A Complete Guide to European Bail-Out Facilities – Part 3: Banking Union

While the Europhiles would like EU to move towards full fiscal union, with corresponding tax and spending harmonization, they have so far “only” managed to get Europe on track for a full-fledged banking union. Over the next 18 months we will probably see major changes in the European framework for banking regulation.

4.1.    Single supervisor Mechanism (SSM)

The first step toward banking union (and a pre-condition for direct recapitalization by the ESM) is the establishment of a centralized supervisory role by the ECB. More specifically, by mid-2014 the ECB will have the final responsibility for supervising all 6.000 banks operating within the Euro area. In practice, the ECB will only focus on “systemic important” banks with asset exceeding €30bn or constituting more than 20 per cent of their home country`s GDC.

Other less significant banks will be supervised by national authorities, but the ECB always reserve the right to directly supervise any bank. If a bank should ask for ESM help, the ECB will automatically be involved as a supervisor.

4.1.1. Asset Quality Review (AQR)

However, for the ECB to take on the role as outlined in the SSM, they have insisted on an asset assessment prior to transfer of responsibility. During the fall of 2013 a comprehensive asset quality review will be conducted across all European banks.

A stress test will ensue during the spring of 2014, before the SSM is formally handed over to the ECB in the second half of that year.

Given the many unsuccessful attempts by the European Banking Authority (EBA) to create confidence by similar stress test, investors should fear the same thing this time.

On the other hand, if the ECB would actually do a proper AQR and stress-test, they would find capital buffers to be severely inadequate. What then? The ECB will be granted no power to enforce resolution of any sort.

Will bankrupt banks be allowed to continue? Of course not, if an AQR turns out to be detrimental for a bank, investors will flee and the underlying solvency issue becomes an immediate liquidity issue and the bank is done for.

4.2.    Single Resolution Mechanism (SRM)

The Eurocrats has obviously thought about this, but a formal and uniform resolution regime will not be established until January 2015, at the earliest.

While the Germans oppose a euro area wide deposits guarantee scheme like the Federal Deposit Insurance Corporation (FDIC) in the US, the current proposal goes a long way to do exactly this.

4.2.1. Resolution fund

One of the pillars of the SRM is the establishment of a resolution fund. This will be built up over 10 years by levying a tax on financial institutions. After ten years, assuming the withdrawal from the fund has been modest, at least one per cent of covered deposits will be accumulated. While this fund of course will be a dynamic number in euro terms, by July 2013 it amounts to approximately €60bn.

4.2.2. Loss allocation and bail-in

The SRM also outlines loss allocation using the Cypriot example as a template. Based on the latest proposal for the SRM (No. 1093/2010 – 2013/0253 (COD)) we have deduced the current loss-absorption hierarchy.

Loss Absorption

Source: European Commission, Bawerk.net

In general, the resolution fund cannot make a contribution to the institution under resolution until an amount not less than 8 per cent of liabilities have been bailed in. In any case, the fund cannot invest more than 5 per cent of the institutions liabilities.

In extraordinary circumstances, whatever that may mean, extra funding may be sought (id est. the ESM, which has designated €60bn to bank bail-outs) as long as equity and unsecured creditors are bailed-in in full.

We also note that short term liabilities from interbank funding are exempt from any bail-in, while large corporation deposits are not. It does not take a genius to figure out that sophisticated corporations will then invest in the new short term money market funds that will specialize in deposit optimization and interbank lending.

There will also be a scramble for covered bonds, while the pricing of unsecured funding will increase dramatically.

In short, as investors try to climb the ladder of loss-absorption in order to enjoy an explicit government guarantee, banks funding structure will change significantly. This process will make debtors without state guarantee ever more exposed and pricing will be affected accordingly.

5. Concluding remarks

The reader should by now have a relatively good grasp on the sheer destructiveness our masters are willing to put their minions through in order to maintain a rotten system.

Needless to say, all the programs enacted by the Eurocrats do not “trickle down” to the hard  working middle class, but only help enrich the politically connected.

They are all designed within the Keynesian framework which basically views an economic system in terms of confidence. For example, it does not matter that the Target2-system enables Spaniards to consume capital saved by Germans. They see no problem in this! All they see is a system that maintains trade between two nations and that can only be a good thing since it keeps spending going.

Reality is obviously quite different and the long term consequences of European policy today are enormous. As Henry Hazlitt once said, “The art of economics consists in looking not merely at the immediate but at the longer effects of any act or policy; it consists in tracing the consequences of that policy not merely for one group but for all groups.”

What is good for one group can be detrimental for all groups. While the visible short term effects – continuation of north-south trade – can be analyzed by a five year old, only a true economist are able to trace the long term consequences.

Eurocrats, pundits and commentators are by this definition not economists, but cranks. They help us analyze what is there for all of us to see, and behave like hapless children claiming they could not know it would end in misery! They are dangerous because people listen to them.