Despite extended talks and very public bickering over the necessity of moving toward a banking union – and how such a union might work – the European Parliament last week finally voted to approve rules that will govern the move. However, a banking union presents a number of challenges to both countries and banks in the region. Here are the top three.
1. Stress Tests
Between May and November, when the European Central Bank assumes authority over the 128 largest banks in the eurozone and gains some oversight over another 6,000, banks will undergo stress tests to see just how healthy they are.
The European Banking Authority has said that banks must be able to prove that capital reserves will not fall below 5.5% of assets should another economic crisis hit. New regulations that have already begun to take effect have caused banks to shed loan portfolios, branches and even whole books of business as they attempt to divest themselves of potentially risky holdings and reduce their size.
The top 30 banks alone have already seen reductions of 2 trillion euros ($2.76 trillion) in 2013, with more to come in 2014. In some cases this is part of a restructuring of banks’ business. UBS, for example, is moving back toward traditional private banking as it abandons newer and riskier trading activities.
New requirements aren’t the only challenge presented by stress tests. If banks are too successful in fulfilling the new requirements and pass the tests with flying colors, the tests’ very credibility could be at issue – something the banking authority is familiar with, since its previous more lenient regulations allowed banks to appear healthy even as collapses were looming. In January, a Keefe, Bruyette & Woods analysts’ report indicated that in a simulated stress test, 27 of the ECB’s 128 banks failed.
Still, so many banks have cut exposures and boosted capital ratios by such large numbers that it is expected they will make a respectable showing.
2. Deposit Guarantees
When the European Parliament voted to approve legislation on the banking union on April 15, it included deposit guarantees for accounts below €100,000 ($138,130) and for short-term deposits of up to €200,000, which would protect, for instance, homeowners who have just sold a residence.
However, those who have larger or longer-term accounts could end up on the hook for funds above those amounts, as they did in Cyprus when banks collapsed in 2012-2013. Regulations don’t specifically include or omit larger depositors; as a result, in the event of trouble, there’s sure to be a major uproar should problems arise, as depositors clamor to have their assets protected while banks and governments seek to recover losses via those same assets.
Meanwhile, authorities will not only have to provide account holders with their money within seven days of a bank closure but will also have to provide subsistence amounts to those account holders within five days. Countries will be obligated to review banks’ efforts to amass national deposit guarantee funds, but the rules don’t take effect till 2015 – and countries can postpone deadlines for satisfying the regulations till the middle of 2016. The pooled guarantee funds are supposed to amount to €44 billion within the next 10 years.
3. The Single Resolution Mechanism (SRM).
The new rules include approval of an SRM, intended to enable the shutdown of troubled banks in a swift and organized manner while removing the authority to do so from national governments or banking authorities and turning it over to an EU authority.
As part of the SRM, banks will have to contribute to a Single Resolution Fund (SRF) that can be used to bail out banks in trouble. Countries, however, aren’t obliged to set up resolution funds or start directing bank funding toward them till the beginning of January 2016, and then they have eight years to come up with the agreed-upon total of €55 billion ($76 billion).
That’s not really a significant amount of money to bail out a large bank or a series of banks cascading toward disaster. The financial crisis ate up almost €600 billion in bailouts and recapitalizations, according to International Monetary Fund and European Union estimates, and while the SRF will be able to borrow money to bolster the fund, it can’t just demand funds from countries within the banking union.
In addition, Thierry Philipponnat, secretary-general of the public interest advocacy group Finance Watch, said, “We note the agreement to let the SRF borrow from the markets. This development raises important questions about who will lend and under what conditions. For example, could market borrowing be relied on in a systemic financial crisis? We look forward to learning further details.”
The long delay in implementation and the lack of immediate substantial funding impair the credibility of both the SRM and the SRF. However, countries have struggled mightily to maintain their own authority and to retain the right not to contribute to such a bailout fund – particularly Germany, which fought tooth and nail to keep from having to surrender authority over its own financial institutions and to obligate its taxpayers in case of another financial crisis.
As a result, both the SRM and SRF not only appear weaker than they should, impairing confidence in the nature of the banking union, but could well prove inadequate to the challenge should another crisis arise. Bondholders and shareholders are likely to find themselves paying the price, since they will have to take losses before the SRF kicks in.
On the flip side, if, as intended, confidence increases in the weaker banks in the system once the banking union kicks in, that’s not without its own repercussions.
Fitch Ratings says it could cost healthy banks on a couple of fronts. Not only will they have to bear the cost of contributing to the SRF, which Fitch says “is unlikely to be substantial, and in an efficient market the additional costs will be passed onto customers” – but also “the stronger banks could face increased competition and erosion of the confidence-premium advantage they enjoy on their funding costs (most notably for German banks, but also potentially for French banks).”
Fitch doesn’t see the latter as posing a major threat in the near term.