Current banking union proposals fail to provide an effective backstop for Europe's €47 trillion banking sector

(PresseBox) (London, ) Ahead of this week's EU summit, Open Europe has today published a new briefing looking at the plans for a eurozone banking union and the various steps that need to be completed to make it credible.

Total bank assets in the EU stand at over €47 trillion, equivalent to 366% of the bloc's combined GDP, illustrating the immense challenge involved in creating an effective banking union. The report notes that a banking union will not be credible unless the second step - a joint financial backstop - is established alongside centralised supervision. However, this will involve a fundamental rewriting of the EU treaties and unparalleled transfers of national decision-making powers to the EU-level - in addition to a risk that weaker banking systems free ride on stronger ones.

Open Europe Director Mats Persson said,

"A proper bank safety net will radically redistribute risk - and potential cost - amongst countries' taxpayers and financial systems in Europe and require a substantial rewriting of the entire EU structure. This is why the current sequencing of the proposed banking union - supervision first, backstops later - is vital to Germany and others, but also why it remains far from clear that the eurozone will actually make it beyond the first step. What's clear is that the EU continues to operate on a hopelessly optimistic timescale."

"Contrary to popular belief, it would be unacceptable to all sides for the UK to take part. Total UK bank assets stand at €10.2 trillion - four times the size of the German economy - meaning that there's no way that the eurozone could underwrite it, financially nor politically."

To read the full document, 'The Eurozone Banking Union, a game of two halves', click on the link below:

Key Points

In 2012, bank assets in the EU are expected to top 366% of GDP, €47.3 trillion. In comparison, in 2011 bank assets were 78% and 174% of GDP in the US and Japan respectively - illustrating the challenge involved in backstopping Europe's banks.

Due to the huge size of the sector, the current sequencing of the proposed banking union - supervision first, backstops later - is paramount to Germany and others. In theory, giving the ECB strong supervision powers could curb perverse incentives for banks and governments to behave irresponsibly in a banking union, knowing that someone else will bear the cost. In practice, however, it remains far from clear that the EU can overcome a series of political and legal obstacles to counter such moral hazard.

At the same time, a banking union would turn the ECB into a hugely powerful body charged with key functions ranging from issuing bank notes to, eventually, winding down banks potentially using taxpayers' money. In the German tradition, monetary policy is independent but decisions involving taxpayers' money are democratically accountable. It is virtually impossible to replicate this at the EU level absent a fundamental rewriting of the ECB's statute and the EU treaties.

We estimate that, in a 'business as usual' scenario, a joint resolution fund needs to have at least €500bn to be convincing and a deposit guarantee scheme €96bn for the eurozone and €114bn for the EU as a whole. Most of this would need to be pre-funded (real cash as opposed to loan guarantees), and, most importantly, both schemes must have a direct credit line to the ECB or national treasuries to unlock more funds in case of a crisis. Again, this would require a fundamental change in the ECB and EU structure, including Treaty changes.

A bank safety net will radically redistribute liabilities amongst countries' taxpayers and/or financial systems. Using the current crisis to illustrate, since 2008, EU states have in total offered around €4.7 trillion in guarantees, capital, liquidity and asset relief measures to the European banking sector. Had a joint a resolution fund been in place during the crisis (note, we assume bailed out states would not have been able to contribute to such a redistribution):

- Germany would have been a massive loser and together with France would have had to provide significantly more funding in our hypothetical scenario - around €400bn (compared to the level of aid they have actually given out to financial institutions in the current crisis - a number of caveats do apply, see full briefing for details).

- Medium-sized and small countries would have been hit especially hard and would have seen a huge spike in contingent liabilities (and some paid up liabilities) relative to their GDP: Latvia (84%), Poland (74%), Hungary (77%) and Bulgaria (129%).

- The huge increase in liabilities also highlights the risk of downgrades and spikes in borrowing costs for individual countries under Eurozone mutualisation schemes. We have recently seen France lose its AAA credit rating partly due to contagion effects and its liabilities under the centralised sovereign bailout funds.

- As would be expected, the bigger the banking sector and the capital injection it received during the crisis, the more a country would 'benefit' from a safety-net. This also illustrates that the UK is simply too big to take part in a banking union - underwriting the City of London (and €10.2 trillion worth of UK banking assets) would be an impossible political sell in Germany. In our hypothetical scenario, where the aid given in the current crisis is shared out under a banking union, Germany's burden would be €200bn higher if the UK were in the banking union.

- The UK has already taken a domestic approach to restructuring and recapitalising its own banking system and is in the process of creating a stricter domestic regulatory framework. Therefore, it has little incentive to participate. In fact participation could create clashes between the two regulatory regimes and may stoke more uncertainty and confusion.


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