Now that the dust is settling from the European Council circus a summary of what has been achieved is in order. Many analysts and market observers hailed the result as a “paradigm shift” a “game changing” decision or that it was the first time that an EU Council did something good for Europe. Others rejoiced at the thought that Germany’s Chancellor Merkel ostensibly backed down or as they claim, defeated. The markets went up on the news and everyone was happy.
I must say that I do not share the same exhilarating feelings. And the reason is reality versus marketing. There is no doubt that from a marketing point of view the summit was a huge success. Germany simply had to look as if they are retreating and Italy’s Monti absolutely had to appear to be standing up. Equally, Spain’s Rajoy needed a political win to gain back some credibility. Monti on the other hand was preparing to fire 100,000 public sector employees and standing up to Merkel was the perfect excuse.
Germany realised that they can play hard on the implementation and conditionality level which is more important. The new regulator and the conditionality on the banks and the states is where the game is going to be played.
On the main decisions taken by the Council we have:
· No seniority on ESM loans
· Setting up a pan-european bank regulator. A banking union.
· Direct recapitalization of banks by the ESM after regulator is being set up
· ESM could buy government debt
Let’s look each main decision in turn.
No ESM Seniority
The original decision of having the loans senior was a gross mistake. It would have meant immediate subordination of everyone else in favour of the ESM. Contrary to popular belief not even the IMF is a preferred creditor on paper. The IMF is assumed to be at the top of the creditors order because no one really wants to upset them. Legally, there is nothing on paper that proves it. In any case, as the Greek restructuring proved the European official sector (ECB, States, EIB etc) is de facto senior to everyone else. Thus whether we like it or not the European Government Bond market has already been segmented. The ECB is claiming a preferred investor status because of monetary policy decisions while other official lenders simply refuse to be on equal footing with the rest of the pack. Thus, overall the decision was a good one but one that would not affect the market greatly.
Most analysts concentrated on the direct recapitalization of the banks by the ESM/EFSF. However, the important one is the bank regulation/union. Reading the Council’s statement you may be forgiven for thinking that there was no regulation in Europe and that the Banks operated under Wild West rules. In fact the opposite is true. There is simply too much regulation, too many bodies “regulating” and too little common sense or implementation of the rules. For example, every country in the Eurozone has an authority that is responsible for regulating the local banks and financial institutions. It could be the Central bank of the country or a separate overseeing organization. On a European level we have
· ESRB (European Systemic Risk Board). Responsible for supervision of individual firms with emphasis on the financial stability as a whole. The board includes the ECB’s president, the Central bank governors, the Chairman of EBA and many more.
· EBA (European Banking Authority). They conducted the famous stress tests that basically gave a clean bill of health to most of them.
· ESMA (European Securities and Markets Authority). ESMA is yet another supervisory authority that “contributes to safeguarding the stability of the European Union's financial system by ensuring the integrity, transparency, efficiency and orderly functioning of securities markets, as well as enhancing investor protection”. Yet despite their role, they failed to protect retail investors who despite the fact that they were prohibited from receiving the Greek PSI offering memorandum they nevertheless ended up with forbidden financial instruments (Options on Greek GDP).
· EIOPA (European Insurance and Occupational Pensions Authority). EIOPA’s core responsibilities are to support the stability of the financial system, transparency of markets and financial products as well as the protection of insurance policyholders, pension scheme members and beneficiaries
· ESFS (European System of Financial Supervision). All of the above comprise the ESFS.
And of course we also have the ECB that is the guardian of financial stability in Europe. It publishes a report on financial stability every year since 2004. The head of the unit was for many years none other than Mr Papademos the former Greek PM that restructured the Greek debt. So Europe is not exactly short of regulators or supervisory bodies. I am pretty sure that there a more committees and technical expert groups that deal with financial stability.
Naturally, one might argue why we need yet another pan-European regulator to oversee the banks. The answer, I guess, is that this is how the EU works.
Banking Union means Sovereignty transfer
Now, the real question is what would be the powers vested on this new banking regulator. Would they supersede the national regulator and parliament? Would they be a sovereignty transfer from the states to this body? And if yes, how is this body going to be accountable? These are important question for the whole of Europe. A banking union can only come about if there is a significant transfer of local power to European level. The point I am trying to make is that as long as this transfer of powers is voluntary and as long as the institutions and organizations are accountable to the people of Europe then there is justification. But the current trend is to pass more and more powers to obscure committees and groups that are not in any way accountable to the people of Europe. Local regulators suffer from this defect too, but at least they are one step away from an accountable government. Passing these powers to a non-transparent and unaccountable European body just adds another layer of arbitrariness.
Market hailed this a significant breakthrough for Europe. The main reason is that the recap money would not be added to the debt of the respective country. This was apparently a victory for Spain even though it looks that the main beneficiary would be Ireland. As for Greece it remains to be seen if the 45billion promised for the recapitalization of the Greek banks would be given directly or added to the Greek national debt. The main unanswered question is who would take ownership of the banks. For example if a major Spanish bank is recapitalised by the ESM/EFSF who would be calling the shots? Ultimately, all banks are the extension of the very long arm of the local politicians. Would that link be severed or strengthened? We have all witnessed how protective countries are of their own banking system and how they erect hurdles to avoid foreign intrusions. Forcing the banking union to the powerless and bankrupt Greece is one thing to do it to Spain or even Italy is another.
From a market perspective, this must be seen as very positive for senior bank debt and negative for bank equity. It looks as if Europe wants to save banks no matter what, but when it comes to countries it has second thoughts.
So let us hypothetically assume that ESM recapitalises a European bank called BCCI (Banks of Crooks and Criminals) because it deems it to be important for financial stability. There would be two options if they want to clean the bank. One is to amortise losses over the next 30 years thus creating a zombie bank and the other to do a PSI Greek-style restructuring on the senior debt and to clean their portfolio. My guess is that if the official sector has placed tax-payers money on risk they would demand also the private bondholders to share some of the risk too. Equity holders were hit already by the recap.
ESM buys debt
This is actually not new at all. The decision was there right from the start but was never activated.
It is too early to signal or to call this summit a life changing experience. The real devil is in how the implement their vague decisions. The problem is that trying to force a banking union without having a full picture on fiscal union is dangerous. In the same way, that having a common monetary policy but no common and enforceable fiscal policy risks the whole union. Countries first surrendered their currency freedom for the marvels of a common monetary policy and the Euro. Now they are asked to surrender their banking systems into a yet unknown body to save few billion. Unless there are steps to a more democratic, transparent and accountable Europe we are just creating a monster.