What sparked yesterday's renewed concerns around the eurozone?

Over on his Forbes blog Open Europe's Raoul Ruparel provides a comprehensive analysis of the renewed concerns around European banks, centred around Banco Espirito Santo (BES), which saw stocks falling across Europe yesterday. The full post is here and reproduced below.

Firstly, there’s no doubt there are some valid concerns surrounding BES, the key ones of which are:

• The ownership structure is a mess. BES is 25% owned by Espirito Santo Financial Group, which is 49% owned by Espirito Santo Irmaos SGPS SA, which in turn is fully owned by Rioforte Investments, which is fully owned by Espirito Santo International (last two are based in Luxembourg).
• The exposure between these level is equally opaque, with the WSJ highlighting back in December that ESI was utilising different branches of its structure, including BES, to fund itself up to the tune of €6bn. Currently, BES has admitted it has the following exposure: €980m debt from Rioforte, but it also helped place €651m of debt issued by Rioforte and ESI to retail customers and €1.9bn to institutional clients.
• This debt could essentially be worthless or massively written down. It’s not clear how open BES was about its conflicts of interest and if it mislead buyers. There is a serious risk of lawsuits here. Citi has put potential total losses at €4.3bn, this could wipe out BES capital buffer and force it to raise a similar amount again.
• BES also has a worrying exposure to its subsidiary in Angola which is draining €2bn worth of funding. This is substantial for a bank with a €6bn loan book. The bank has also required a 70% guarantee from the Angolan state, which itself has a poor credit rating meaning the usefulness of such guarantee may be limited (the fact it was needed at all says a lot). This has also been weighing on the share price.

All this culminates into some very real concerns. While there are plenty of unfounded rumours flying around, the fact is they are hard to disprove because the structure of the bank and its affiliates is so maddeningly complicated. The exposure has also been continuously underestimated and hidden so it’s only right to ask, what else might they be hiding?

But all of these are very specific BES problems, why has this suddenly sparked Europe-wide contagion. I believe there are a few factors behind this:

• The market has pulled too far ahead and was looking for an excuse to pull back. The market is also in a bit of a price discovery phase, still trying to figure out how to balance the issues of low inflation, search for yield, remaining eurozone risks and future ECB action, so it can be prone to sharp moves. The lower volumes and liquidity in certain markets may also exacerbate the move. Lastly, with the recent market convergence, there is bound to be more spill over between and within markets. All to say, part of this may be the confluence of market factors and circumstances – such a situation can last but is more likely to be temporary.

• More importantly though, investors are realising that, if the bank got into trouble it would have to rely on its sovereign for help. The bank cannot afford to recapitalise to the tune of €4bn. Equally though, Portugal (in the midst of trying to find further budget savings) would struggle to stump up the cash – hence the sovereign spill over. Talk of the sovereign-bank loop being broken are seemingly premature (as I have said before). 

• On top of this, investors are also looking at a lot of uncertainty about how a bailout/bail-in might work and what the exact rules would be. The eurozone’s rules on bank bail-ins and the single bank resolution mechanism don’t kick in for some time and while the state aid rules make it clear investors will take losses the exact format is very uncertain. These two points should once again peak investors’ concerns about how such bank resolutions might be handled. Throw the political obstacles in the mix surround a national flagship bank such as BES and one might wonder how much has really changed since such questions were asked at the peak of the crisis.

• More generally, BES’s problems show some elements indicative to periphery banks (particularly in Portugal and Italy). It has a very old, complex and opaque structure and its exposures are still not well known. Too little attention has been paid to this in the past year. The loan books are also weighed down by investments and lending to zombie firms. Let’s not forget, these two countries did not suffer from bubbles but chronic low growth and high corporate debt levels – neither of which has been tackled.

There are clearly some lessons in this situation for eurozone investors and they would do well to remember the short comings in the eurozone architecture, particularly when it comes to the banking sector which is yet to be cleaned up even after six years of crisis. That said, given the specific nature of the problems it is unlikely to mark a huge turnaround in market sentiment. Sure, the market will pull back a bit but we still have the injection of the new ECB lending operations (TLTRO) to come and the hope of some positive data on the GDP and inflation front.

One final point out of all of this is to watch how BES does in the upcoming ECB Asset Quality Review (AQR) and bank stress test. If it is not seen to have been rigorously assessed and problems highlighted then serious questions will begin to be asked about the credibility of an exercise. Now, the failure of the AQR would really be the start of bigger problems for the eurozone. 

When it rains, it pours – EU legal opinion puts UK on backfoot over revamped Liikanen rules

It’s not shaping up to be a great month for the UK government with respect to the EU – a pretty poor showing at the European elections, a looming defeat over the Spitzenkandidaten process and now, just to top it off, a troublesome legal opinion from the European Council legal service.

The FT and Reuters overnight reported on a leaked legal opinion from the European Council legal service which looks at the new rules on proprietary trading and the structural reform of the European banking sector published in January.

As a reminder, these proposals are the offspring of the Liikanen report and we covered them in detail here.

The wider political importance of these reforms relates once again to how much control the UK can retain over how to structure, regulate and, by extension, supervise its own banking sector (which, lets not forget, it continues to backstop alone) in light of further eurozone integration, which it cannot be part of. And whether the EU can be flexible enough to accommodate this.


The legal opinion, which Open Europe has seen, is a blow to the UK because it focuses on the specific article of the legislation which allows the UK and other member states which already have reforms aimed at overhauling or ring fencing their banking sector in place (such as the Vickers reforms).  The opinion notes that:

“The derogation mechanism established in Article 21 of the proposed Regulation is not compatible with the legal basis of the proposal, with the nature of the proposed instrument as defined in the TFEU and with the general institutional principles established in the Treaties.”

There are a number of justifications for this judgement given (these are the arguments of the council legal service not OE):

• Firstly, any derogation under the single market article (Art 114) should be “temporary” according to the treaty. Since the derogation seems to be permanent it falls foul of the treaty here.
• Secondly, allowing for exemptions here breaks Article 288 of the EU treaties because it stops the “general application” of a regulation across all member states. It also falls foul of the “uniform application” of regulations across member states.
• Thirdly, the legal service does not buy into the justification for the derogation, suggesting that the costs of changing legislation to meet EU rules would not be prohibitively high. This sets it apart from previous instances where objective justification has been given. Furthermore, the use of the derogation is reliant on member states making an application and does not rely solely on the Commission.
• Fourthly, the derogation only applies to countries where similar legislation has been passed before 29/01/14 – the opinion stresses that no justification is given for such a date and calls for more explanation. This cut-off date also means the exemption applies differently to certain countries which happen to already have passed their own legislation. On top of this, it only applies to certain credit institutions.
• Finally, since the exemption essentially allows national law to take precedence, it questions the primacy of EU law.

The legal services suggest a number of remedies including: allowing the derogation for a specific temporary time period, clearer justification for the cut-off date, adopting the legislation as a directive rather than regulation (allowing for greater national flexibility) or dumping the derogation altogether.

As we noted previously, the target adoption date for these rules is January 2016 and there are plenty of negotiations still to come, as such this opinion, while a blow to the UK, is the not the end of the discussion by any stretch. As the remedies suggest, there are options open to the UK and others for adjusting these rules.

Furthermore, there are plenty of other controversies in the rules, such as how to properly define proprietary trading and how all the technical standards are defined. This one will run for some time still.

The long lost Liikanen report returns – but it looks pretty different

Has the Liikanen report become the Barnier plan?

Update 30/01/14 11:45:

Some eagle eyed HM Treasury officials have flagged up that the recitals of the proposal (the preamble points before the articles of the regulation) do allow for the derogation to apply to secondary legislation as long as the key primary legislation has been passed. As we note below, this is the case with Vickers and the UK therefore certainly counts for the derogation. It is a bit strange that this isn't also spelt out in the article of the proposal but its inclusion is likely to be more that sufficient for the UK.

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Okay, maybe long lost is an exaggeration, but it’s certainly been off the front line agenda for some time.

The time away from the spotlight has been used to significantly overhaul the European Commission’s flagship proposal on reforming the banking sector in the aftermath of the crisis.

Here’s the full proposal, out this morning, while here are the press release and Q&A.

While the proposal was always expected to be the offspring of the Liikanen report, in this case the apple has fallen quite far from the tree. The proposal is quite a change from the original report and as expected focuses more on a Volcker-style rule on proprietary trading rather than a significant separation of large banks. That said, the focus remains on separating off risky trading activities, meaning the main impact is a lessening of scope. We outline our thoughts below.

A reform overtaken by events?
While this was originally flagged as a key proposal, it has been a long time coming. In the meantime, a new single supervisor has been created, new plans on capital requirements, a new macro prudential framework, new plans on bank bail-ins and a new bank resolution scheme have all been substantially developed. The new framework for the financial sector has largely grown up without this proposal, and how exactly it will fit in – both in terms of timeline and structure – remains unclear.

An EU Volcker rule – the Barnier rule?
The key part of the new proposal is a ban on “proprietary trading in financial instruments and commodities, i.e. trading on own account for the sole purpose of making profit for the bank.” While this is well intentioned, it does come with some complications:

• It has proved very difficult to identify what exactly classifies as proprietary trading, compared to necessary trading to manage risk and to act as a market-maker.
• The current definition in the proposal is fairly narrow, and refers to activities specifically dedicated to making a profit for the bank itself. In other words, it looks as if it could be fairly easily side-stepped. It also exempts trading of government bonds and money market instruments for cash management.

Separation power – moving away from national control?
As we have noted before, the prospect of a supranational body ordering the break-up of a flagship national bank has the potential to be incredibly explosive. The banking union has brought this closer, but final decision on how to resolve a bank remains mostly national. This proposal would allow such a decision to be taken not just to resolve a bank, but also if its non-retail activity was impacting financial stability. However, it seems that the final say will now rest with the ‘competent authority’ (a definition which is never spelled out), which in the case of large eurozone banks would likely be the ECB as the SSM (Single Supervisory Mechanism).

Has the UK secured a derogation?
As expected, a clause has been included on a general derogation (not specific and only applying to the separation rule not the prop trading ban) which allows for the rules on separation to be superseded by any national rules which aim to achieve the same goals. While Vickers would certainly qualify on this front, the text specifies that the derogation can only apply to legislation adopted before 29/01/2014. Currently, all legislation relating to Vickers is not expected to be adopted in the UK until mid-2015. However, the key banking reform act (which includes the ring-fencing plans) was made into law in December.

For the most part then, it seems the UK has secured a derogation, which can be put down as a small but important win for the government. Plenty of other states have also secured scope for their national plans.There is clear encouragement in the wording for states who are yet to put a comprehensive system in place, to adopt the EU framework. That said, with lots of different national plans in place, one has to question how effective this system will really be.

A long way to go
As the points above suggest, this remains a controversial proposal and negotiations will be tricky. Little should happen this year, due to the European Parliament elections and the new Commission entering office. Assuming the next Commission picks up the same proposal (which is not guaranteed) the aim is to have the necessary legislative acts approved by January 2016, with the prop trading ban coming into force at the start of 2017 and the separation powers in mid-2018. As with some of the other regulations, it seems the EU response to the financial crisis will only be in place a decade after the crisis hit.

These are just some of the key points of contention upon first reading. There is much more to go in this process with the input of member states and the European Parliament likely to be very different, and sometimes even adversarial. There is also a lot of scope for the rules to be altered using delegated acts and technical standards – these will ultimately determine how the prop trading ban and separation rule work in practice.

So far, a large part of the banking sector (mostly smaller banks) will probably be happy. Larger banks will see it as an improvement, but will likely push for a further watering down. Questions can still be raised over whether costs will be passed onto consumers and whether it will really help limit risky activity, which can often be related to mundane retail bank activity. But then the idea is that other parts of the framework will also help limit this effects.  

In any case, the proposal is likely to once again fall away from the frontline and it could yet come back with a different face once again.

An EU bank bailout facility?

Bloomberg reports on a potential proposal by the European Commission to alter the EU’s ‘Balance of Payments’ (BoP) facility to allow it to aid banks which may need to be recapitalised in the aftermath of next year’s ECB Asset Quality Review and the EU's bank stress tests.

As a reminder, the BoP facility was originally created to aid countries with currency crises that may impact the rest of the EU or the fundamental stability of the state. It has since been adjusted to apply to only non-euro members and seen its scope widened slightly with its budget increased to €50bn due to the financial crisis. It is guaranteed by the EU budget and therefore ultimately by the member states - with the UK underwriting around 14-15%.

What is the rationale behind this move?

• Next year’s stress tests are hopefully going to be the most stringent and comprehensive so far, yet there are fears that, without clear aid to help banks found to be in trouble, supervisors may shy away from revealing any deep problems.
• This is backed somewhat by the ECB’s insistence that the stress tests will not be able to be effective unless there are clear backstops for banks in place.
• The eurozone does have some form of backstop in the shape of the ESM which can provide aid to banks (via states) but also has a direct bank recap tool.

Can it be done?

• The most likely approach would be to use Article 352 (the flexibility clause) to adjust the regulation establishing the facility.
• However, the facility also has a treaty base, Article 143, which specifies lending to states. For this reason, it seems unlikely that a direct recapitalisation tool could be added but a credit line which is lent to states to solely aid banks could potentially be. This could come with less or more specific financial sector conditions than other loans (for example see ESM and Spanish bank bailout).
• This would require unanimous approval in the Council. So far, Germany and the UK have expressed scepticism based on the fear that a backstop would reduce the pressure on banks (and their governments) to reform and clean up ahead of the tests.

Could it be significant?

• Yes. If it were approved it would create a collective fund to salvage banks should a member state be unable to deal with the problem alone. If the UK were to approve the move it could open up the door for future pay-outs of funds to aid other countries' banks – decisions taken under qualified majority voting. 
• Furthermore, it also seems to be driven by events in the eurozone. Firstly, it seems an attempt to extend this centralised banking union model (to break the so-called sovereign-bank loop) to the entire EU - even though the other countries have already rejected this to a large extent. If they really wanted to join the banking union, which some might, there will be chances for them to engage directly.
• The creation of the fund would raise some serious questions. Will this backstop exist without strong influence over the amount of risk taken in or the relative size of banking sectors to governments across the EU? If so, surely that creates a moral hazard problem. If not, it would necessitate far greater powers over member states' financial sectors. 
• Lastly, it highlights the level of concern around the health of many of the EU's banks. This was furthered by the EBA's recent assessment that the largest EU banks are some €70bn short of where they need to be to meet the new Basel III rules.

A subtle shift in German policy on banking union?

With talk of the upcoming German elections dominating over the weekend, a potentially important yet subtle shift for post-German election policy on banking union may have received less coverage than it ought to have.

Reuters reported on Saturday that Germany is working on plans to create a single eurozone bank resolution mechanism (SRM) within the EU framework without the need for changing the EU’s treaties – something the German government had previously insisted was necessary because it deemed the Commission had no legal base for the proposal to give itself the power to order banks to be wound down. Bloomberg followed this up with a report suggesting a tentative agreement had been struck with the Commission which would see the new resolution fund cover only the largest eurozone banks, thereby exempting the German savings banks (and their large pool of deposits).

German Finance Ministry spokesman Martin Kotthaus has since played down any German proposal, but stressed that "very many other member states" have also raised similar concerns to those of Germany.

It remains early days then, with lots of negotiating still to go but this could have important implications for the eurozone and the UK which are worth exploring.

What could this mean for the eurozone?

• As we have noted, Germany essentially had two choices following its stark rebuke of the Commission’s SRM plan – either work within the framework to alter it or propose an intergovernmental alternative (a similar ad-hoc set up to the temporary bailout fund EFSF). Judging from these developments it seems to have gone for the former, on the surface this is positive for the eurozone since any SRM enshrined in EU law will look more lasting and solid.
• That said, the German plan (if there is one) would clearly involve further watering down a mechanism which already looked woefully short of what was needed to help shore up the eurozone banking sector.  The crisis has clearly shown that smaller parts of the banking sector can cause significant problems (see Spanish cajas).
• The Commission is likely to have less responsibility but it remains unclear where the power will lie. Creating a new institution is impossible without treaty change while using existing ones for eurozone-specific tasks creates serious questions about the single market. The fundamental question of who decides to wind down a bank in crisis remains unresolved.
• Even if the above issue is settled, oversight of the banking sector would still look fragmented with many different institutional layers including – national regulators and supervisors, the ECB and the new SRM as well as possibly the ESM. Furthermore, the Council of Ministers, European Parliament and national parliaments will all have a role in decision making and/or accountability.
• Other problems, including the size of any resolution fund, remain – as we have pointed out. Last week’s legal opinion from the Council of Minister's legal service noted that the national budgetary implications of an EU bank resolution mechanism meant that the Commission's proposed legal base might need to be rethought.

What does this mean for the UK and other non-eurozone countries?

• How the SRM is established could well set the tone for future eurozone integration, therefore ensuring it does not alter the dynamic of the EU to serve eurozone ends using a single market legal base is important for both the UK and other non-euro countries.
• That said, a purely intergovernmental legal arrangement, outside the EU treaty, could reduce the UK's ability to influence the outcome still further. The upshot being that there probably needs to be a treaty change to ensure eurozone crisis resolution is kept distinct from and yet compatible with the single market. 
• Despite this latest attempt to avoid treaty change, Finland has also voiced concerns about the legal base for the SRM, while Germany still has concerns about the separation between the single supervisor function and monetary policy at the ECB - suggesting treaty change as solution. So, both are still keen on shoring up the banking union via treaty change in the not too distant future.

Some interesting developments then, but a long way to go yet. In any case the time line for the banking union looks the same with the process being phased in over the coming years to 2018 – far from an immediate solution to the crisis.

Meanwhile, the whole discussion over the extent to which the treaties can be stretched to help solve the eurozone crisis once again reminds us of the inherent tensions and structural flaws in the current eurozone/EU setup. Even if not done through the banking union, this will have to be settled at some point.

Spotlight on Slovenia

Back in the spring, we looked at who might be next in the line of eurozone bailout requests. It's now looking increasingly likely that one of our predictions, Portugal, will require some form of further assistance to fully exit its current bailout. Now, suspicions are rising that our other tip, Slovenia, may need external aid in a not-too-distant future.

Today and yesterday, eurozone finance ministers have been meeting in Lithuania with aid for Slovenia (as well as Greece, Portugal and Ireland) top of the eurozone’s agenda.

Recap – What problems is Slovenia facing?

• The banking sector is nursing a possible €7.5bn (21% of GDP) capital shortfall. Although Slovenia’s government debt remains very manageable (at 54% of GDP) it could increase quickly due to a toxic combination of collapsing economic growth and spiralling costs of bailing out banks.

• As we noted back in the spring, provisions against this capital shortfall are far below the levels needed and covered at best half of the problematic loans. Since then, the level of bad loans has increased, while little progress has been made on recapitalising banks. The recent bailout of two small banks cost a combined €900m+, and included a bail-in of subordinated debtors. This could set the tone for the approach to the rest of the sector. Worryingly, this is also around the total amount previously estimated for the capital needs of the whole banking sector.

• The European Commission has pushed the independent bank stress test to be expanded to cover the whole banking sector. The results are expected at the start of next month, and could well reveal deeper holes in Slovenia banks. Filling these without external aid will be tricky.

• Non-financial corporations also continue to struggle under a mountain of debt, with a debt-to-equity ratio of around 200%. This will be a significant drag on the economy for some time as firms shrink and deleverage while many could well shutter for good. This of course has further knock on impacts for the level of bad loans at the banks and the level of unemployment.

• Austerity has been limited so far with the government deficit at around 8% of GDP (and possibly set to increase this year). Significant cuts will still have to happen and, as we have been at pains to point out before, the combination of bank deleveraging, fiscal consolidation and struggling domestic demand can create a very painful downward spiral.

• The privatisation programme has failed to get off the ground, with the only sizeable move so far being the €240m sale of retailer Mercator.

• Concerns also remain surrounding the significant amount of cronyism and corruption at play, particularly within state owned firms and within the financial sector. The government has recently moved to crack down on the shadow economy with wider taxes, although whether this will prove successful remains to be seen.

Despite these issues, German Finance Minister Wolfgang Schaüble struck a positive tone today, saying,

“I think if they stay strictly on course -- and they’ve said that want to do that; they’ve supplied two small banks with capital over the weekend -- then they’ll manage without it…So as long as Slovenia itself says they can manage it, we should encourage them in that.”

EU Economic and Monetary Affairs Commissioner Olli Rehn voiced similar sentiments. So far then, Slovenia seems to be happy to go it alone and (possibly with other things on their minds) Germany and others are happy to acquiesce. But with the ECB reportedly increasingly concerned about the state of the banking sector, the upcoming stress test results could be a turning point – assuming of course they are judged credible (far from a given). 

If any aid is eventually forthcoming, as we’ve argued before, it seems much more likely to take a similar form to that in Spain than in Cyprus or elsewhere.

Ireland prepares to exit financial assistance…with further assistance…

Talk surrounding the Irish exit from its bailout programme has been picking up in recent days and weeks given that it is supposed to get off its current bailout programme at the end of this year (the final disbursement of funds is expected sometime in November).

The last few days in particular has seen increased interest with Eurogroup head Jeroen Dijsselbloem telling the European Parliament yesterday that there would be “measures to support [Ireland’s] gradual exit” from its programme. Irish Finance Minister elaborated on this suggesting that Ireland will seek a €10bn credit line to help aid its transition back to fully funding itself.

All this means that it is looking increasingly likely that Ireland will request some form of ESM credit line towards the end of the year. This could take two forms:

Precautionary credit line (PCCL): open to eurozone states that have sound economic and financial situation including: sustainable public debt, access to capital markets, sustainable external position and solvent banking system (amongst others).

Enhanced credit line (ECCL): essentially for member states who do not meet the criteria for PCCL but do not require a full bailout programme. Conditions will involve improving shortcomings that prevent PCCL access.

Looking at the above criteria Ireland is likely only to be eligible for the ECCL, given the on-going banking sector issues and the questions over debt sustainability after the bank bailout. The procedure is pretty similar to any other bailout request and given Ireland's relative success in implementing reforms, approval seems likely. Importantly, “enhanced surveillance” (read strict conditions) will apply in either case, so Noonan’s hope that this can be done without further austerity and/or reforms seems unlikely to be fulfilled.

The key aim of such a loan is to gain access to the ECB’s OMT, its bond buying programme. Under a credit line Ireland would be eligible for the OMT as the programme applies the much needed conditionality. The combination of the loan (the size is not particularly important) and the OMT means it may not have to be tapped.

All that said and despite the many resounding endorsements for Ireland’s progress, many problems remain. In particular, toxic loans at Irish banks continue to increase while households struggle under the burden of such loans. The issue of how to deal with the public debt created by the previous round of bank bailouts remains unsettled and leaves a cloud hanging over the Irish economy.

Bank bail-in plans finally agreed, but its only a small step towards banking union

Despite some sizeable differences, EU finance ministers finally managed to reach an agreement on the bank bail-in plans last night (after only 25 hours of talks in the past few days). As always with this type of EU deals, it is a compromise and often an imperfect one. The agreement was much as expected in the end, given the drafts circulating over the past week. Below, we lay out the key points and the positives and negatives of the deal as we see them.

Key points

• Some more flexibility included, with government allowed to inject funds but only after minimum bail-in of 8% of the total liabilities of the failing bank – although such intervention is capped at 5% of the bank’s liabilities.
• The ESM, the eurozone's bailout fund, can also inject funds but only after all unsecured bondholders wiped out.
• The UK secured wording which allows it to avoid setting up an ex-ante resolution fund, as long as it is already receiving funds from the bank levy and/or stamp duty. Sweden also secured an adjustment to the text which allows for it to maintain its current model to a large extent.
• The agreement sees the bail-in plans coming into force in 2018, while the directive as a whole still needs approval from the European Parliament - so it could yet change.
• Certain creditors are excluded: insured deposits, secured liabilities, employee liabilities, interbank and payment liabilities with maturities of less than seven days. National resolution authorities can also exclude other creditors in exceptional circumstances.
• As in earlier drafts, insured deposits are completely protected, and the preference given to SMEs and individuals deposits (see here) has been retained as well.

Positives

• Reaching a deal is positive in itself, as it adds some much needed certainty following the Cypriot crisis. It also keeps the progress towards banking union inching along.
• The burden has been shifted away from taxpayers towards bank creditors.
• The added flexibility is important between eurozone and non-eurozone countries, with the UK and Sweden scoring some important caveats. The deal highlights that non-eurozone countries can still have influence on such rules and the acceptance of the need for flexibility between the two groups.

Negatives

• From a eurozone point of view, the flexibility could be counterproductive, particularly the use of exemptions in exceptional circumstances. How exactly will this be defined and determined? If at national level, then there could be clear political pressure in a crisis to invoke this. For example, it is hard to imagine that the crises in Greece, Portugal, Ireland and Spain would not have triggered this in some way.
• Could see cost of bank funding rise, particularly in terms of unsecured credit due to fairly strong depositor preference.
• Lots of unanswered questions – not least, when and how will these rules apply? It’s not clear in exactly what situation and at what time the new rules would kick in. Does it rely on a request for aid from the bank or the national government?
• Furthermore, there are questions over how this will work practically in different circumstances – for example, the difference between a bank which has almost completely failed and one which is simply struggling to recapitalise.
• The timeline also still seems very long, with the actual bail-in rules not in force until 2018, even though the directive is due to be in place by 2015. That said, the broad template may well still apply, particularly where banking union is involved.

In the end, this seems to be a reasonable compromise - not least because all sides seem fairly happy. It’s clear than a new set of rules was needed with the focus on creditors rather than taxpayers. That said, though, this is in the end only a very small part of banking union and the pace at which the eurozone is proceeding towards it remains fairly limited.

The key remains the single resolution mechanism and/or authority. As we have argued before, until this is in place it is hard to see how the poisonous sovereign-banking-loop will be broken or how cross border lending will begin flowing freely again. Until that is settled, the effectiveness of other factors such as the bail-in plans will remain unclear at best.

Bank bail-in plans: is France becoming nervous about being left alone with Germany?

As we have pointed out repeatedly, those who think that the eurozone is one German election away from a full banking and fiscal union (which includes a surprising number of British eurosceptics) should have another look around Europe.

As we noted last week, the latest draft of the bank recovery and resolution directive left plenty of questions unanswered.

[Background - this is the proposal which looks to establish a clear and standardised pecking order for losses in the instance of a bank failure. It is not the full 'banking union' proposal, which involves some form of combined backstop. Despite being first suggested as far back as 2010 and with a proposal put forward last summer which was largely ignored, this has become an important piece of legislation since the Cypriot crisis.]

That EU finance ministers failed to reach an agreement after 18 hours of talks on Friday is therefore not entirely surprising. What is perhaps slightly more surprising is the dividing lines and in particular which countries found themselves arguing the same side.

We highlighted before where each country broadly stands on this issue. This does not seem to have changed much, although the focus of the discussions has. Previously, much of the emphasis was on ‘depositor preference’ – i.e. when and to what extent uninsured depositors would face losses during a bank bail-in. Not exactly surprising given the Cyprus debacle.

A broad consensus seems to be emerging around a structure which protects insured depositors completely and gives added seniority to those uninsured deposits held by individuals and small and medium size enterprises. With the pecking order broadly settled, focus has shifted to the level of flexibility allowed within the structure, in particular whether bail-ins should be automatic or whether there should be sizeable national discretion to decide on which format to use.

This debate has seen the EU split into two broad groups: 

• One led by France, the UK and other non-eurozone countries, arguing for greater flexibility and national discretion – although presumably for different reasons, the UK because it fears its financial sector is larger and more varied than many in the eurozone and France because it is keen to keep open the option of a bank bailout due to fears automatic bail-ins could increase funding costs (souveraineté). 
• The second group is led by Germany and the Netherlands, both of whom are keen to limit flexibility to allow for a standard framework across the eurozone and also partly because they fear governments will put domestic political needs above those of the single currency as a whole. This is a trust issue as these countries' taxpayers may one day have to stand behind the continent's banks.

Ignoring the technical details for a bit, the wider political dynamic at work here is fascinating. France is actually on the side of the non-eurozone countries. This is bending assumptions as it's usually France that is the keenest on doing stuff at the level of 17 rather than 27, as Paris is proportionally stronger in that smaller constellation. Germany, on the other hand, prefers 27 to 17, for the opposite reason.

There seems to be good reason to expect some greater flexibility for non-eurozone countries, with the idea reportedly gaining support towards the end of negotiations.

Now, we don't want to read too much into this but first, this dynamic suggests that France could actually find itself isolated within the eurozone (we're looking forward to that FT headline). Secondly, as we have mentioned in the past, perhaps this is another indication of how Paris - who used to see the euro as a way to lock in Germany - is actually getting quite nervous about losing the UK as a balancing force in the EU.

As ever in Europe, there's always that political sub-story worth keeping an eye on.

Eurozone compromise on using ESM to directly recapitalise banks - a stopgap at best?

Eurozone finance ministers finally reached a compromise yesterday which will allow the ESM, the eurozone

bailout fund, to directly recapitalise ailing banks.

This is likely to be an important element of any ‘solution’ to the eurozone crisis, especially since it will probably be incorporated into the plans for a eurozone banking union and single bank resolution fund.

Below we summarise and analyse (in bold italics) the key points of the agreement:

€60bn limit: ESM funds available for direct bank recaps will be limited to €60bn out of the total €500bn, since this method of funding eats up the capital of the ESM more quickly. Given the size of the eurozone banking sector – around €34 trillion or 360% of eurozone GDP – this seems far from sufficient.

Burden sharing: National governments will have to contribute 20% of the funds for the first two years and 10% thereafter. Furthermore, ESM funds can only be injected once the bank has reached a core tier one capital buffer of 4.5% - any recapitalisation to achieve this minimum level will also fall on national governments. This is a logical compromise, but it means that the link between sovereigns and banks is not completely broken. It is only "diluted" (as EU Economic and Monetary Affairs Commissioner Olli Rehn put it). Combined with the above funding limit, this places some tight constraints on the level of capital injection possible.

Strict conditions: The funds can only be used for banks which are deemed 'saveable' and have no other alternative. These banks must also be systemically important (in the relevant member state at least). It must also be impossible for the member state to bailout the bank on its own without harming its fiscal sustainability. There must also be independent stress tests performed ahead of any ESM contribution. Any contribution will come with strict conditions both on the bank and possibly on the member state.

Bail-ins: The agreement states that “sufficient contributions from existing shareholders and creditors of the beneficiary institution”will need to be explored. This suggests that the final agreement on the Bank Recovery and Resolution Directive will play an important role in determining how and when this fund is tapped. The emphasis on bail-ins is of course positive but until related plans are settled uncertainty will remain.

Final liability: A subsidiary of the ESM will be set up to directly purchase equity in ailing banks. This allows final liability for the rescue programme to rest with the ESM rather than states.

Retroactive use (legacy assets): The funds can be used to retroactively takeover the burden of previous bank bailouts, although this will be decided on a case-by-case basis. German Finance Minister Wolfgang Schäuble described this as "a concession to our Irish friends". This gives hope to Ireland that the cost of its bank bailout can be shifted. However, given the above limits and the conditions, this still seems a distant prospect.

At first look then, it is positive that an agreement has been reached but this looks to be a stopgap at best. It is clearly tightly constrained by the limits on lending but also by the conditions – in particular the need for a strict independent stress test which could eat up precious time in a crisis. The hurdles to retroactive use are also significant – there is far from sufficient funds to cover for the Irish, Spanish and Greek bank bail-outs (up to €125bn in total), while opening a country's economy to further oversight is far from desirable.

To be fair, given how tied in this is with the single bank resolution mechanism, banking union and the Bank Recovery and Resolution Directive, it may be too early to fully assess how effective it might be. It's also worth noting that the plan will likely need approval from some national parliaments, notably the Bundestag (H/T Bruegel).

The most conerning point is probably that if this is a precursor to the eurozone's single resolution mechanism, it is likely to fall short of fully breaking the dangerous sovereign banking loop in the eurozone.

EU edges towards compromise on bank recovery and resolution plans

Tomorrow and Friday will see the next round of meetings between eurozone and EU finance ministers respectively.

The meetings will focus on a number of issues, but the key ones will arguably be the Bank Recovery and Resolution Directive (BRRD) and the plans for a single eurozone resolution mechanism.

The full agenda is spelled out in detail in this background briefing.

As we have noted before, the proposals for new rules for bank resolution are quite controversial and have caused significant splits both within the eurozone and the EU more generally. See our previous blog here which laid out each EU country's position.

Ahead of the meetings, we have managed to get a look at the latest draft of the Recovery and Resolution Directive. Despite being 300+ pages, it makes for some interesting reading.

From what we can see there are two key changes:

1. A compromise on depositor preference:
The previous draft looked to establish a clear hierarchy for bank bail-ins and put uninsured depositors on level pecking with other senior creditors. This draft moves away from that towards a bit more depositor preference. It says:

“In order to provide a certain level of protection for natural persons and micro, small and medium enterprises holding eligible deposits above the level of covered deposits, such deposits shall have a higher priority ranking over the claims of ordinary unsecured, non-preferred creditors under the national law governing normal insolvency proceedings.”

So under the current plans, insured depositors are the most senior, as previously. Uninsured (i.e. over €100,000) deposits from individual private citizens and SMEs will also be given preference over other senior creditors. Essentially, large firms' uninsured deposits will rank level with senior creditors (bondholders etc.)

As we noted before, this is similar to an idea put forward by Italy, but is also likely to appease France, Spain and Portugal.

2. A reduction in ex-ante funds
This is another controversial measure, with many (including the UK) disputing the usefulness of ex-ante funds (funds which are collected on an on-going basis and are therefore in place before any crisis). In the latest draft, the level of ex-ante funds has gone from 1% of all deposits to 0.5% of covered deposits – a fairly sizeable cut given that covered deposits are only a proportion of total deposits.

This looks like a concession to the other side of the spectrum, including the UK, Netherlands and Denmark.

Some concessions on key points to both sides then, as may have been expected. That said, there are likely to be plenty who are unsatisfied by the current draft and hopes of a final agreement this week may be premature.

We’ll keep trawling through the mammoth doc, and bring you any important developments.

More of the same expected from the ECB despite eurozone economic malaise

The ECB holds its monthly meeting tomorrow. Below we look at the main topics of discussion, with the ECB weighing some important decisions.

Could the ECB cut its main interest rate again?

• Possibly. It is certainly considering it. As with last month, growth and inflation have remained subdued, providing further incentive and scope for the ECB to cut rates.
• There has not been a significant downturn on either front however, meaning many do not expect further action.

The ECB is considering a negative deposit rate
Most reports suggest the ECB Governing Council is split on this issue. At the least this means it is unlikely to push ahead with it. We also believe the problems and complications outweigh the benefits. There has been much written about this but below we summarise the key points.

Logic: banks are now charged for holding large excess reserves (deposits) with the ECB, this will hopefully encourage them to make loans on the interbank market and make more loans to the real economy rather than holding the money at the ECB.

In favour:

• Banks and investors look for higher returns and begin lending cross borders again. This aids financial integration and could help tackle other issues such as the large Target 2 imbalances.
• Increases the amount of times money is circulated through the economy (the velocity of money) as lenders try to avoid getting stuck with excess cash. This could in theory help boost inflation and growth.

Against:

• Contrary to prevailing logic it could actually cause a drop in liquidity. As excess reserves become more expensive banks begin repaying loans they have taken from the ECB. All the while they are deleveraging (may even speed it up), causing less money to flow to the real economy.
• Rates could actually rise for a number of reasons. Larger number of weaker banks forced onto the interbank market. Banks may simply look to pass on increased costs to consumers.
• If banks do not pass on costs or deal with them, then profits will be hit – in many cases they are already worryingly low.
• Could increase the flood of money to safe assets, particularly from the core eurozone countries. The return on these would become even more negative, increasing their costliness and driving divergence with the rest of the eurozone.
• The large money market fund industry, which plays an important role for liquidity in bond markets, could struggle to stay afloat since it relies on small positive returns on safe short terms assets (see above points).
• The euro is likely to weaken, this combined with the other effects could cause a large outflow of cash to other parts of the world, exacerbating problems.

What about all the talk of boosting lending to small businesses?
This focuses around the creation of a new market for securitised loans to small businesses. The logic being: banks make these loans, package them together into securities and then sell them on to other banks and investors. There is a clear demand for quality assets which provide a decent return meaning there could be demand for such securities.

However, the ECB has backed away from grand plans on this issue. As we pointed out previously it was always very hesitant about purchasing such securities itself, with the Bundesbank in particular opposed to such action.

More of the same seems likely
With things ticking over the ECB is likely to hold off on any further drastic action at its meeting tomorrow. It will continue to emphasise that monetary policy will remain loose for some time (the concept of forward guidance which it began to adopt last month to some extent). It may also put more flesh on the bones of schemes to work with the European Investment Bank (EIB) to boost lending to small businesses. Some easing of the collateral rules as we predicted last month is also a definite possibility.

As we’ve said before, the ECB continues to look constrained. It does of course have a few more tools, however, they are in many cases quite extreme and have potential side effects. These are best suited to very extreme scenarios (euro break-up) rather than the wider malaise and long term endemic crisis which the eurozone now faces, particularly given that often (as we are now seeing with banking union) any ECB action sparks complacency and inaction on the part of politicians.

Cypriot deposit developments

Update 31/05/13 09:40: As we noted below, it seems that the figures do include some of the write-downs of deposits under the bank restructuring (but not all). Apologies for the confusion. As the Central Bank of Cyprus notes the initial write down for Bank of Cyprus depositors is included. This totals around €3.2bn. This means the actual outflow was around €3bn, similar to the previous month.

This is still fairly significant, although we expect much of this may be domestic and due to people and businesses running down their cash reserves. This also likely reduces some of the concerns over the workings of the capital controls. The data does give some feeling for who might be losing from the bank restructuring - US Dollar depositors and foreign NFCs are probably a large share. The concerns over the bank deleveraging and increasing reliance on central bank financing also remain (since they were already well established).

The real test of the deposit flight will come, firstly once the bank restructuring is complete (by end of July) and secondly once the capital controls are removed (who knows when).

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Yesterday saw the release of the latest data on the state of bank deposits in Cyprus – which always makes for interesting reading.

The headline figures are pretty terrible. Overall deposits declined by €6.346bn (10%) in April, almost double the level seen in March (when the crisis was in full swing) - despite stringent capital controls being in place for the entire month. However, given their importance, these figures deserve delving beyond the headlines.

The charts above (click to enlarge) raise some interesting points:

• First, it’s clear that the deposit flight is continuing despite the strict capital controls. This is concerning, since it shows the Cypriot government’s inability to enforce the rules, particularly on the financial sector. It also means that capital controls continue to hamper the functioning of the Cypriot economy, but are failing to stop an outflow of money (though admittedly it could have been much larger without them).
• Second, the outflows are split between domestic residents and those in the rest of the world (ROW). ROW deposits are unlikely to return for some time. Cyprus could hold out hope that domestic residents are just stashing cash due to concerns over the economy and banks, meaning this money may eventually return. Unfortunately, given the bleak outlook this is unlikely to happen anytime soon.
• Third, a surprisingly large amount of the withdrawal (€3.2bn) has come from deposits held in US dollars. This money might also have moved abroad and is unlikely to return, suggesting both domestic and foreign investors are moving money away from Cyprus.
• Lastly, much of the withdrawal has been by non-financial corporations (NFCs) and households. This was perhaps more predictable, but again raises concerns about the future of investment and consumption in the economy. The underlying data shows especially strong withdrawals from ROW households and NFCs which have been a big source of economic growth for Cyprus in recent years. It could also peak concerns over the impact the capital controls are having, as firms and households are forced to eat into their cash reserves (although they still remain at a decent headline level).

One important point to keep in mind concerns the losses for some uninsured depositors under the bank restructurings. It is not clear from the Central Bank of Cyprus figures whether this has already been accounted for in the data above, although this looks unlikely since the process is still continuing. That said, if it has been, then the actual withdrawals are smaller - though still high. The overall economic impact also remains similar.

What does all this mean for Cyprus and the eurozone?

• Much of it confirms what many people feared in the aftermath of the crisis. In particular, it paints a bleak picture for future growth in Cyprus as money flows out of the economy. It also raises questions over whether such outflows were accounted for in the overly optimistic assumptions about Cypriot growth.
• Another problem will be bank financing. Cypriot banks are locked out of the markets and may well be for some time. With deposits falling they will be forced to access more ECB liquidity and possibly the Emergency Liquidity Assistance (ELA). This is something which the ECB has notoriously been trying to avoid in Cyprus, and more generally. Not least because under any future restructuring/default/euro exit scenario the ECB would face larger losses.
• But it’s also important to remember that there is a limit to how much Cypriot banks can access through these facilities since they require assets to be posted as collateral. Even if they are able to, it is clearly possible that this pressure could force them to increase the already rapid pace of deleveraging. This would undoubtedly further hamper lending to the real economy and in turn economic growth.
• As noted above, from a wider perspective it will increase already pressing concerns over the enforcement of the controls and more generally over regulation of the financial sector in Cyprus.

Another blow in the bank bonus debate - but there's something far more fundamental at work here

Yesterday saw the opening salvo of what is sure to become a heated debate over the new ‘technical standards’ for the EU’s banker bonus rules.

Why is this so important? Well, these rules will essentially determine how far reaching the EU's already controversial bankers' bonus cap will be. But this decision also encapsulates a range of other issues that will have a defining impact in the way Europe is governed in future - and whether there's a future for the UK in there somewhere.

With that in mind, the first draft produced yesterday to launch a period of public consultation on the standards would have been particularly worrying. The key points are:

Standard quantitative criteria: related to the level of variable or total gross remuneration in absolute or in relative terms. In this respect, staff should be identified as material risk takers if:

 (i) their total remuneration exceeds, in absolute terms,  €500,000 per year, or
 (ii) they are included in the 0.3 % of staff with the highest remuneration in the institution, or
 (iii) their remuneration bracket is equal or greater than the lowest total remuneration of senior management and other risk takers, or
 (iv) their variable remuneration exceeds €75,000 and 75% of the fixed component of remuneration.

As the numerous press reports today have highlighted, these are far more wide ranging than many expected and are likely to further raise concerns that these rules will have a substantial negative impact on the City of London (and therefore the UK economy). (For background on these concerns see here and here). There are several different things going on here:

Are the EU agencies already exceeding their mandate? As we flagged up at the time of their creation, there's a substantial risk of mission creep under the EU's three supervisory agencies - EBA, ESMA, EIOPA - due to the fluid nature of these bodies. Remember, under the ECJ court case which allowed these agencies to be established under the EU single market (via QMV and co-decision), they should be blocked from having any type of decision-making powers. But EBA's standards on remuneration comes worryingly close to legislation.

Politicisation of ‘technical standards’: Related to this, and as we also flagged up at the time, technical standards have a worrying tendency to become politicised - which clearly is the case here. This type of stuff should be decided through political negotiations and defined within the regulation. Any necessary technical background and info should be provided for and incorporated, even is this means delaying the legislation slightly.

Need for non-eurozone safeguards ASAP: Though this isn't strictly a eurozone vs non-eurozone issue, it does illustrate just how vulnerable the UK and other outs could be to eurozone caucusing in banking / financial rule-making. This is also exactly why the UK and other non-eurozone countries need to ensure that the agreement in principle for double majority at the European Banking Authority - that Open Europe first floated - are held up and pushed through.

Trade-off between "single rulebook" and control: The UK says it likes the EBA since it contributes to a single rulebook for the single market, and can, for example, contribute to stamping out protectionist implementation of banking rules in Europe. This is all true. However, it does, of course, assume that the UK itself is writing the single rulebook, which may or may not be the case.

Democratic accountability: As the Times noted today, with central banks such as the Bank of England (BoE) and the ECB taking over financial supervision they must become more transparent and accountable. In this case it is unclear what role the BoE played in drafting the rules or whether they raised the concerns pushed by the government and firms in the UK.

What next?

Again, this is only a first draft. The public consultation is open until August, after which the EBA will review the evidence and provide a new draft - so a lot of the issues we highlight below should be considered with this in mind. There will then be a vote in the EBA with the final standards needing to be submitted to the Commission (which will approve or reject them) in March. One final interesting point here is that any vote in the EBA could come close to coinciding with the introduction of any double majority rules, although there are a lot of hurdles to overcome before then.

Expect a summer of furious lobbying and behind the scenes discussions as the UK and others make a final push to water down these proposals.

Where do EU member states stand on bank bail-in plans?

It’s been pretty tough to follow where countries stand on the latest proposals for the EU’s Recovery and Resolution Directive, not least because the debate has lasted three years with people mostly talking past each other.

But the Cypriot crisis has now focused minds and a deal is top of the agenda. The proposal will lay out rules for bank bail-ins and dealing with cross-border banks, while it also links closely with plans for a eurozone banking union. To clear up the differences, we have put together a table.

(The table is broadly ordered by how strongly the country is in favour of uninsured depositor preference and how strongly against flexibility it is. Hence Spain which is strongly for depositor preference and little flexibility is near the top, while Sweden which barely favours a bail-in plan and wants significant flexibility is near the bottom – click to enlarge):

As you can see, there are some big splits remaining. The ECB, Spain, Portugal and France (amongst others) want a clear depositor preference regime – where uninsured depositors are the last to be written down. On the other hand, Germany, the Netherlands and the UK want more equality between senior bondholders and uninsured depositors. Going even further, there are Sweden, Poland and Denmark - which have already clearly defined national schemes which do not fit well with the EU plans for a bail-in hierarchy.

Another area of disagreement is the amount of national flexibility. Sweden, the UK and the Netherlands are pushing hard for flexibility, particularly for non-euro members. This has some backing from Germany. Further disagreements over the timeline for implementation and the level of resolution funds needed remain a bit of a free for all.

The few points they do agree on include: complete protection for insured depositors, a broad bail-in scheme and (somewhat ironically) the fact that this legislation is urgent.

We will keep updating the table as the negotiations develop. There is a lot of talk of compromise but as of yet there is a long way to get there.