The European Central Bank (ECB) just announced its planned review of the largest banks in the euro area, before assuming direct supervisory authority over these banks in early November 2014. (March 1, 2014, had been initially envisaged as the date for this transfer of authority from the national to the European level, but various institutional squabbles have delayed it by eight months.) This communication marks the concrete start of a yearlong review process that will be the make-or-break test for Europe’s banking union, which itself is arguably the most important structural change the crisis has prompted in Europe so far.
The ECB’s announcements do not have any major surprises, but they help clarify the review process. To echo Article 33.4 of the EU Single Supervisory Mechanism Regulation, the legal basis for the new supervisory role of the ECB which is expected to be published in final form within two weeks or so, the exercise is called Comprehensive Assessment, a bland label that will probably not end the minor semantic confusion that has affected it. Many market participants like three-letter acronyms and refer to it as the AQR (Asset Quality Review), while others use the term “stress tests” to echo the spring 2009 Supervisory Capital Assessment Program in the United States and the successive (and ill-starred) rounds of capital simulations conducted in 2009, 2010 and 2011 in the European Union. In fact, the AQR and stress tests will be two separate components of the Comprehensive Assessment, which will also include a third one called “supervisory risk assessment.” The latter is still loosely defined for now, but appears to focus on liquidity and funding patterns.
The Comprehensive Assessment will be conducted over the next 12 months. This is a very long period of time for such a market-sensitive process but is justified both by the large scale of the endeavor (the ECB describes it grandly but aptly as “the largest such exercise ever undertaken in terms of the number of banks, their overall size, and geographical reach”) and by the lack of prior supervisory experience at the ECB. The AQR will be based on balance sheets as of end-2013, an early cutoff date that is welcome as it reduces the risk of aggressive credit contraction by banks over a long period of time, which would have weighed negatively on European growth. The ECB will use an 8 percent threshold for the minimum capital requirement, corresponding to the 7 percent reference of the Basel III Accord (4.5 percent so-called core equity tier one capital + 2.5 percent so-called conservation buffer), plus a 1 percent surcharge as all banks are considered of systemic importance. This is a reasonable yardstick for capital adequacy, and marks an acceleration of the long Basel III transition period as enshrined in the European Capital Requirements Regulation. In addition, the ECB will introduce a leverage ratio, also in reference to Basel III but in anticipation of EU legislation.
The ECB has published a tentative list of 124 banks to be reviewed, which it reckons represent an aggregate 85 percent of the euro area’s total banking assets; 18 of these are local subsidiaries of non-euro-area banks (from Canada, Denmark, Russia, Sweden, Switzerland, the United Kingdom, and the United States). The list also includes a few government policy banks such as France’s new Banque Publique d’Investissement and Germany’s KfW IPEX import-export promotion bank; financial arms of carmakers (PSA Peugeot Citroën, Renault, and Volkswagen); two subsidiaries of financial infrastructure firms (LCH.Clearnet in France and Clearstream in Luxembourg); and 15 banks that were nationalized during the crisis (including Allied Irish Banks, ABN Amro, Bank of Cyprus, Bankia, Dexia, and Hypo Real Estate). The other names on the list illustrate the diversity of bank governance models in Europe. More than half of them are cooperatives and national or local government-controlled banks, including savings banks; of the remaining ones, which can be considered commercial banks, many have a controlling shareholder, leaving relatively few in the sample (but several of the largest) as publicly listed companies with dispersed ownership, the dominant model in the United States and United Kingdom. This is one more reason why the political economy of Europe’s banking sector is so different from that in the United States.
Most importantly, the ECB’s announcement confirms that this will be a markedly different process from the 2010 and 2011 stress tests, and potentially a much more credible one. The European Banking Authority (EBA), which directed the 2011 round, did all it could to ensure a rigorous and consistent assessment, but it had no mandate to impose its demands on reticent national authorities. By contrast, next year’s review will be conducted by the ECB itself, of course with help from national supervisors but with its own supervisory staff, direct access to information from banks, and additional help from private-sector consultants, some of which (such as Oliver Wyman) will report directly to Frankfurt and not national capitals. National authorities will not be able to veto consideration of some issues, in contrast to the 2011 exercise, when they could raise so-called red flags. Recent communication by Eurosystem officials indicates that the final recommendations (to the ECB’s still-to-be-formed Supervisory Board, which itself will be placed under the authority of the existing Governing Council) will be made solely by ECB staff, rather than on the basis of consensus-dependent committee decisions. If national authorities disagree, their position will be reported to the Supervisory Board, but only as a dissenting opinion.
Even so, the 2014 review raises monumental challenges. The key reason is that the assessment by the ECB is by definition only part of the action. The other part is that, if some banks are found undercapitalized to an extent that could not be corrected only by raising money from market investors, these “problem banks” will need to be restructured (recapitalized, taken over, sold, or resolved) by public authorities. The previous steps taken during the European financial crisis since mid-2007, not to mention earlier European episodes or the parallel experiences in the United States and elsewhere, have amply illustrated how difficult and contentious such government-led bank restructuring could be. It is widely suspected that the number of such problem banks is probably in the double digits and that the corresponding financial shortfall could be very large, possibly higher than 100 billion euros.
To finance these future operations to which the ECB refers euphemistically as “corrective measures,” in cases where market investors would not be willing to step in, forced losses (for which the clumsy but now-fashionable euphemism is “bail-in”) may be imposed on junior and perhaps also in some cases senior creditors. But in certain scenarios of systemic contagion risk, one cannot rule out the need for some funding from the public purse. Following a decision in June, the European Stability Mechanism (ESM) essentially will not play a significant role in such cases, at least outside of countries under an assistance program, such as Greece or Cyprus (Ireland and Spain are expected to exit their current assistance program shortly; the case of Portugal is more uncertain). As a consequence, resources may have to be found in national budgets, for which the current ECB jargon is “backstops.” A minor controversy in July between the ECB and the European Commission on the specific cases of solvent but slightly undercapitalized banks, which was revealed a few days ago, illustrates the ECB’s skepticism about an excessive recourse to bail-in, which may correspond to the prevailing political mood—particularly in Germany—but would swing the pendulum too far compared with the European’s near-systematic recourse to public bailouts in the first five years of this crisis.
All this sets the stage for a politically complex series of choices to be made in 2014 to prepare for the consequences of the banks’ assessment by the ECB. Some member states, including the largest, might push for “forbearance” (i.e., hiding the bad news) for fear of the political and financial consequences of publicly led bank restructurings. The ECB has strong incentives to resist them. Its credibility is at stake, not only as a supervisor but more broadly as a European institution, with possible spillovers to its reputation as a monetary policy authority. The sad precedent of the EBA, whose reputation never fully recovered after it gave a clean bill of health in July 2011 to banks such as Dexia and Cyprus Laiki, which collapsed shortly afterwards, can only reinforce the ECB’s determination not to follow the same path. Germany, here as elsewhere, will be in a pivotal position. On the one hand, it is a natural defender of the ECB’s integrity and has enough heft to take responsibility for the euro area as a whole. But on the other hand, its banking system is notoriously politicized, and some banks might be in a sorry state (all Landesbanken are included in the ECB’s assessment list). Furthermore, the consequence of large bank restructurings in, say, Italy or France may create domestic difficulties for the German government as well. To top it all, the European Parliament election of May 2014 may trigger unpredictable political interferences in the midst of the assessment process, especially if, as opinion polls currently suggest, it marks an unprecedented setback for most of the euro area’s governing parties, at least outside of Germany.
The 2014 bank review thus presents a choice between two diverging scenarios. In the first, “forbearing” scenario, the ECB would yield to the political pressure from member states, and do little better than the EBA did in 2011 in terms of rigor and consistency of the assessment. The ECB would avoid flashpoints, but the “zombification” of the euro area’s banking sector would continue, with a heavily negative impact on Europe’s future growth. In the second, “rigorous” scenario, the ECB would resist the pressure for forbearance and expose a number of problem banks, whose restructuring will involve some public cost and political turmoil. But the corresponding cleanup would gradually lift the drag that dysfunctional credit allocation has put on European growth since mid-2007. Furthermore, only in the “rigorous” scenario can the Single Supervisory Mechanism be established on a sound basis, which is a necessary condition for further successful steps towards banking union, itself an indispensable (though not sufficient) component of an eventual resolution of Europe’s current predicament. Alas, it is difficult to imagine that the assessment would be rigorous and not expose a number of significantly undercapitalized or insolvent problem banks, some of which quite large. If all were already well in the European banking system, these disclosures would already have happened and investors would have been reassured long ago. It is also difficult to imagine a happy middle ground between the two above described scenarios. The ECB can probably not sugarcoat the assessment’s results sufficiently to avoid painful restructuring, while preserving its credibility.
Thus, the conflict between the ECB and member states will escalate. It is likely to trigger significantly more financial-market volatility in 2014 than Europe has witnessed (so far) in 2013, in spite of sizeable internal shocks this year such as the February election in Italy and the March developments in Cyprus, and external ones such as the turmoil in emerging markets and the recent US fiscal drama. If the assessment is lax, the risks are a major loss of ECB’s reputation and thus further weakening of an already fragile euro area and European Union, which would be compounded by a final loss of hope in Europe’s ability to address its now many-years-old banking problem. By contrast, if Europe’s leaders choose the more rigorous option, they have the opportunity to allow trust to return to Europe’s banks and pave the way towards a much more resilient financial system. They will need to be clear-sighted about the consequences of their choices in the weeks and months ahead.
This speech was given in late June in Istanbul, at the 30th anniversary symposium of the European Private Equity and Venture Capital Association (EVCA). It has taken me some time putting it into written format. It has also been posted by the Peterson Institute and Bruegel.
In the speech, I develop a narrative of the run-up to the European crisis and of its management since 2007, through the lens of what I see as an important and under-analyzed driver of financial sector policy. This driver is labelled here "banking nationalism" for lack of a better term, but is really about the mismatch between national banking policy frameworks and the integration of the European financial system through EU policies. The initiative to create a banking union may resolve this mismatch in a manner that preserves European integration, but whether it will actually do so is still too early to tell.
Bruegel and the Peterson Institute both published this new paper, in which I emphasize the crucial importance of the handover of supervisory authority to the ECB in late 2014 and of its adequate preparation. This transition will most likely include a wave of bank restructuring that will shape the future of Europe's banking policy framework.
Click here to upload the version published by Bruegel.
Click here to upload the version published by PIIE.
The texts of the two versions are identical.
The Financial Times today published my analysis of what the bank restructuring in Cyprus and of Eurogroup President Jeroen Dijsselbloem’s much-commented interview earlier this week. I suggest that the EU must now find a more stable path between too extreme, harmful policy stances – excessive moral hazard (which I call the “Sanio Doctrine” based on the seminal decision to bail-out IKB in late July 2007), and denial of systemic risk (the “Mellon doctrine” with reference to ill-fated US policy before the inauguration of Franklin D. Roosevelt). This is an important debate for Europe and not least for future discussions on the banking union framework.
The late Mike Mussa of the Peterson Institute, a former Chief Economist of the International Monetary Fund (IMF), noted about some episodes of the late-1990s Asian financial turmoil that “there are three types of financial crises: crises of liquidity, crises of solvency, and crises of stupidity.” This quip comes to mind when considering the developments of the past few days around Cyprus.
The March 16 announcement of an agreement backed by most European leaders and institutions as well as the IMF, which called for a tax (or possibly an unfavorable cash-for-equity swap) on holders of bank deposits, no matter how small, was a policy blunder likely to cost the European Union (EU) dearly.
The sequence that led to this “Saturday-morning plan” is well known. Greece’s sovereign debt restructuring a year ago hit Cypriot banks that had bought Greek bonds, raising doubts about the Cypriot government’s own solvency. Negotiations on a possible bailout by the EU had been seen as inevitable as early as mid-2012. But discussions were frozen until a general election in Cyprus last month. Unfortunately, the delay pushed the timetable of negotiation into German election cycle territory, constraining the latitude of the euro group, in which Germany is now the unquestioned central actor. Driven by the domestic German political debate, European negotiators were intent on forcing losses on large (read Russia-linked) Cypriot deposits as an indispensable component of the package.
To the surprise of many, the recently elected Cypriot president, Nicos Anastasiades, added a further twist to the tangled situation by suggesting a hit to small depositors as well. According to some reports, he wanted to limit the losses imposed on large depositors in order to preserve the island’s future as an international financial center. All negotiators seem to have accepted this offer before realizing, too late, how damaging it might be to trust in the safety of bank deposits well beyond Cyprus.
No easy or painless option was available for Cyprus. However, some of the Saturday-morning plan’s flaws were avoidable.
First, the plan disregarded the lessons of financial history about the high importance of deposit safety, particularly for middle-class households (which is why there usually is an upper limit for explicit deposit insurance, harmonized at € 100,000 in the EU since 2009). Based on the experience of the early 1930s, it is virtually undisputed in the US that a breach of deposit insurance will primarily hurt the “little guys.” Sheila Bair, the respected former Chairman of the US Federal Deposit Insurance Corporation, has expressed this view with reference to Cyprus. Similar lessons arise from the record of many recent emerging-market crises.
If it is true, as alleged, that Cyprus’s own president was the one who recommended hurting small depositors, European negotiators were not justified in going along. After all, in November 2010 the Troika of the EU, the European Central Bank (ECB) and the IMF rebuffed the Irish authorities’ proposal to “burn” the holders of senior unsecured debt in failed banks. Their concern was to prevent damaging contagion in the rest of Europe. A similar argument was more straightforward and sensible for Cyprus than it had been for Ireland, and should have led them to oppose Mr Anastasiades’ proposal from the outset.
Second, the festival of finger-pointing in Brussels and across Europe following the Cyprus debacle shows that the negotiators had no “plan B” were the Cypriot Parliament to reject their initial scheme. One must wonder whether the EU is ready to handle the complex Russian side of the Cypriot equation, including the wisdom of depending on Russian goodwill for a solution to the current mess.
Third, the Saturday-morning plan raised profound questions about the democratic nature of EU decision-making. The problem is not that hard measures were to be imposed on the Cypriot population. A loss of autonomy, alas, is the inevitable consequence of the Cypriot state’s inability to meet all its commitments on its own, as Mr. Anastasiades had earlier acknowledged. Moreover, Cyprus has earned no sympathy by rejecting the United Nations plan for the island’s reunification ahead of its entry into the EU in 2004, and for harboring Russian and Russian-linked financial activities widely presumed to be connected with money-laundering.
The problem, rather, lies in the extent to which the European crisis management is now being held hostage by German electoral politics. This dynamic is not new in the euro-crisis, but has reached new heights as Chancellor Angela Merkel’s main opposition, the Social Democratic Party (SPD), has identified Cyprus earlier this year as a “wedge issue” on which it could challenge her. The SPD calculation was to paint Ms. Merkel as too lenient with shady Russian oligarchs and their “black money” held in Cypriot banks, while she would presumably be prevented from responding because of a fear of destabilizing Europe’s financial system. In effect, Ms. Merkel called the SPD’s bluff by risking the euro zone’s first bank run. No wonder that placards on Nicosia’s streets carry slogans such as “Europe is for its people and not for Germany,” or that Athanasios Orphanides, until recently the governor of the Cypriot central bank and a member of the European Central Bank (ECB)’s Governing Council, complains that “some European governments are essentially taking actions that are telling citizens of other member states that they are not equal under the law.”
It is too early to evaluate the lasting damage, but it is likely to be significant. The Saturday-morning decision-making process leaves an impression of incompetence and groupthink, tainting all of the participating actors, including all euro zone finance ministers, the European Commission, the ECB, and the IMF. The EU’s earlier sense of purpose by committing to a banking union last June and delivering on its first step (the Single Supervisory Mechanism) in December has now been battered. So has the aura of statesmanship and control developed by Ms. Merkel and the ECB. Possibly most damaging, even if the deposit tax is reversed or adjusted, the trust of middle-class households throughout the Eurozone in the safety of their banking system has eroded. Hopefully there will be no immediate deposit flight in other countries than Cyprus. But in future crisis episodes, households will behave in a destabilizing way, assuming Europe’s deposit insurance arrangements are not profoundly reformed. There is an apt parallel with the Deauville declaration by Ms. Merkel and French President Nicolas Sarkozy, endorsing losses for Greek sovereign bondholders in October 2010, which started an 18-months cycle of increasingly negative market expectations throughout Europe.
What now? A week ago, the challenge in Cyprus was to close the fiscal gap with a bailout package. Now it is to close the fiscal gap, and to restore a minimal level of trust in the banking system, without which the economy cannot operate. This raises the bar. The obvious risk is of massive deposit withdrawals whenever the Cypriot banks reopen. Now that the seal on deposit safety has been broken, depositors will do their best to avoid additional taxation or expropriation in a few weeks’ or months’ time, no matter how many promises are made that this is a unique and once-and-for-all occurrence. Cypriot authorities are likely to address this with a mix of capital controls and deposit freeze, perhaps in the form of conversion of deposits to interest-bearing certificates of deposits, as recently proposed by Lee Buchheit and Mitu Gulati. But “financial repression” or even incarceration can only last for a limited period of time given the freedoms guaranteed by the EU treaty.
Unlike in previous euro-crisis episodes, there is little the ECB can do alone. The problem is fiscal at the core and must be addressed by elected leaders. They may conclude that it is best to let Cyprus default, impose capital controls and leave the euro zone, an option that was reported to be explicitly considered in European policy circles. But such a move would violate the promise of European leaders to ensure the integrity of the euro zone, no matter what, and potentially set off a chain reaction, including possible bank runs in other euro zone member states, starting with the most fragile ones, such as Slovenia and of course Greece.
On the other hand, it is difficult to see how the risky scenario of a Cyprus exit could be avoided without further fiscal commitments by euro zone partners, including Germany. Their help could be in the form of additional direct transfers to Cyprus to plug the fiscal gap, or some form of guarantee of deposits that would come from the European rather than the national level. A quick but imperfect way to achieve the latter would be for a European entity, possibly the European Stability Mechanism, to provide an unconditional guarantee for a limited but sufficient period of time (say, 18 months) to all national deposit guarantee schemes in the euro zone, up to the € 100,000 European limit. Such “deposit reinsurance” has been rejected absolutely by European policymakers so far. It would constitute a major contingent financial commitment, even though the trust-enhancing effect would arguably result in an eventual net fiscal benefit for all. But it would be a powerful preemptive tool to make sure a scenario of retail bank run contagion does not materialize, and might also become the only option available to restore confidence if such a scenario were to become reality.
Assuming that the current situation is somehow brought under control, longer term questions beckon, beyond the geopolitical considerations related to Cyprus and its neighborhood. The breach of the deposit guarantee, materialization of the bank run threat, and probable consideration of capital controls will cast the euro zone debate on banking union in a new and starker light. Since mid-2012 and until now, the policy consensus in Europe had been to pretend that the question of supranational deposit insurance, with its direct links to the currently-frozen issue of fiscal union, was important but not urgent, and should be left out of the explicit banking union agenda. This convenient stance will be harder to hold given the Cypriot experience. More broadly, the episode will contribute to an overdue debate about the democratic (or otherwise) nature of European decision-making and the effectiveness of its crisis management, two challenges more tightly connected than many observers realized. A first step might be to recognize the plan of March 16 as a mistake, and to have an honest debate about how it could have been avoided.
Many commentators are puzzled by the general lack of negative financial market reaction to the fast-unfolding events in Cyprus. The most likely reason, to be tested in the next few days, is that investors have been sufficiently impressed by last year’s whatever-it-takes commitments, particularly those by Ms. Merkel and ECB President Mario Draghi. The markets’ baseline assumption remains that a last-minute solution will be found after all the brinkmanship. Longstanding observers of the Eastern Mediterranean tend to project a darker mood, as they recall that this is a region in which individuals, groups and nations do not always act in their self-interest. One can only hope that the market’s assessment is the correct one.