Banking Union challenged at the German Constitutional Court

It emerged over the weekend that five German academics have launched another challenge at the Bundesverfassungsgericht – the German Constitutional Court (GCC) – this time against the proposals for a banking union based on the Single Supervisory Mechanism (SSM) at the ECB and the Single Resolutions Mechanism (SRM) at the Commission, with a Single Resolution Fund (SRF) set up via a separate intergovernmental treaty.

For background on all these institutions, see these links: SSM, SRM & SRF. 

One of those bringing the complaint is Prof Markus Kerber of Europolis (who has been heavily involved in previous suits). According to the press release the key point of the challenge is:

• That the banking union plans overstep power given in Article 127 TFEU. This is the article which was used to create the SSM in the ECB. Essentially it seems the group take issue with the idea that this could be done since the article refers only to conferring “specific tasks upon the European Central Bank concerning policies relating to the prudential supervision of credit institutions”. The thinking seems to be that, article 127 allows for the ECB to take on certain specific tasks, but not to turn the ECB into the eurozone's single supervisor, giving it complete supervisory control over certain banks and, to an extent, superiority over national supervisors (which some might see as a transfer of power).

• A key question will be around the amount of power transferred to the ECB. (There is no doubt it has become one of the most powerful institutions in the eurozone crisis both due to de facto action and de jure changes. There are certainly valid questions to be asked here, particularly since the level of democratic oversight is limited due to difficulties in combining this with its strict independence when it comes to monetary policy matters).

• Although the details are yet to be released, the complaint is also likely to question the legal base of creating the SRM inside the Commission and the pooling of national funds through the SRF. The main questions here relate to the level of control and oversight from the national level, particularly whether the Commission is the right institution to take on this new role and whether it is gaining too much power - not least since the decision was taken under qualified majority voting due to the use of the single market legal base.

The group are far from alone in raising legal concerns surrounding the basis for the banking union. As we have previously noted, both the German government and the European Parliament have expressed legal concerns over the structure; the former with regards to the fiscal impact and the legal basis for pooling of funding and the latter with regards to the use of intergovernmental treaties and the circumvention of the EP. (Ironically, such intergovernmental agreements arose in large part to avoid Germany’s original concerns).  The German government’s concerns have also been mostly dismissed by the Council legal service previously.

The UK Government has also made noises about concerns around the use of the single market article (114) to create a new eurozone architecture.

As the FT notes, these cases take some time to work their way through the system and the GCC has shown a track record of generally siding with the EU, albeit often with some caveats.

Given said track record and the previous opinions expressed by the Council legal service, we can’t help but feel the outlook is already dim for this challenge. As with all eurozone policies, overturning it would likely cause huge market disturbance and shift the eurozone back towards an existential crisis – something the court is usually quite aware of.

That said, the court could add caveats in terms of the democratic assent required for banking union and the role of the Bundestag where funds are concerned. It could also pass the judgement onto the European Court of Justice, as it has done with the case over the ECB’s bond purchase programme the OMT, not least because it seems to mostly question the legality under EU treaties.

In any case, this is certainly one to watch and not just from the eurozone perspective. Any ruling could well set a precedent and have a role in determining how far the eurozone can push certain treaty articles in terms of legal bases but also how it fits with national constitutions. In other words, it could be important in determining the issue of euro-ins vs. euro-outs as the EU develops.

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.

The EU wades into the murky world of shadow banking

The European Commission this morning unveiled its initial proposals to regulate ‘shadow banking’ and money market funds (MMFs) – the press release is here and the FAQs are here and here.

We covered this issue back in May when we exclusively released the initial drafts of the proposals – not too much has changed since then. We’ll refrain from recapping the details since the press releases lay them out but below we outline some of our thoughts.

• The key point in the regulation is that MMFs will be required to hold a ‘Net Asset Value’ Buffer, equal to 3% of all assets under management; the Commission predicts this will “result in an increase of the management fees of 0.09% to 0.30% annually”. There will also be harmonisation with UCITS and AIFMD to move towards a uniform set of rules for the shadow banking sector.

• As we noted before, the required buffer has real potential to harm the MMF industry. Given the record low interest rates, and very low returns on liquid short term debt, many funds are struggling to stay afloat (with some already shutting down). Although an outcry against increased costs may be expected from the industry, in this case many of the concerns seem valid given the very small margins involved in these funds.

• There are also some requirements on MMFs holding very liquid assets which can be sold off quickly, while also limiting the level of assets taken from a single issuer to encourage diversification. These rules seem sensible but add further constraints to the returns and flexibility of these funds. There is always a risk in dictating the investment decisions to the market, although its important that the risks in these funds is made clear. It also seems to be doubling up the effort of the buffer mentioned above  - given that losses of such funds rarely exceed 3% (as the Commission itself notes), pushing beyond this level seems slightly redundant.

• The question of ‘sponsors’ – the banks or institutions which own and/or backstop an MMF – is also vital for a couple of reasons. First, its clear that some sponsors have a competitive advantage, larger institutions will have the ability to provide greater financial aid to its MMF if it gets into trouble – this gives large banks a significant advantage over smaller asset managers. Secondly, it also provides another clear link between the shadow and traditional banking sector, this could potentially become an avenue for contagion (as was seen in the financial crisis) if MMFs get into trouble and need to be bailed out.

• Much of the rest of the regulation looks fairly sensible at first glance. It’s clear there needs to be greater transparency within the MMF sector – it can no longer be assumed to be equivalent to bank deposits. There also needs to be significantly less emphasis on external ratings by the credit rating agencies (equally true of the standard banking sector ). Furthermore, investors need to be clearer on the risk taken on when investing in these funds and their approach used to make profit (short term funding of long term assets).

• The broader shadow banking communication remains fairly vague but it is certainly an area which needs to be regulated. The main aim should be to incorporate international regulatory efforts with the existing multitude of EU regulations (many of which cover parts of the shadow banking sector) and avoid duplication. Tackling the issue of ‘collateral chains’ (using a single piece of collateral many times) is also vital, although the importance of the repo market should not be forgotten (see failure of the FTT).

All that said, there is a long way to go in these regulations yet. There is likely to be significant industry opposition (or at least discussion) and approval from both the European Parliament and member states will be tough to gain. It also seems unlikely that this will be completed before next May’s European elections, adding further delays but also raises the question of whether the next Commission will push in the same direction on this issue.

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.

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.

Exclusive: Internal docs give first look at EU plans to regulate 'shadow banking'

The Times reports today on another round of exclusive documents leaked by Open Europe, this time regarding European Commission plans to regulate the ‘shadow banking sector’. See here and here for the docs.

A rather niche story you might think but it could have important implications for the way money is lent throughout the economy. Below we provide some background and our thoughts on the proposals.

What is the shadow banking sector?

“The FSB defined the shadow banking system as "the system of credit intermediation that involves entities and activities outside the regular banking system". This definition implies the shadow banking system is based on two intertwined pillars.

First, entities operating outside the regular banking system engaged in one of the following activities:

• accepting funding with deposit-like characteristics;
• performing maturity and/or liquidity transformation;
• undergoing credit risk transfer; and,
• using direct or indirect financial leverage.

Second, activities that could act as important sources of funding of non-bank entities. These activities include securitisation, securities lending and repurchase transactions ("repo").”

Essentially, it is made up of institutions outside the banking sector but which provide paths for borrowing and lending as well as significant financial investments. According to the Financial Stability Board (FSB) in 2011 it totalled €51 trillion worldwide.

Why are there concerns regarding it and are they valid?

• Shadow banking came to light in the aftermath of the financial crisis where it is thought to have played an important role in allowing the financial sector to hide the true level of risk in the system.
• There are some valid concerns over shadow banking. It operates outside but closely related to and interlinked with the regular banking system. This means it falls outside of scope of regular supervision and regulation.
• Often pursue highly leveraged activities, search for high yields and transform maturities from short to long (can cause a mismatch in funding if a crisis hits). There is significant use of opaque securitisation, hard to judge real value.
• Often have very low levels of capital, funded in the short term by lending and investments which needs to be regularly rolled over. This is used to fund long term assets. Helps boost profits but also magnifies losses. Due to this set up, the system very exposed to liquidity crises which can hit hard and fast.
• IMF recommended recently that key aims should be to reduce spill over from shadow banking to regular banking system (reduce prospects for rapid contagion in a crisis) and to reduce the procyclicatlity of the shadow system.
• All that said, it does provide a valuable service in many cases, particularly as an alternative method for distributing credit to the real economy when the banking sector is failing to do so sufficiently.

Thoughts on the EU proposals so far

• The proposals are still at an early stage and subject to change. A key issue is how any shadow banking regulation will fit with the raft of other financial regulation in the pipeline or already in force – AIFMD, CRD IV, EMIR, UCITS, and Solvency II to name but a few.
• Importantly, many of these other regulations already cover many of the institutions involved in the shadow banking sector. Avoiding double regulation and inefficiency is vital, therefore judging and implementing the current regulations is important before a shadow bank regulation is brought in.
• Shadow banking is not part of regular market and those involved do not have deposits so there is no question of a government backstop or bailout scenario. Can and should go bust. The main point is that any shadow banking crisis should not transform into a ‘systemic crisis’. The approach should therefore be ‘macroprudential’, taking an overview of the market and ensuring it is not overly risky and/or that it is not too heavily intertwined with regular banking sector.
• This may be more effectively done by setting out guidelines for supervision and cross border data collection that a strict regulation.
• The EU must also be wary of regulating against specific financial instruments, which could have perverse effects. For example, ‘securitisation’ has become a hot topic. This tool was misused during the financial crisis but is not an inherently bad thing. As ECB President Mario Draghi pointed out recently, effective securitisation of SME loans could help boost lending to SMEs and increase level of quality assets in Europe.
• Money Market Funds are different to many other parts of this sector. They are essentially pools of deposits or excess funds from finanical firms which are invested in the short term to gain small gains above what standard deposits would reap. They invest heavily in short term government, corporate and finanical debt and play a key role in providing liquidity to the market. The Commission looks to be regulating these separately, which is the right way to go. However, any small increase in costs could hamper the whole industry since their margins are so low - in fact some have already been closed due to the record low interest rates. 

As we said the proposals are just getting going so all this is still open. Regulation of the shadow banking sector is necessary but its also vital to note that it plays an important role in providing credit to the real economy (despite its rather ominous sounding name). At this point in time its not clear that a regulation is needed immediately and it may be more effective to improve and work with what is currently on the table. Furthermore, in an ideal world, any attempt to tackle it would be done on a global level in the form of a set of guidelines and plans for data sharing and increased transparency.

Has Germany really gone off the idea of EU treaty change? (Part II)

Some EU pundits have spent the last several months arguing that a change to the EU treaties is a non-starter. "Don't you know", they say with a high degree of confidence "the Germans have gone off it." And in any case, no one else wants it any way for fear of ratification problems, not least in France.

Charles Grant from the Centre for European Reform said last week that "the Germans have cooled on the idea of rewriting the treaties." Another observer on BBC Newsnight (not our guy of course) said as late as last Friday that "the German government isn't at all keen on EU treaty change in the short-term", which the studio discussion then picked up on.

It's is definitely the case that the appetite for EU treaty change across Europe is limited, and for that reason it'll be a challenge to achieve it. But as we've said repeatedly, it's absolutely 100% wrong to say that the Germans have gone off the idea of EU treaty change. As we stated in our briefing ahead of Cameron’s Europe speech in January:

“There are currently seven broad proposals floating around for more Eurozone integration – most of which need EU treaty changes to be fully completed...Germany, in particular, is nervous about ad hoc-arrangements lacking firm constitutional grounding.”

Here is the full list:

Crucially, this also includes current proposal for a banking union, which from a German point, sit uncomfortably with the EU treaties. A few weeks ago we noted,

"Those who say that Germany has 'gone off the idea' of Treaty change - in light of David Cameron's speech where he mentioned EU treaty change as an avenue for reform - clearly haven't quite appreciated the nature of the proposals floating around."

Well what do you know, as we reported in today’s press summary, at last week's crucial meeting of EU finance ministers, German Finance Minister Wolfgang Schäuble insisted that an EU Treaty revision is necessary to achieve a banking union, claiming that:

“We’ll only do this on a clear legal basis, because I don’t want risks in Karlsruhe.”

Somehow this announcement still managed to surprise people. But wasn't it always obvious? Anyone who is at all familiar with German history will understand why they're so keen to separate monetary policy from bank supervision. If keeping the two tasks with the ECB, such separation can only take place  if there's a rewriting of the EU treaties (so that the final say no longer rests with the ECB Governing Council). This also matters for non-eurozone countries as that guarantees them an equal say in the ECB supervision structure, and therefore makes them more likely to join (particularly Sweden and Denmark, which the Germans are keen on). Indeed, the Swedes - in a very brave moment - tried to push for just such a treaty change but dropped the idea. Further steps, such as a joint resolution fund, will also require treaty changes.

There are plenty of hurdles to fresh EU Treaty negotiations - some countries will want to avoid them like the plague - and even if the Germans can get them off the ground, the timing and scope (limited or full?), remains unclear. It is also still not fully clear whether the eurozone could circumvent the UK via an inter-governmental arrangement if the latter kicks up too much fuss.

But what's clear is that, in the land of ordnungspolitk, the idea of an EU treaty change is alive and well. So hör auf mit dem Blödsinn as the Germans would say.

Has Germany really gone off the idea of an EU treaty change?

Usually technical meetings behind closed doors in Brussels are pretty dull. However, judging by some of the reports floating around, yesterday’s meeting of the EU Committee of Permanent Representatives (COREPER) may have bucked the trend somewhat. This is the negotiation forum for member states' EU ambassadors - the key guys involved in talks over EU policy. This is where a lot of decisions, de facto, are being made.

As we noted in today’s press summary the UK was outright outvoted on the plans for capital requirements for banks (CRD IV), which entail the controversial caps on bankers' bonuses. 

However, though it was already clear that the UK had lost that particular battle, it was the talks over the EU's proposed, and in part agreed, banking union which caught our eye. EU ambassadors failed to reach agreement amid continued North-South divisions, but the reason why is interesting.

Most media failed to pick up on this, but the WSJ Real Time Brussels blog rightly notes that Germany was strongly pushing for a clearer separation between the ECB's monetary duties and supervisory responsibilities, to avoid a running conflict of interest (see here). The only way this can really happen is to give the supervisory board the final say over supervisory decisions (as opposed to now when it rests with the ECB's Governing Council). This, in turn, requires EU treaty change. The Germans wanted a clear commitment from other member states that this would happen.

According to the WSJ, Berlin also insisted on giving national parliaments (not just the European Parliament) the right to ask questions and get answers on supervisory policy, and giving states under the single supervisor along with the EP the power to remove the Vice Chairman of the supervisory body.

A couple of interesting points there. This is an incredibly fluid target but those who say that Germany has 'gone off the idea' of Treaty change - in light of David Cameron's speech where he mentioned EU treaty change as an avenue for reform - clearly haven't quite appreciated the nature of the proposals floating around. Of course, Berlin won't be shouting it from the rooftops ahead of a national elections and with the relationship with France at an all time low (well almost), but in many of the Germans demand on eurozone governance is an implicit acknowledgement that something has to change in the EU's institutional framework (see our table here of the broad proposals being discussed [p.9]).

The scope (limited or full treaty change), nature (EU treaty or inter-governmental) and timing will be discussed, but it will likely happen sooner or later.

Easing of the Basel III rules - a test case on conflicts of interest?

A lot has been written over the past few weeks regarding the easing of the Basel III banking rules, which we've been meaning to cover but didn't get round to doing.

The specifics and details have been well covered so instead we'll look at some of motivations behind the changes. In our view, the change provides an interesting insight into the potential conflicts between monetary policy and financial supervision – something we have discussed at length with regards to the ECB being turned into the single financial supervisor for the eurozone (see also Felix Salmon’s blog for a wider discussion of this issue).

The changes, which are fairly technical and complex, focus on easing the burden of banks in creating what is known as the Liquidity Coverage Ratio (LCR). This is essentially a liquidity buffer which banks will be required to hold to ensure that they have enough cash (or cash like assets) on hand in a crisis to cover themselves for 30 days. The time frame in which the banks must have this buffer in place has now been increased by 4 years as well.

Again we won’t go into the detail of whether this change undermines the attempts to make banks safer but we would highlight that many banks already meet the adjusted standards, albeit with significant support from central banks (a point we’ll expand on in second) – given the on-going banking troubles in Europe and the US this is naturally a concern.

Monetary policy vs. financial regulation

More interesting from our perspective is the motivation for this change. As Bank of England Governor Mervyn King said:

“Most banks are completely overflowing with liquid assets…[Which] reflects the way in which central banks around the world have expanded balance sheets to provide economic stimulus. That won’t always be the case in the future.”

“Since we attach great importance to try to make sure that banks can indeed finance a recovery, it does not make sense to impose a requirement on banks that might damage the recovery.”

So it seems that the ultimate motivation for the move is to make it easier for central banks to remove themselves from non-standard monetary policy measures (such as QE or the LTRO) without fearing a massive drop in lending.

Clearly, both these concerns fall into the realm of monetary policy, rather than supervision or regulation. Obviously, a collapse in bank lending would be bad for everyone, so the measures are tied to some notion of short term financial stability, but surely these comprehensive Basel III regulations – which will set the basis for financial regulation over the next decade or more – should be taking a much more long term view than this. There are very real concerns that in the long term this could hamper the safety of banks and their ability to withstand future crises without taxpayer help.

A further motivation for the changes seems to be an attempt to encourage demand for a wider variety of assets by allowing them to be held as part of the LCR. Again this is all well and good, but it is the job of monetary policy to manage such demands and should not become ingrained in long term regulation. It is hard not to see this as a sop to the current crisis and immediate economic problems. (On the other hand we would note that this does help ease concerns that the requirements for banks to hold more sovereign debt would worsen the sovereign-banking-loop, although again increasing the risk on banks’ balance sheets is not a desirable trade-off.)

As mentioned above, the easing of regulations may make it much easier for central banks to exit their non-standard monetary policy measures without causing market distortions. The lack of a clear exit strategy is something which we have continuously warned of within regards to greater ECB intervention and the problem still applies. Obviously, finding the best way out is important but not at the expense of a safer banking system. Furthermore, taking such substantial action, such as that seen during the crisis, should not be done lightly and altering regulations to ease the potential problems or side effects of such actions could lead to a situation where the final cost of such actions are not fully considered. It is not hard to imagine similar pressure being applied to the ECB’s monetary policy, particularly if the eurozone crisis escalates again, while easing supervision would provide an easy out rather than managing the imperfect one size fits all monetary policy.

We must note that these regulations are produced by the Basel Committee and the BIS, not the ECB, so it is far from certain that the ECB will act in a similar way (although many of the central bankers involved do overlap). Additionally, the ECB will not be directly responsible for regulation but supervision, although there is substantial flexibility within this bracket and the people involved will still have a large say on regulation at the European Banking Authority (EBA). 

Our main point is that there will be very similar pressures and very similar powerful lobbies, which seem to have had a substantial impact here. This of particular concern for the ECB, where the Chinese walls could well prove insufficient, with the ultimate power for both supervision and monetary policy residing with the Governing Council.

We would suggest the previously mostly theoretical conflict of interest between financial supervision/ regulation and monetary policy just got a little bit more real.

ECB as the single bank supervisor: How high is the Chinese wall?

We’ve already assessed the impact of the new single supervisor with regards to the UK and the EBA, here and here, but there is also the obvious question of how the ECB will fare as the single supervisor.

The utmost attempt has been made to stress the separation of supervision and monetary policy within the ECB, but the fundamental fact remains that the ECB Governing Council still has a veto over the decisions of the supervisory board.

The regulation introduces a ‘mediation panel’ to “resolve differences of views” between the Supervisory board and the Governing Council (GC). However, it seems fairly clear that this panel will not be able to vote to overturn the GC decisions but simply provide another talking shop to resolve any differences. As we pointed out before this is the maximum separation allowed under the treaties and therefore the limits how high the Chinese wall between supervision and monetary policy actually can be.  Practically, separation may hold in placid times but in times of crisis it is not clear whether this will be sufficient.

There are also a few other remaining concerns and questions:

• A non-euro country can reject a decision which has been altered by the ECB GC, however, it then runs the risk of being kicked out of the banking union.
• When exactly can the ECB take over supervision from national regulators? This seems to be mostly the ECB’s own decision, however, the instances are very loosely defined and the relationship between the ECB and the national supervisors remains fairly vague. Expect turf battles.
• What does the €30bn asset threshold apply to – i.e. does it include off balance sheet items – and who determines this?
• The regulation goes to great lengths to ensure that there is a clear flow of all “relevant” information between national supervisors and the ECB. However it is not clear who decides which information is “relevant”, meaning that the "principal-agent" problem still holds. In other words, the national supervisors are likely to have superior information about the banks still under their direct supervision and may have interests which run counter to the ECB.
• As we have noted previously, this puts a huge number of tasks under the ECB’s purview – there is yet to be a clear declaration of the democratic oversight of tasks (such as supervision) which should be held to account. There is also the practical question of how it will manage these tasks in terms of staffing, offices and funding.

Plenty of details still to be fleshed out then and questions remain about how effective a single supervisor the ECB will become. And as ever, though significant, this is only the first part of what will be a very, very long journey towards an EU banking union.

A big leap towards banking union - and a victory for the UK?

Leaving aside whether David Cameron actually is right to actively back and call for an EU banking union (and our views on that should be well known), Britain did just score a diplomatic victory in Europe, securing safeguards similar to those we have previously proposed. It has also established a very important principle in the battle against "not in the euro but run by the euro" scenario.

In the early hours of this morning, EU finance ministers reached a technical agreement on the plans for a single financial supervisor under the ECB.

This deal is pretty big, as it links to a number of key questions surrounding the future of the eurozone, including whether the permanent bailout fund (the ESM) can directly recapitalise banks. It was always going to have important implications for the UK, given the threat of eurozone caucusing - the 17 writing the rules for the 27 - in the European Banking Authority (EBA) and changes to EU financial regulation (as we discussed here).

The details on the deal are still emerging and we'll look at the ECB-side later (our assessment from last night still stands). But the Chancellor George Osborne stressed that the UK (along with Sweden and the Czech Republic who also decided not to join) got a “very good deal” and that the “single market was protected”. He would, wouldn't he, so what deal did the UK actually secure and how good is it?

Double simple majority within QMV – This means technical rules at the EBA will (as before) need to be approved under QMV. Additionally, within this vote, there must be a simple majority of ‘ins’ and a majority of ‘outs’. So say that no non-eurozone country will join the banking union (which is very unlikely), this means the UK along with 4 other ‘outs’ can block any regulations which they do not support.

Revised voting rules once there are only four countries left: For the UK, there's one potential weakness, if the number of 'outs' gets below 4 then the rules will need to be reviewed - and could be completely rewritten. Currently only three countries have explicitly said they won't join: the UK, Sweden and the Czech Republic. If all remaining countries decide to join, then these rules could need to be changed almost immediately. Here's a concern: the EBA regulation is decided by QMV, the ECB regulation by unanimity. Once the UK has agreed to the ECB regulation, it loses much of its leverage. The concern is that at a later date, the double majority principle is watered down using QMV, meaning that the UK gets stuffed anyway. Also, remember, MEPs must also approve this deal. Any changes made by the EP would also be subject to QMV approval. However, as a further guarantee, there seems to a provision making clear that the revised voting modalities will need political approval at the European Council (where unanimity applies). This is not a legal protection but a political one, so not completely watertight but clearly a useful addition.

Non-discriminatory clause – The separate proposal giving the ECB supervisory powers (see Article 1 here) also includes a provision meant to commit the ECB to not discriminate within financial regulation against a single or a group of countries. 

 So a big question remains:

Who are the ‘ins’ and who are the ‘outs’? Currently the UK, Sweden and the Czech Republic have said they definitely will not join the single supervisor, while all eurozone countries are obliged to. The other non-euro countries have suggested they will have a ‘close cooperation’ deal with the single supervisor (expect for Denmark) – this basically makes them count as ‘in’. For the UK point of view, 5 non-participants seem the ideal number as it will be much easier to block unwanted regulations, while 4 could trigger the review referred to above.

Will Croatia be an ‘in’ or ‘out’? This could alter the necessary majorities in EBA. 

On current count, this is a pretty good deal for the UK and it does establish that principle that the eurozone cannot run over none-eurozone countries.

ECB's Chinese wall still full of holes?

We've had a look at the latest compromise proposal to turn the ECB into the eurozone's single banking supervisor. It has been put together by the Cypriot Presidency in a bid to finalise a deal at today's meeting of EU finance ministers. Below are some of our initial thoughts (we may update in due course).

Arguably, measures aimed at reaching a clear separation between the ECB's monetary and supervisory tasks - Germany's main concern - are the most interesting part. This is what the proposal under discussion says:

Composition  of supervisory board
Chair (can’t be a member of the ECB Governing Council)
Vice-Chair (is a member of the ECB Executive Board)
3 ECB representatives (with voting rights, but can’t perform ECB monetary policy-related duties at the same time)
National supervisors of participating member states – i.e. including non-euro countries that want to join

Decision-making 
Simple majority (Chair can cast vote in case of draw)
QMV for regulations on matters “having a substantial impact on credit institutions” – although there is no clear definition of what “substantial” impact is or who determines it.

What does the Supervisory Board do? 
Tables draft decisions and submits them to ECB Governing Council for adoption, “pursuant to a procedure to be established by the ECB” – so the details have yet to be fleshed out. Governing Council has up to ten days to object to draft decision, but has to give written justification – and is encouraged to voice any monetary policy concerns in particular.

If a decision taken by the Supervisory Board is changed following objections by the Governing Council, a non-euro country can express its disagreement (a safeguard, given that non-euro countries don't sit on the Governing Council).The country also can notify the ECB that it will not abide by the relevant decision if it is still not happy with the outcome. However, in this case the ECB will "consider the possible suspension or termination of the close cooperation with that Member State" - so if a country objects to a single proposal it runs the risk of being excluded from the banking union.

This draft then, contains some progress on the make-up of the boards and a bit more in terms of how they will interact, but the crucial decision making process still lacks some detail. Particularly over the exact interaction between the Governing Council and the Supervisory Board if the Council objects to a proposal.

It is also clear that ultimate power resides with the Governing Council and although non-eurozone countries do have somewhat of a get-out-clause, the separation between monetary policy and financial supervision still seems limited. (As we suggested would always be the case due to the legal constraints).

Much work to be done, especially on the finer points.

The Four Presidents Report?

Or was it the Van Rompuy report...looking at the report on moving "Towards a genuine economic and monetary union" released earlier today its hard to judge how closely involved the other Presidents were, notably ECB President Mario Draghi and Commission President Jose Manuel Barroso.

So to recap, this was meant to be a report reflecting the views of the EU's four Presidents (in addition to the three already mentioned, also Jean-Claude Juncker, the outgoing head of the Eurogroup).

First, we've spotted a couple of areas of confusion between what European Council President Herman van Rompuy and Draghi have been saying.

The report suggests that,

"The ECB has confirmed that it will establish organisational arrangements guaranteeing a clear separation of its supervisory functions from monetary policy." 

However in his monthly press conference today, when pushed on the ECB's view on the single supervisor Draghi stressed that the ECB is a "passive actor" in all of this and was not involved in designing the legal structure of the new supervisor. Clearly these two views are directly at odds, which fails to fill us with confidence that the new tasks of the ECB will be combined with its current ones in a legally sound and practical way. A concern which has previously been voiced by ourselves and many others.

Draghi was also at pains to stress that the link between sovereigns and banks can only be broken when the banking union is complete, i.e. with a common resolution mechanism. The report argues that the set up of the single supervisory mechanism (SSM) will play an important role in "contributing to breaking the link between sovereigns and banks". Not necessarily directly at odds, but it again peaks concerns that the Council plans for banking union over-estimate the impact of the SSM.

Additionally, as the FT's Brussels Blog notes, Van Rompuy also disagrees with European Commission President Jose Manuel Barroso on the issue of debt mutualisation, with the latter favouring eurobonds.

We at least can't blame Draghi for struggling to find the time to help write the report while also running a giant institution. But if the supposed authors can't agree on the logistics it doesn't bode well for next weeks EU summit...

Banking union and the EBA: where do we stand?

Yesterday, EU finance ministers failed to reach an agreement on a single eurozone banking supervisor. Ahead of the meeting, the Cypriot Presidency put forward a new compromise proposal aimed at concluding a deal before the next EU summit on 13-14 December.

We have had a look at the latest drafts. Starting with the new voting rules within the EU-27 banking watchdog, the European Banking Authority, these are the most interesting changes proposed by the Presidency:

Voting on technical standards/end of restrictions on financial activities/EBA budget

European Commission proposal: QMV - meaning that countries outside the eurozone which do not want to join the new ECB-led Single Supervisory Mechanism (SSM) risk being in permanent minority

Cypriot Presidency proposal: QMV stays, but it must include at least a simple majority of countries participating in the SSM (say at least nine, assuming that only eurozone countries join the SSM) and a simple majority of countries not participating in the SSM (say at least six, assuming that none of the non-eurozone countries joins the SSM)

This goes in the right direction, although we proposed going one step further and having all decisions in this group adopted by 'double QMV' - i.e. a qualified majority of participating countries and a qualified majority of non-participating countries.

Voting on breaches of EU law/dispute settlement

European Commission proposal: An independent panel (composed of three people) takes a decision. The decision is considered as automatically adopted unless it is rejected by a simple majority of member states - including at least three countries participating in the SSM and three countries not participating in the SSM

Cypriot Presidency proposal: A larger independent panel (composed of seven people) takes a decision. The decision is considered as automatically adopted unless it is rejected by a simple majority of member states participating in the SSM and a simple majority of member states not participating in the SSM

And here is where the main problems with the Presidency's proposal lie, according to us:

•  A larger panel is good in principle. However, the proposal fails to specify how many of the seven members should be from countries not participating in the SSM;

•  Even assuming a three 'ins' + three 'outs' + the Chairperson composition of the panel, decisions would still be taken by simple majority - i.e. four of seven members;

• Overturning a decision taken by the panel becomes even more difficult under the Presidency's proposal, given that a simple majority of 'ins' and a simple majority of 'outs' are both needed to do so. Therefore, the proposal would end up giving the independent panel (and the EBA) more power. This is why we proposed that, instead of this 'reverse majority' system, decisions taken by the independent panel should be confirmed by both a qualified majority of countries participating in the SSM and a qualified majority of countries not participating in the SSM.

Enough technicalities for now - we will look at the ECB Regulation in a separate blog post.