How in the world did central banks miss this?

An interesting story has been developing over the past couple of weeks and has been flying under the radar somewhat, though Alex Barker over at the FT has covered this story very well, here, here and here.

The issue is that the Bank of England has found wording in the details of the EU’s Bank Recovery and Resolution Directive (the bank bail-in plans) which could prohibit governments from protecting central banks against losses when they  provide emergency lending to banks in a crisis. Quite a surprising find given that the final text has just been passed (the error was found with only weeks to spare).

This is the Emergency Liquidity Assistance (ELA), which we have covered here and here. As a recap, this is the lending which a central bank takes on in a crisis and offers to banks at less favourable rates if they have no other choice to avoid a liquidity crisis. As might be expected it was used heavily by the UK and many eurozone countries during the crisis.

Essentially, the concern is that it could expose the BoE to greater risk since it will not have the backing of the UK treasury when extending liquidity assistance, which is risky and can be very large when a financial sector the size of the UK’s is in crisis.

In fact the story now seems to have run through its full lifecycle:

• The BoE located the problem and alerted the European Parliament (EP) and other member states, while requesting to reopen the text of the legislation to amend the wording.
• The EP accepted and even published a revised text to take account of the concerns - see article 27 (2).
• In the end, however, the move was formally vetoed by the Netherlands, Finland and the Czech Republic due to concerns that reopening the text would lead to a raft of other demands, notably by France, Italy, Sweden and Portugal who were seeking further assurances that they could issue guarantees for bank bonds without requiring bank bail-ins first.

This may potentially be a very big deal - but there could also be ways around it. Ultimately, ELA can still be extended it just cannot have a blanket guarantee from the government. The central bank balance sheet should be strong enough to deal with this, although if losses were taken it could become an issue – would bail-ins be required, say, before the central bank was recapitalised? Furthermore, this doesn't just impact the UK, ELA was heavily used in the eurozone and is arguably more important for the eurozone than the UK since the ECB still struggles to act as a real lender of last resort.

However, this episode also speaks volumes about how EU rules are decided and assessed - and, in this instances, doesn't necessarily reflect well on the Treasury and the BoE:

• That the deal isn't now re-opened despite an obvious flaw in the legislation is symptomatic of EU law - the constant fear of  reopening deals or reassessing them due to uncertainty over what countries might begin to demand. This too often used as an argument against reform, when in fact it should be one in favour of reform. It highlights the need for a broader overhaul of the legislative approach and the need for a clearer structure and mechanism to reassess legislation. All too often this fear paralyses the process of improving or changing the EU.

• That said, looking at the revised EP text, there do seem to be a huge amount of changes (the text in bold and italics). This seems to highlight some severe concerns with the original agreement and again brings home concerns over the level of uncertainty - what is a precautionary recapitalisation? - that continues to dog the agreement.

• The alliances that built up on this issue are also interesting and somewhat unusual. The UK had the support of the European Parliament and even France and Italy, although they seemingly wanted to reopen the text for other reasons. However, Netherlands and the Czech Republic were firmly against, while Germany was very hesitant. The UK should take comfort in this. On this particular issue, the divide wasn't eurozone versus non-eurozone - that potential divide remains one of the biggest liabilities in the UK-EU relations, particularly in financial services. 

Most importantly though, how in the world did finance ministries and central banks - including the Treasury and BoE effectively - miss a provision which governs fundamental central bank actions? Admittedly, we didn't spot it either and it is a very technical clause but these are exactly the types of things that central banks should be on the look out for. It certainly raises some serious questions about the level of oversight and analysis of EU legislation both at the EU and national level. How did everyone miss this the first time around? If the central banks weren’t involved earlier, should they be on important financial legislation such as this?

Credit to the Bank of England for at least detecting it. Better late than never (well, sort of, in this case). 

The German banking union

A deal emerges. It seems that the negotiations are finally coming to a conclusion on the issue of banking union – after just a year.

There has already been lots of coverage of the details of the deal, see in particular the excellent summaries from the WSJ and the continued coverage from the FT Brussels blog, so we won’t bother rehashing all the specifics here. Instead we’ll provide some analysis of the deal and flag up what we think are the most important implications.

First point to make to those who are frustrated about this deal not going far enough: what did you think realistically could happen? 

The deal is not that different from the previous version which we laid out here, although a few (if not all) of the unanswered questions have been cleared up.

What’s new?

• Earlier this week an agreement was reached on the structure of the funds. It was, as expected, decidedly German. A €55bn fund will be built up from levies on the financial sector between 2016 and 2026. In the meantime, any funding required to aid banks above bail-ins will come from national coffers or ESM loans to sovereigns. Only after 2026 will a centralised fund be created and while there may be some mutualisation, it is yet to be defined and will be subject to future negotiations. There is also scope for national funds to lend to each other but this is to be defined in an intergovernmental treaty.
• The decision making process will be thus: as supervisor the ECB recommends a bank be resolved, the board of national resolution authorities devises a plan and votes on it ( any release of funds will require approval  two-thirds of voting countries contributing at least 50% of the common fund). This will then have to be approved by the Commission. If there is a dispute at any stage of this process the Council of EU finance ministers will decide on simple majority (if not then it will approve through a ‘silent procedure’).

What does this mean for the eurozone?

• Well, we’re seriously at risk of repeating ourselves here, but here we go. A deal is positive and necessary. That said, the process remains incredibly complex and still seems highly national or intergovernmental. If there was a serious failure of a large cross border bank, such as we saw with Dexia, would the process really be any smoother or simpler than last time around?
• The funding remains minimal and only enough to cover the resolution of one or two medium sized banks. It will also not be available for some time and certainly will have little role in helping to deal with any recapitalisation costs outlined by next year’s stress tests.
• Taking a broad view, it’s easy to question how cross border this ultimate banking union is. The single supervisor under the ECB will only cover the largest 130 banks. The resolution mechanism will cover the same banks, plus another 200 or so which are cross border. However, there are around 6000 banks in the eurozone, and the very large majority of these remain under national purview.
• Generally, this also raises questions about how effectively the ECB can do its job as national supervisor. While the cracks in the system could push it to be harsher to ensure there is not a systemic crisis, it also poses problems given the current issues on bank balance sheets. It is crucial that next year’s stress tests are credible, if the ECB shows signs of insecurity about the ability to deal with a large bank recapitalisation it could raise questions about the process.
• Clearly, given the intergovernmental nature and the prevalence of national governments it is likely to be insufficient to break the loop between sovereigns and banks in the eurozone.

How about for non-euro countries?

• Again we have outlined these points before. It seems that they managed to secure specific protections to ensure they will never be on the hook for eurozone banks, which is good but also the absolute minimum that should be expected.
• The use of an intergovernmental treaty is tricky. It side-lines these countries somewhat but also shows the limits of what the eurozone can do within the EU treaties.
• The creation of the resolution board as a new agency within the Commission does raise some concerns. It is clear it should be its own separate institution for the eurozone only, however, the lack of willingness to open the treaties has created this system. If the eurozone continues to push new institutions into older ones and distort the structures of the EU for eurozone use, it could become problematic. It also creates a complex and ineffective decision making procedure for the eurozone as is clear above.

Winners and losers

• Germany. Plain and simple. For all the talk of a compromise earlier this week, it was incredibly minimal compared to how closely the plans as a whole match the German desires.  Think back to the original Commission plan, which was incredibly centralised. We said then it wouldn’t fly with Germany and it hasn’t.
• The structure is intergovernmental, has minimal pooling of funds, is built up overtime, excludes smaller banks, does not include direct bank recapitalisation from the ESM and has a large bail-in element. All key German demands. They have made a vague promise to have some sharing of funds in a decades time, the details of which need to be negotiated over and may be limited to an intergovernmental treaty.
• If there are any losers, then it is likely to be France and the Mediterranean bloc. They were pushing for significantly more pooling of funds and a more centralised process. That said, France did previous publish a joint vision of the banking union with Germany, which is not a million miles from the current structure. The deal also allows them some more scope to use bailouts rather than bail-ins if needed – something else they were keen on. 

As we have noted recently, 2014 is likely to be another year where governments come to the fore in eurozone. 2012 and 2013 were the ECB's years, where its actions held the euro together. With the focus now on growth, more emphasis will fall on the governments of the eurozone to develop a new structure and strategy to put the bloc back on a sustainable footing and a path to prosperity. 

Eurozone inches towards banking union but may need to resort to intergovernmental treaties

Eurozone finance ministers yesterday took a belated step towards the key part of the banking union, the single resolution mechanism (SRM), with many reports suggesting that the broad outlines of an agreement have emerged.

We’ve written about the background to this extensively, see here and here for example. As a recap, a deal was expected to be completed by the end of the year so that the framework is in place for after next year’s ECB Asset Quality Review and EBA bank stress test. This now looks unlikely, with technical details being ironed out into next year, but there is still hope for a political agreement at the EU Council on 19 December.

What are the key points of the latest agreement?

• The latest official draft of the plans was published early last week and things don’t seem to have changed massively.
• A board of national resolution authorities will make recommendations on how to resolve banks (after the ECB as supervisor recommends the need for action). The Commission then decides whether the plans are adequate or not.
• There will not be a centralised fund, at least not immediately. As in previous plans, one will be built up over the course of a decade to €55bn, through undefined levies on the financial system.
• A network will be set up between national funds allowing them to lend to each other and take action when there is a crisis. This may be governed by a separate intergovernmental treaty, to assuage German concerns over its legality.
• Taxpayer-backed funds remain a last resort, in particular European funds (either through the network or the ESM, the eurozone’s bailout fund), with bail-ins being the initial response. The plans for bail-ins, under the EU’s Bank Recovery and Resolution Directive, could be moved forward from 2018 to 2016 to help appease Germany further.

What is still yet to be agreed?

• Numerous points remain unclear, not least, who has the final say if the Commission and national authorities disagree. If it involves national funds, it is almost certain to be national authorities.
• The exact process for triggering the use of funds remains unclear, particularly in a situation where the resolution process involves a large cross border bank.
• More importantly, if a new treaty is needed, the details of this need to be thrashed out – as we saw with the fiscal compact, this can take time and will itself require a tricky negotiation. It also needs to be decided whether this will be incorporated into EU treaties, as is planned for the fiscal compact.
• There continues to be talk of the SRM and its rules applying only to larger banks, similar to the setup of the ECB’s single supervisor.

Has Germany really moved that far?

• Reports suggest a shift in the German position is the key factor behind the compromise. While Germany has clearly shifted a bit, it has also got plenty of things it wanted.
• Looking back at the proposal laid out by German Finance Minister Wolfgang Schauble in the FT in May, Germany has secured the following – significant national power, increased role for a board and less for the Commission as well as limited use of taxpayer funds, with no central fund. It could also potentially secure an SRM focused on larger banks and a quicker introduction of bail-in rules.
• It has of course compromised on its view that the treaties need to be adapted, after its position took a blow somewhat from the recent legal opinion on the issue. It has found a halfway house with the intergovernmental treaty, giving it some further legal protection.

What would this deal mean for the eurozone?

• As we have said before, progress towards a deal is positive. But the deal still suffers from some key short comings namely: the system will not be in place for the immediate aftermath of next year’s stress tests, the system is still reliant on national authorities and ad-hoc measures as well as suffering from constraints in terms of reaction time in a crisis. 
• Any funds, be they national or European or ESM, remain short of what is likely needed to help backstop and resolve any large failing banks in the circa €33 trillion eurozone banking sector.
• We remain unconvinced that this will be sufficient to break the sovereign-banking loop which has intensified during the crisis (breaking it remains the stated goal of the banking union) – national politics and money still has a huge role to play in this system.
• An important point to consider is that, given the current setup of the eurozone banking system, bank bail-ins remain, for the large part, national affairs. While this is separate to the sovereign-bank loop, it does highlight the tight feedback loops within many eurozone economies and could intensify the problem of nationally systemically important banks. This may change over time but is not guaranteed.

What would it mean for non-euro countries?

• The use of an intergovernmental treaty is interesting and could have ramifications. While it is far from ideal for the eurozone, it does side-line the potential influence and control of non-eurozone countries.
• One potential upside is that the eurozone will not be able to force through its own institutions under the single market article (Article 114) which does highlight the limits to how far they can stretch this.
• The ad-hoc part of the agreement does fragment the process and fails to provide a systematic blueprint for how future institutional changes will address the EU/eurozone conundrum.

Commission banking union plans met with scepticism

As we noted in our flash analysis yesterday, the European Commission has put forward its plans for a Single Resolution Mechanism (SRM) which would oversee the eurozone banking union, manage bank resolution and enforce the recent bank bail-in plans.

The proposal seeks to move quickly and decisively to create a strong banking union but do so within the current framework of EU treaties and domestic politics. Unfortunately, it seems to have found itself in the worst of all worlds. The mechanism is unlikely to be large enough or responsive enough in a crisis, while it will not be in place until 2015 at the earliest. Furthermore, it is based on a significant legal stretch of the EU treaties, which has already raised objections from Germany and creating concerns for non-eurozone members (due to fears that the EU's single market could be hijacked by the eurozone).

The German response was swift and hostile. At a press conference German Chancellor Angela Merkel’s spokesman Steffen Seibert argued:

“In our view the Commission proposal gives the Commission a competence which it cannot have based on the current treaties…We are of the opinion that we should do what is possible on the basis of the current treaties.”

Dr Gunther Dunkel, President of the influential VÖB (the German association of Public banks) added:

"We reject the creation of a European resolution authority for many good reasons …it is not up for discussion for us, that funds gained through the work of German banks are used to contribute to the rescue of banks in other Member States… [Furthermore] the SRM would require a change to the EU treaties to necessitate harmonised corporate, insolvency, and administrative procedural law.”

The FT cites an unnamed German official as saying:

“We would be willing to speed up the process, but then the proposal has to be realistic…The commission is behaving like a vacuum cleaner, sucking up everything into its proposal. It may be effective but it is not legally safe.”

Dutch Finance Minister Jeroen Dijsselbloem was none too keen either, suggesting (in what seems to be a veiled insult to the Commission) that the new authority had to be "decisive, effective, and impartial," adding, "It's not completely decided what that authority should look like."

All in all, a rather disappointing proposal given the numerous delays (it was due out at the start of last month) and the fact that it forms such an important pillar of banking union. The Commission’s inability to produce the full text of the proposal, making detailed analysis difficult, also provoked some understandable outrage.

There was also another interesting development on the banking front. The Commission yesterday confirmed the expected changes to bank state aid rules which will come into force at the end of this month. The rules mean that any bank receiving aid would have to present a restructuring plan in advance, likely with shareholders and junior bondholders taking losses. Any bank which accepts aid will also face strict limits on executive pay.

The move may seem innocuous but, as we have consistently pointed out, all other changes to bank regulation and supervision won’t come in for some time. This means that the new rules on state aid will de facto enforce some of these measures, in particular the move away from bailouts towards bail-ins. That at least adds some limited certainty but still leaves the banking union looking woefully incomplete.