, the optics exceed the likely reality. First, the overview from the pink paper:

Germany’s finance minister has offered hope of a breakthrough in plans to create a full eurozone banking union by ending Berlin’s opposition to a common scheme to protect savers’ deposits….

The European Central Bank and EU chiefs in Brussels have long urged governments to end political divisions over further banking union. They have argued that the project is vital to ensure that bankrupt banks can be safely wound down without the need for large taxpayer bailouts, and to make the eurozone more resilient to economic shocks.

The most surprising element in Mr Scholz’s proposals is his plan for a common EU scheme to shield depositors during a banking collapse. Germany has previously rejected such plans amid public hostility to any perceived attempt to put taxpayers on the hook for shaky banks in other countries.

The reinsurance system would act as a backstop to national funds, helping to ensure that governments can honour their legal obligation to protect deposits of up to €100,000 in the event of a banking collapse.

Next, the caveats:

Merkel hasn’t blessed this plan. I’m no expert on German politics, but Scholz is no Schabule, who was able to stare down Merkel in financial policy. However, given that, I also can’t imagine that Scholz would go out too far ahead of what Merkel would back. So the fact that Merkel is silent so far may reflect her traditional caution, particularly since she could distance herself from the plan if it got too much heat from the budget scolds.

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The scheme won’t cover all banks. This gap raises big questions about its practical utility. A German insider (who was in on some of the debates) tells me it won’t cover German cooperative banks, which are much like US credit unions.

Lots of strings will be attached. My contact says that banks that participate in the scheme will be subject to supervision by EU as opposed to national regulators. The Financial Times sets forth other expected conditions:

His demands include amending EU capital rules to remove incentives for banks to buy up large quantities of their home country’s sovereign debt; further action to reduce bad debts in the EU banking system; and the establishment of common European rules on calculating companies’ taxable profits.

Mr Scholz also wants the EU to harmonise bank insolvency law, saying a patchwork of national rules undermines EU attempts to make sure senior creditors share the cost of dealing with bank failures.

Of course, one could argue that this change of heart is because Deutsche, but it appears to be even more because Brexit. The prospect of stress on the EU has led at least some to realize they need to get their house in order:

He [Scholz] said that Brexit, which would see the EU losing the City of London — its largest financial centre — also meant it was time for the bloc to promote better integration of its banks….

Mr Scholz said that Brexit and the risk of dependency on China and the US compelled the EU to make headway.

Again, while it is far from clear how far Scholz’s initiative will go, any movement in the direction of more EU level banking support is a big break from Germany’s historical pig-headedness. One can hope this is the start of a better trend.

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1 For the record, our longstanding view is that backstopping banks is an ugly necessity and as a result banks should not be allowed to operate like private enterprises, since they are so heavily subsidized that they aren’t. They should have their activities circumscribed, be modestly profitable and have modestly paid executives, among other things.

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