EU's Latest Nail In Its Own Coffin
by Cliff Wachtel, FX Empire
The New Agreement Still Isn’t Good Enough, Same Obstacles, Same Inadequate Results. Conclusions On How To Protect Yourself And Profit
In late December 2013 EU member states agreed on an EU banking union plan. It was widely criticized as too slow implement and too underfunded to provide a credible guarantee of EU banking stability in case of bank failures. It also left individual member states without any outside aid for many years to come.
Late Thursday March 20th the European parliament and EU member states finally settled terms on the unified system for handling bank failures and potential banking crises that partially addressed the faults of the original version of the member states.
The final EU Parliament approved version is still too slow and underfunded to consider the EU banking system as stable as that of the US or Japan. It remains a ticking time bomb under the EZ and EUR, only now it’s a smaller bomb, and one that may be easier to disarm if times of potential bank crises.
Changes From The Original Agreement
We covered the terms of the original single resolution mechanism (SRM) here back in December.
Here are the changes from the original agreement of the EU finance ministers of December 2013.
The EU parliament wanted and got:
More and faster mutualization, i.e. aid from wealthier nations to bail out banks in poorer member states.
- The new deal accelerates the build-up of a common bank-paid fund from 10 to 8 years.
- It also makes the common funds available sooner. Under this provisional deal, 40% of the donations are mutualized after first year and 60% after the second. The original deal limited the growth in the percent of funds available to all to the percentage growth of the fund. Ten percent of the final 55 bln EUR fund was to be contributed each year, therefore after the first year only 10% of that amount was available to all members, 20% after the second year, and so on.
- More centralization (more real power to close banks and disburse common EU funds) in the central EU bank regulator rather than committees of member states. In the original deal, a resolution board comprised of EZ member representatives would make the proposals for dealing with the problem bank, and the central EU commission would only have a veto power, which could be overruled by a majority vote of banking union member states. Now, the Commission is given a formal role to approve resolution decisions recommended by an independent board. Finance ministers would be able to overturn the decision, but only in limited cases.
Flaws: Why The New SRM Is Still A Time Bomb Under The EZ and EUR
Although some of the same fatal flaws of the original deal have been partly remedied, the deal remains fatally flawed. For example:
- The new deal purports to have cut enough procedural hurdles to enable wind-up decisions to be taken swiftly over a weekend before markets open and prevent market panic situations. However the decision making process still involves over 100 separate voting decision-makers on multiple panels. It’s theoretically possible, but getting all that done so quickly, on a weekend, will be, ahem, a challenge. Remember that these meetings also require an army of support staff and translators too.
- The size of the fund remains at 55 – 70 bln EUR, depending on how you calculate contributions. Even if it’s adjusted for inflation, the fund is only large enough to handle a medium sized bank closure. However in times of financial stress multiple banks could be in trouble simultaneously. Unlike the Fed, the ECB is not currently free to promise unlimited money printing, and certainly not within a matter of hours. As we discussed in some depth here: The €55-70 bln may sound impressive at first glance, but for perspective, consider the costs of some of the EU’s prior bank rescues of:
- Spanish banks: €40 bln.
- Greek banks: €40bln.
- Ireland: Anglo Irish alone cost nearly €30bln.
Ratings agency Standard & Poor’s forecasted this month that the stress tests will reveal a capital shortfall that may total a bit over 1 % of EU GDP, which comes to anywhere from 55-95 bln euros depending on the source and its method of calculation.
- The SRM won’t be ready in time to cover bad banks that are revealed in the coming ECB stress tests. So we must ask:
- How can the ECB make these tests rigorous (the banks become its headache once it takes over as bank supervisor) if there is no safety net for them?
- The ECB won’t risk starting a crisis by uncovering bad banks without a safety net, so how can we really trust that the tests will be any more serious than those of recent years, which saw banks like Dexia fail shortly after passing its stress tests?
- Private sector bail-ins remain. Large depositors, as well as bank shareholders and bond holders, are still the first in line to take losses. That sounds great to voters, but as we learned when bail-ins were imposed in the summer of 2012, these policies make bank crises more likely and risk costing the public more in the end, as the very depositors and lenders the banks need to survive will now be quicker to run at the first sign of trouble.
- Member States’ financial commitments are not assured. This fact alone could kill the confidence needed to prevent a crisis.
As we reported here back in November, in order get Germany to sign on to the original deal, there were provisions that essentially allowed a member to walk away from its funding commitments by leaving each member states’ contribution to bailout a foreign bank subject to its Parliament’s approval.
- Limits On Central EU Control, Mutualization: In return for German finance minister Wolfgang Schauble’s agreement to faster debt mutualization, and member states’ sharing control of those common funds with the EU, it was agreed that:
- EU finance ministers – not Brussels – had the final say on a bank being shut.
- There are voting safeguards to ensure that bigger countries retain more voting power over when common bank resolution funds were used.
- Ideas to back-up the fund, for example by using the ESM fund (reserved thus far for sovereign bailouts), were stifled.
Highlights of banking deal (via ft.com here)
● €55bn pot is built up over 8 years, not 10
● Fund is 40% shared in year one, 60% year two
● Finance ministers set bank levy to build fund
● European Commission approves resolution decisions and suggests revisions
● Finance ministers have power to reject a resolution decision in certain cases
● Fewer checks on independent resolution board’s executive formation
● ECB has primary responsibility for declaring a bank likely to fail
As with every other EU agreement, the ambivalence of member states to cede meaningful sovereignty sabotages attempts at the very integration most believe is vital for the EU to survive in its current form.
The EU’s flawed bank deal remains a material threat to the EU and EUR, and makes the coming bank stress tests later this year the most likely driver of a new EURUSD downtrend at least, and quite possibly a pullback in risk assets in general.
A successful currency union requires a credible central bank authority that can quickly shut insolvent banks and provide enough depositor guarantees to maintain trust in the stability of the banking system. The current deal doesn’t do that.
- It’s probably too slow to avoid market panics, Unless you believe that over 100 separate voting decision-makers on multiple panels (along with their translators and other support staff) can reach reliably reach decisions within 48 hours.
- It’s almost certainly underfunded, even if it already had its full 55-70 bln, as noted above
- The national parliaments of Germany and other nations still can veto funding contributions (granted, we suspect the ECB can fill some gaps in an emergency, at least in the short term)
Although in a given situation the pact might not be too slow or underfunded, the mere questions doom it to failure by lack of confidence. If the above flaws weren’t enough to undermine confidence, then the required private sector losses will do the job. Large depositors, as well as lenders, and shareholders are the first in line to take losses, and THAT virtually assures us that a mere hint of trouble will be enough to start bank runs, interbank lending freezes, and bank stock selloffs. We learned this in the summer of 2012, when the Greek ‘voluntary’ bondholder haircuts shook Italy and Spain.
Too bad that lesson has been forgotten. Private sector bail-ins play well to voters, but scare off the investors and depositors the banks will need in order to avoid risking a bigger taxpayer bill from a banking crisis.
Meanwhile cash continues to flow into European assets on the assumption that the EU crisis is over. We don’t believe that, and remain bearish on the long term prospects for the EU until it starts taking meaningful steps towards greater integration. This banking pact was the EU’s first chance to show it could that member states were ready to cede sovereignty and cash to a central EU authority. It failed.
Now the big question is whether it will have the time to fix things before the next crisis hits. As things stand now the same flaws that caused the original sovereign debt and banking crisis remain.
The next big developments to watch in the EU are:
- EU Parliament Elections: These are expected to give anti-EU forces a stronger voice as popular support for greater integration has weakened further, making further steps to integration harder.
- ECB Bank Stress Tests: As we noted in past articles, member states remain fully responsible for any of their banks that fail the tests, the new deal doesn’t take effect this year. Spain (if not others too)is unlikely to be able to afford a major recapitalization without aid. Then what?
Ideas On How To Profit
The obvious thing to do would be to get ready to short the weaker GIIPS banks. However in the past various EU nations have banned the short selling of bank stocks.
In the event of a real EU bank crisis, stocks in general would drop, especially those most exposed to Europe, though it’s possible that there could be bans on all short sales.
Governments can’t stop short selling of currencies, so when the time comes, shorting the EUR and other risk currencies is a more reliable option. Those without spot forex accounts can consider shorting proxies, like the EUR ETFs (FXE) or going long USD ETFs (UUP) as the USD tends to move in the opposite direction of the EUR. Other safe haven assets like the JPY, or US and Canadian sovereign debt would likely do well too, of course.
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DISCLOSURE /DISCLAIMER: THE ABOVE IS FOR INFORMATIONAL PURPOSES ONLY, RESPONSIBILITY FOR ALL TRADING OR INVESTING DECISIONS LIES SOLELY WITH THE READER.