EU falling short on implementing bank capital rules

The BIS Basel Committee has today released its assessment of the EU’s (and the USA’s) implementation of the Basel III rules on bank capital and it does not make good reading for the EU. They key findings of the report are (as detailed in the press release and the graphic below, click to enlarge):

• “Eight of the 14 components meet all minimum provisions of the relevant Basel standards and these were therefore graded as "compliant".”

• “Four of the components were assessed as "largely compliant", reflecting the fact that most but not all provisions of the global standard were satisfied.”

• “One component - the Internal Ratings-based (IRB) approach for credit risk - was assessed "materially non-compliant" and pertained primarily to the treatment of exposures to SMEs, corporates and sovereigns.” In particular, the report notes that exposures to SMEs are given concessionary risk weightings, presumably to try to encourage this specific type of lending, however it is nonetheless not in line with the rules. Furthermore, it finds that banks are given a significant amount of leeway in how to value their sovereign debt holdings, with most across the EU simply applying zero-risk weighting – again this is a deliberate attempt to limit any distortions to the sensitive Eurozone government debt markets.

• “Another component was found to be "non-compliant". This relates to the EU's counterparty credit risk framework, which provides an exemption from the Basel framework's credit valuation adjustment (CVA) capital charge for certain derivatives exposures.” Essentially the current rules allow exemptions for instruments which are not traded on exchanges or the wider market and therefore may be hard to value. Furthermore, this “materially boosts bank capital ratios,” though the report accepts that the EU is considering changes to these specific rules.

• Overall the EU was given the second lowest rating (on a scale of four) of “materially non-compliant”, making it the first jurisdiction to be found on the whole not the be complying with the Basel rules. The assessment is also particularly poor compared to the US, which was found to be “largely compliant” with the rules, in general its failings also seem to be more minor as well as less numerous.

The European Commission’s response can be found here, while there is also a response section following the executive summary in the main report. The EC claims the EU’s approach is “particularly ambitious approach, unique in the world”, which is true to an extent given the diverse nature of national banking systems. The response notes that some changes are already in the pipeline, but largely challenges the interpretation which the Basel Committee makes of the rules. On the whole it is not entirely convincing but then, since the Committee cannot force the EU to change, it seems the Commission is largely happy to ‘agree to disagree’ on a number of areas.

While all of this may seem rather mundane and technical it does have some important implications.

First off, it raises questions about the quality and thoroughness of the recent ECB and European Banking Authority stress tests. We, along with plenty of others, have already raised concerns about this and the report adds further weight to those concerns. Furthermore, the specific problems outlined would certainly have helped present European banks as having higher capital ratios largely by reducing the perceived riskiness of certain assets they hold.

A report by Yalman Onaran for Bloomberg earlier this week highlighted the problems relating to the use of banks internal models to weight risk by contrasting this approach to that of using the pure leverage ratio. As the article notes, under the leverage ratio approach 12 large European banks would need to raise a further €66bn in capital. While neither approach is perfect, the Basel Committee’s indictment of the bank’s internal models and the way a large number of exposures in a number of sectors are valued seems to support such analysis and criticisms.

The second important implication is that is once again clearly highlights that the EU probably remains the more important level of policy making and legislation than international level or international organisations – at least when it comes to how things are structure on the ground.

Despite agreeing to follow the Basel III rules the EU is the one that designs and implements the specific legislation. In this case it has clearly altered the rules significantly to suit its own needs – the gap with the original rules as well as how they are interpreted and implemented in other jurisdictions is clear. Furthermore, while the Basel Committee can issue a damning judgement of the EU’s approach, it cannot force it to change. In this relationship all the hard (legal) power lies with the EU. This also extends beyond just implementation to interpretation. Despite writing the Basel III rules the Basel Committee is not even able to guarantee primacy on how they should be interpreted as the EU’s response to the report clearly shows.

UK looking down and out on banker’s bonus cap challenge

It’s a bad start to what looks as if it could be a very challenging day for the UK government with UKIP looking likely to win the by-election in Rochester and Strood.

This morning the European Court of Justice (ECJ) Advocate General Niilo Jaaskinen issued his opinion on the UK’s challenge against the EU’s banker’s bonus cap and it does not make good reading for the UK. Jaaskinen suggested that “all the UK’s pleas should be rejected and that the Court of Justice dismiss the action”. The key points of his reasoning are:

• The legal basis of the legislation cannot be challenged since remuneration in this sector “impacts directly on the risk profile of financial institutions”, since these operate freely across the EU this can have impacts on markets across the EU.
• Jaaskinen “accepts that the determination of the level of pay is unquestionably a matter for the Member States”, but since the law is just a stipulation of the ratio and not a direct cap on pay, there is still flexibility to set pay levels.
• The delegation of power to the European Banking Authority (EBA) is “valid” since it is “merely empowered to elaborate non-binding draft measures” – i.e. create technical standards.
• There has been sufficient notice of the legislation to allow firms time to adjust to the new rules.

A fairly comprehensive rejection, but there are a few points which we believe have been overlooked or under discussed, laid out below.

• One of the UK’s main arguments is that this law will result in higher fixed pay which makes remuneration less flexible and raises fixed costs for banks, thereby undermining any attempt to improve financial stability. This issue is not addressed at all in the opinion. Furthermore, while the opinion addresses the issues of remuneration impacting risk and the fact that fixed pay can still vary it does not look at how the two can interact. It is clear that as a result of this fixed pay will increase substantially but there is no question of how this impacts stability. This may be more an economic/financial point but given the issues are discussed separately their interaction should also be examined.

• The ruling could also have interesting implications for EU jurisdiction when it comes to the rate of pay. Variable pay is very loosely defined. For example, standard overtime paid at double the hourly rate could theoretically fall under EU jurisdiction by the definition used here. This highlights the importance of this ruling as a step into an area which the EU has previously largely steered clear of and the potential precedence it creates. This could develop in many unknown ways in the future.

• There is no mention of the UK’s claim that this violates international law or is extraterritorial since it applies to all employees of EU banks no matter where they are based. We noted this may not be entirely a legal issue for the ECJ but it deserves some attention. Related to this, it remains unclear whether third countries firms operating in the EU will be forced to institute similar caps if there are to be deemed ‘equivalent’ under rules coming in under MiFID II in 2016.

• One of the weakest points seems to be on the powers transferred to the EBA. Control over technical standards, particularly here, should not be dismissed lightly. The regulation deals in very broad strokes and leaves significant interpretation for the technical rules – including the exact level of the cap and who it will apply to. This power is being borne out right now with the EBA passing judgement on the way in which the rules are being implemented and whether ‘allowances’ count as variable pay. The EBA retains significant power to judge how the rules are being implemented and adjust the technical standards if it think the spirit of the rule is not being followed.

• In general, the combination of the ECJ and EBA seem overly focused on the UK (accepted the UK has been pushing the issue as well). But looking at the legislation which Germany has passed on this issue, there are serious questions over how it has implemented the rules. Germany has exempted anyone covered by collective bargaining from all the remuneration requirements of CRD IV, including the bonus cap. This is because collective bargaining is a constitutional right in Germany and cannot be overridden. While it’s not clear how many people this applies to, the principle is concerning and it is a significant exemption. Why this does not merit examination while the use of allowances as a de facto exemption does is not clear.

What happens now?

• The full ECJ ruling will come early next year and is likely to be in line with the opinion – although the ECJ did previously ignore Jääskinen’s opinion on short selling where to leant towards siding with the UK.
• The EBA will publish updated guidelines and technical standards in the new year which will incorporate its concerns about allowances. At this point the UK will likely find itself squeezed by both the EBA and ECJ and could face punishment if it is not seen to be implementing the rules properly. The UK could of course refuse, but given the high profile nature of the issue it could escalate the situation. One option for the UK would be to point to other infringements such as the German example above.
• In terms of the bigger picture, though not a huge issue on its own, this will be another ruling which plays into the hands of those who wish to see the UK exit the EU. It also continues to add to concerns over the role of the ECJ and its ability to be an impartial arbiter, particularly on financial services – an aspect which will likely be crucial if the UK is to remain an EU member both in the short and long term.

UK takes another blow over bankers' bonus cap

EBA HQ in London

The European Banking Authority (EBA) on Wednesday released the results of its investigation into whether banks across Europe have been using ‘allowances’ to skirt the EU’s bankers’ bonus cap. This is obviously a hugely contentious issue in the UK and the fact that UK banks have been taking this approach has been well publicised and oft criticised by EU politicians. But it’s interesting to note that the EBA found 39 banks across six EU states had been using such allowances, so clearly it is an issue which extends beyond the UK’s big banks.

Nevertheless, the opinion does not bode well for the UK with the EBA concluding:

“The EBA found that in most cases institutions had topped up the fixed remuneration of their staff and had introduced discretionary ‘role based' allowances which have an impact on the limit of the ratio between variable and fixed remuneration required by the EU Capital Requirements Directive (CRD IV).”

“The report showed that most of the allowances, which were the subject of the EBA investigation, did not fulfil the conditions for being classified as fixed remuneration, namely with respect to their discretionary nature, which allows institutions to adjust or withdraw them unilaterally, without any justification.”

The report is much as expected, with the EBA making the case that the allowances are not permanent pay for a number of reasons: they are revocable with little notice, specific to the staff member not the role, often have forfeit clauses therefore not permanent and are often linked to proxies for the firms performance (such as the economic environment).

The last point in particular clearly chimes with concerns from banks that they will have less control over their costs at times of economic hardship. This is exacerbated by the point (number 37 in the report) below which is frankly just a bit strange:

"Some role-based allowances might only have been introduced to comply with the bonus cap introduced by the CRD IV while retaining some cost flexibility. Cost flexibility is of importance where the performance of the institution or a business unit is no longer considered adequate."

Surely, cost flexibility is always relevant for a business, particularly one in a very competitive environment, and not just when it is failing? We’re not quite sure what the EBA is getting at there.

What happens now?

• The opinion isn’t binding, although the EBA has said it expects national regulators to make sure that all banks are in compliance by the end of the year, however, it has no legal way to enforce this (yet).
• The EBA is currently reviewing its guidelines on the issue and will hold a public consultation before the end of the year with the new official rules being published in the first half of 2015 (at this point they will be legally binding).
• In particular, if banks want to continue using allowances they will have to be “predetermined, transparent to staff and permanent”.
• Ultimately, this throws a bit more uncertainty in the mix with banks uncertain over exactly how and when to adjust their allowances.

What does this mean for the UK?

• Clearly, this is a bit of a blow for the UK. That said, the issue has already to an extent moved out of the EBA’s hands. The UK is challenging the original proposal at the European Court of Justice. Even if this proposal fails it could challenge the updated guidelines/rules which are used to implement the cap. Banks themselves could of course choose to launch legal challenges although this looks unlikely at this stage.
• Banks will ultimately find a way to pay their staff the market rate. This will likely end up being in the form of higher base salaries, something which will make banks less flexible and push up their average costs. This could potentially harm competitiveness and possibly force banks to pass on such costs to consumers.
• The biggest concern is a broader one of precedent and where laws are really made. The bonus cap was a specific law tagged onto a much larger piece of legislation to which it is largely unrelated. This significantly aided its passage through and watered down scrutiny. Then given the technical nature of the rules a lot of the holes were filled in by the Commission and the EBA in setting the exact parameters for implementation – providing a lot of power to the two institutions. The temptation to take such an approach with complex financial regulation is obvious and circumvents the little accountability and control which member states have.

This debate surely has some way to run yet but this looks to be one battle which so far the UK is losing.

Foreign Affairs Select Committee welcomes "Double Majority" voting at the EBA as concrete example of UK influence in Europe

Double majority lock voting at the EBA was a
significant and valuable use of UK influence

In a report published today the influential cross-party House of Commons Foreign Select Affairs Committee commended David Cameron "for launching an ambitious agenda for EU reform". The full report, including evidence presented by Open Europe, also makes a number of sensible observations such as:

"the point of a Member State having influence in the EU is to achieve EU policy outcomes that realise its interests and objectives."

We agree - too often the EU is described by politicians in terms of "influence" and being "at the table" something that looks (and often is) of more benefit to politicians than those they serve - something we pointed out in our evidence:

"Open Europe contended that 'influence’ is a term too often used in a rather lazy and undefined way”. Open Europe argued that the debate on UK influence in the EU should focus on identifying the concrete cases where the UK should exercise influence and had or had not done so."

One case made of very tough concrete we brought to the MPs attention is the tricky issue of EU voting weights:

"Open Europe reminded us that from 2014 the Eurozone states will command sufficient weighted votes in the Council of the EU to muster the qualified majority required to take Single Market decisions alone."

For this reason we have argued consistently that the UK needs a new safeguard to protect itself from Eurozone caucusing. The test case for this was the adoption of "Double majority" voting in the EBA - originally proposed by Open Europe.

The achievement of this new "double majority" was therefore a genuine success for UK diplomacy and has a significance well beyond that of the EBA. We are therefore glad the Committee picked up on it. As they conclude:

"The agreement on the Single Supervisory Mechanism (SSM) which was struck among EU Finance Ministers in December 2012 was significant on several grounds. It shows what the UK can achieve, in terms of protecting its position in the Single Market, through close and constructive engagement and innovative policy solutions."

"We note that the deal went some way towards entrenching the kind of safeguard against discrimination in the Single Market that the Government failed to secure in the December 2011 negotiations on the ‘fiscal compact’. We also note that the arrangements that were agreed to protect non-Eurozone states—on this occasion, for ‘double majority’ voting in the European Banking Authority—responded directly to a concrete proposal (in this case, one which gave rise directly to a risk of caucusing)."

They could not have put it better.

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.

Poland has nothing to gain from rushing to join EU banking union

As we pointed out last week, the number of eurozone outs remaining outside the EU banking union is critically important for a number of different reasons. As the second largest non-euro member, Poland's decision will be an important one, not least because it will also affect the choices made by its neighbours. On our new blog platform at Rzeczpospolita - Poland's second most widely read daily - Open Europe's Pawel Swidlicki takes a closer look at the choices facing the government:

"What does this mean for Poland? Well, since 2008, EU states have in total offered around €4.7 trillion in guarantees, capital, liquidity and asset relief measures to the European banking sector. Under an illustrative scenario, were a joint resolution fund been in place during the crisis (we assume the bailed out countries would have been unable to participate) the Polish state would have had to stump up over €200bn – 74% of its GDP – whereas in reality it only had to put up €9bn. These figures are clearly purely illustrative but they highlight that such a burden sharing arrangement – based roughly on each state’s GDP and population size – would be hugely iniquitous given that Polish banks only hold 0.73% of EU wide bank assets. It should not be forgotten that this is the clear and stated, but also necessary (if it is to offer any solution to the crisis), end goal of the banking union." 

"Likewise, for similar reasons, Poland and other EU member states should be hugely pleased that the UK, with its €10.2tr of bank assets – four times the size of the German economy – is staying out of the EU banking union, and that Polish taxpayers will in no way be exposed to any of their associated risks. Fortunately, there is no realistic prospect of Poland joining the euro within the next couple of years, and the government is absolutely right not to jump the gun on declaring whether it will join the banking union or not, especially with the additional safeguards detailed above. Poland’s interests will best be served by staying out in the immediate future and seeing how the later stages, such as the joint resolution scheme, develop."

Banking union: are you in or out?

Ask what is the ideal outcome for the UK from the talks on EU banking union and - much like when the super-computer in the Hitchhikers' Guide to the Galaxy is asked about the meaning of life, the universe and everything - you'll get a number: in this case 5 as opposed to 42.

This is the number of countries that should stay outside of the banking union for the UK to have the greatest leverage at the European Banking Authority. Anything less and, as we've noted, there may be a risk that the very beneficial "double majority" voting rules will be re-written, with Qualified Majority Voting amongst ministers and a simple majority in the European parliament (though there's a political agreement to solve the matter through unanimity in the European Council). Any more wouldn't be a disaster, but would proportionally dilute the UK's influence.

That's of course only one of many reasons why the exact membership of the banking union matters for everyone. So, who's in and who's out? This is the current state of play:

Definitely Out

The UK: As we've noted, even if the "referendum lock" and virtually every Tory backbencher weren't  enough to keep the UK out, add €10.2 trillion worth of UK bank assets, and there's no chance that the eurozone would ever allow Britain to join. The UK could not be more out.

Out "for now"

Czech Republic - Czech Prime Minister Petr Necas wrote an op-ed for Lidove Noviny arguing that Czech taxpayers can’t be asked to save troubled European banks. The government has said the country is out "for now", and requested guarantees that its domestic banking supervisor, the central bank, will have a decisive say if a foreign bank seeks to turn its operations into a branch from a subsidiary, which is subject to stricter local regulation.

Sweden – Swedish Finance Minister Anders Borg said that "These were tough negotiations. Sweden will remain outside the banking union, but we believe this is a good compromise." However, the Swedish Government has also left the door open for joining at a later stage.

"Wait and see"

Denmark – Both the centre-left coalition government and the main opposition party, Venstre, have said they have not yet decided whether Denmark should join the banking union. Two other opposition parties, the People’s Party and Enhedslisten, have called for a referendum on whether the country should join, saying it’s required under the country's constitution. Other than the UK, Denmark is the only EU member state with a legal opt-out from joining the euro. 

Hungary – Having been very strongly critical of the original proposals, Hungary's position is  somewhat ambiguous. PM Victor Orban is playing his cards close to his chest: "In view of the proposals, we are in a much better position than anticipated... The non-Eurozone countries are now free to decide whether or not they wish to join the European banking supervisory system. Sometimes even we can be lucky”. 

Poland – Polish Europe Minister Piotr Serafin said that Poland had not yet decided whether to join, and will not declare a position at this week’s EU summit. He argued that “Our job over the course of the last few months was to create a better balance between the rights and obligations of non-eurozone countries. I think a lot has been achieved, although there is still room for improvement in some areas”. Polish PM Donald Tusk announced he will be consulting the finance ministry, central bank and the national regulator prior to making a decision. Polish daily Gazeta Wyborcza suggests the government will wait for further details on the second part of the banking union proposals to emerge, in particular concerning the common resolution fund.

Latvia – Latvian Finance Minister Andris Vilks tweeted yesterday that Latvia’s three biggest banks may fall under European Central Bank supervision, but without giving additional details. Latvia hopes to join the currency bloc in 2014, the year the new supervisory mechanism should be fully ready, so looks likely to join.

Lithuania – No official position has yet emerged from Vilnius, but like neighbouring Latvia the country wants to join the single currency by 2014 so we would expect it to opt in.  

Romania - We are still waiting for official confirmation to emerge either way, but we hear rumours from Romanian officials that "the vibe is positive". Romania could therefore well opt in.

Bulgaria – According to Bulgarian National Radio, Prime Minister Boyko Borisov seemed to suggest ahead of the EU summit that his country would definitely join the system of single supervision. However, following a number of conflicting reports, we were able to clarify that the official position is that Bulgaria is ready to join, but it has not committed to a timetable for doing so.

So the UK remains the only one that is out - indefinitely - while the Swedes and Czechs are unlikely to join any time soon. On the other side, Latvia, Lithuania are the most likely to join while Hungary, Poland and in particular Denmark are very difficult to call at the moment.

So on current count - though this is an exceptionally moving target - two probably in, three out and five uncertain.

NB This blog post was updated at 11.21 on December 18 to reflect that Bulgaria was in the "wait and see" camp rather than being definitely in.

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.

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.

Banking union: moving forward or standing still?

Media reports on the outcome of eurozone summit discussions last night are mixed, but there is general theme that eurozone leaders have taken ‘a step closer to banking union’. Looking at the latest conclusions  (see here),we wouldn't quite describe it as a step closer - at least not a big step.

·         The timetable (which everyone admittedly knew was unrealistic) has been delayed. Previously the eurozone was insistent on the single supervisor being up and running by the start of 2013, now it is some point during 2013 (with strong suggestions that this will be after the autumn German elections).

·         There is discussion on including / accommodating non-euro members but no detail on how this will be done (particularly in reference to Sweden, Poland but also the UK) or how the recently publicised legal concerns within the Commission will be dealt with. There is expected to be a substantial amount of progress on tricky legal and political issues before the end of the year.

·         The one point of agreement was that the ECB will supervise all 6,000 eurozone banks, seemingly a positive step on the surface. However, in a concession to Germany, it was also established that much of the day to day running of the supervision of smaller regional banks would still be conducted by national financial supervisors. This raises further difficult questions about the already poorly defined relationship between the ECB and national supervisors.

·         The leaders simply reaffirmed that the ESM, the eurozone’s bailout fund, would be able to recapitalise banks directly once the single supervisor is in place – but this was never in doubt. The real question over whether the ESM can retrospectively take on the burden on bank recapitalisations, relieving ailing governments of the problem, was left unanswered with little discussion.

·         There was another call for the harmonisation of deposit and resolution schemes across the eurozone – an issue which has already been delayed by two years due to political posturing. More importantly, talk of a combined backstop and resolution mechanism for the banking union was kicked into the long grass. As we said before, that element of banking union is, at best, years away.

·         Lastly, we still find it hard to see how the EU can hold a meeting and not find time to discuss Spain or Greece in detail, given that their problems are the most immediate concern.

So more standing still or treading water. Again this reinforces the fear that, as soon as the financial and economic climate looks slightly more positive, any hope of progress on the tough decisions goes out the window.To be fair though, as Swedish PM Fredrik Reinfeldt likes to say, the most important thing is to get it right.

Perhaps the UK should join the banking union after all (here's why...)

Update 11/10/2012:
For the avoidance of doubt, this post was clearly meant to be lighthearted, we have pointed out plenty of flaws and inconsistencies in the banking union proposals both from the UK perspective and the eurozone's (see here, here and here). The idea, which we seem to have failed to express clearly, is to highlight the inconsistencies in the banking union proposals but also that a concept, weighting votes according to shares of a specific sector, which people in the UK have previously suggested and been laughed out the room for is now being suggested by Germany.

**************

Negotiations on establishing the ECB as the eurozone's single banking supervisor, the first stage of the much heralded (but yet to make much progress) proposals for banking union, made little headway at yesterday’s meeting of EU finance ministers.

As we noted on our blog last month - and reported by the FT today - Germany has been insisting on altering the ECB’s one-country, one-vote governance system by matching voting weights on the ECB's proposed supervisory board to the size of countries’ financial sectors. This would radically increase its power and ensure it cannot be held hostage to member states who have much less to lose if eurozone/EU-level banking rules don’t go their way.

Wait a minute. Should the UK not take up the Germans on their offer? Linking voting weight in the EU to the size of member states’ financial sectors - in the European Banking Authority or in the Council for example - would immediately eliminate fears over the eurozone writing the rules for all 27 using an inbuilt majority (a scare amongst British diplomats and officials).

And in a spectacular fashion. The graph below (click to enlarge), taken from our report on EU financial regulation, published in December 2011, charts member states’ share of the wholesale finance market against their voting weights under QMV. The blue column - share of wholesale finance - would represent the new voting weight under a German-style system (if it was directly proportional).

Perhaps the UK should join the banking union after all...

Banking Union Part II – now for the safeguards

Here’s the continuation of the EU banking union saga – the document (also leaked, see here) that sets out how the single market and banking union are meant to fit together. A crucial point for the UK and others. As we noted on Friday, the Commission was set to table a series of documents establishing the first step towards a banking union. Well, there will be three of them, to be precise:

• A regulation to make the ECB the supervisor for “all” banks in the Eurozone, with non-euro countries able to join if they wish. This is the one we looked at – and published – on Friday.  

• A regulation making adjustments to the European Banking Authority in light of the new powers of the ECB, with the objective to avoid the banking union fragmenting the single market. This is the one that we look at below. 

• A “communication” which sets out the Commission’s vision of the banking union long-term, including a deposit guarantee scheme and a single resolution fund (also known as wishful thinking, at least for now).

Following our analysis of the first document, here are our thoughts on the adjustment to the EBA’s rules and whether the ‘safeguards’ proposed by the Commission will address the risk of the Eurozone/ECB/banking union encroaching on single market territory or the 17 outvoting the non-euro 10 on financial regulation in particular (i.e. Eurozone caucusing at the EBA).

The EBA will have powers over roughly the same areas as before and the same voting weight too, and will continue to serve as the bank supervisor-cum-regulator for the EU-27 (which was already a quite confusing arrangement). However, the EBA may, in a round-about way, actually gain powers vis-a-vis the UK (which we'll return to). To avoid the ECB over-ruling or undercutting it on matters of the single market, the following safeguards have been proposed:

• Interestingly, when within its remit, the EBA would be able to circumvent the ECB in an “emergency situation” and impose a decision directly applicable to an individual bank or financial institution. In such cases, therefore, the ECB would be ‘junior’ to the EBA – much like national authorities. 

• A new “independent panel” of experts could be created by the EBA to judge on breaches of EU law i.e. when a country breaks single market rules or when two “competent authorities” (of which the ECB could presumably be one) disagree on whether rules have been breached. The panel’s decision could be over-turned by a simple majority at the EBA’s supervisory board, which needs to include at least three votes from non-euro members (if they have not opted into the banking union) and three votes from euro-members. This is an interesting one, and we need more details to make a clear assessment as to what this would mean in practice – or how effective it’ll be. Who will the independent experts be (drawn from the EBA itself)? How will they be appointed? Will it always be ad hoc or more permanent? And will this, in effect, make the EBA more powerful at the expense of UK authorities (this will be a tricky one, stay put)?

• Decisions on capital requirements for banks is addressed specifically. This is a key concern for the UK government and an area we’ve pointed to consistently where the Eurozone could face a fresh incentive to act as a block under banking union. The proposal suggests that issues relating to capital requirements – over which the EBA has some moderate powers – will be decided by QMV within the Board of Supervisors but can be overturned by a simple majority, again including at least three non-euro states. 

• The management board of the EBA must consist of at least two non-participating member states (out of six).

Marks for creative solutions, and it seems the Commission genuinely wants to preserve, as it puts it, “the proper functioning of the EBA in the interest of the union as a whole.” Part of the UK financial services industry might be reasonably happy that the UK would have a seat at the table, at least in the EBA. But this remains an awkward patchwork, and it probably won't be enough to eliminate British anxiety over the banking union.

And remember, this only addresses the relationship between the EBA and the ECB, which is only one of the many relationships within a banking union that needs to be clarified. As we’ve argued before, the biggest worry remains an incremental, de facto institutional shift from the EU-27 to the Eurozone 17, involving the Commission and the European Parliament as well, which is why we want to see stronger single market safeguards, also at Council-level.

And it ain’t getting any easier to work out who has final accountability over financial supervision in Europe…

While everyone is talking bond-buying: Here's the first proposal for an EU banking union (leaked)

That ECB, it's so hot right now.

While everyone is watching and reacting to the ECB announcement from yesterday, the Commission's highly anticipated proposal for an EU Banking Union, due to be released on 12 September, has leaked (courtesy of Italian daily Il sore 24 ore). The full document can be read here.

It's the first chance to analyse the first document in its entirety (though snippets have leaked in various media reports over the last week or so - more to come for sure, that will add to this proposal) and below we highlight some of the key points. We’re still going through the main doc and will update this blog with anything else that catches our eye, but this is what we got so far:

• As expected, the Commission proposes that the ECB should supervise all banks, as the document notes: “recent experience shows that smaller banks can also pose a threat to financial stability. Therefore, the ECB should be able to exercise supervisory tasks in relation to all banks”.

• National supervisors will continue to assist the ECB with preparation and implementation of its new role as necessary, but the ECB will have final authority in most areas (a major change).

• Paragraph 25 of the preamble notes that: “In order to ensure consistency between supervisory responsibilities conferred on the ECB and decision making within the EBA, the ECB should coordinate a common position amongst representatives of the national authorities of the participating Member States in relation to matters falling within its competence.”

• The ECB will have to power to wind down banks if necessary, as well as grant or remove banking licences within the eurozone.

• The ECB will work with the Commission and the ESM to recapitalise ailing banks (this could be a hint that the ESM could form the future resolution mechanism and financial backstop).

• Paragraph 10 of the pre-amble says that “In view of the close interlinkages and spillovers between Member States participating in the common currency, With a view to maintaining and deepening the internal market, and to the extent that this is institutionally possible, the Banking Union should also be open to the participation of other Member States.”

• Paragraph 18 highlights that the ECB has the power to increase capital buffers if deemed necessary under its macroeconomic surveillance.

• Paragraph 41 states that: “Given the globalisation of banking services and the increased importance of international standards, the ECB should carry out its tasks in respect of international standards and in dialogue and in close cooperation with supervisors outside the Union, without duplicating the international role of the EBA. It should be empowered to develop contacts and enter into administrative arrangements with the supervisory authorities and administrations of third countries and with international organisations, subject to coordination with the EBA while fully respecting the existing roles and respective competences of the Member States and the Union institutions.” 

The relationship outlined between the EBA and the ECB is vague but interesting. The ECB (eurozone countries) will be represented as a single bloc in the EBA from now on, meaning, under the voting procedure of simple majority (applicable to settlement of disagreements and breaches of EU law) , the ECB will always have a majority. Also under the new voting weights coming into force in 2014 / 2017, the eurozone will have permanent majority under QMV (applicable to technical standards and some other issues).  Even though the eurozone often voted cohesively previously, the fact that it will now be represented by a single voice and will always vote as a cohesive bloc looks worrying for the UK in future negotiations on financial supervision and regulation.

It is also concerning, from a UK/non-euro point of view, that the ECB will be able to develop international relationships on supervision. This could undercut the wider EU poisition on negotiating international standards such as the Basel III (bank capital) rules and other such issues.

The point in paragraph 10 is interesting as the Commission seems to draw a direct link between a Banking Union and the ‘deepening’ of the single market – which involves all 27 member states – which again raises huge questions over where regulation at the level of all 27 member states ends, and supervision involving 17+ begins.

This ties in with the plans to allow the ECB to increase capital buffers above EU-wide standards, which could see a blurring of supervisory and regulatory powers. It also increases the incentive for the euro countries/ECB to set the agenda in international forums, such as Basel, and in future regulations adopted at the EU level.

Update 07/09/12 16:45 - 
A key discussion – and no doubt one of the key issues that will be subject to intense negotiations once the Commission has tabled all its docs - will be whether the voting weight within the EU financial supervisory structure (ESAs) will change (if the ECB does indeed get involved in votes in, say, the EBA). Will the ECB essentially control all 17 eurozone member votes or condense it into a single vote, or will it simply be a matter of soft coordination. How will non-euro countries ensure that the Eurozone isn’t using an inbuilt majority to basically push through euro-tailored measures? Decisions in the ESAs are taken by a simple majority vote or QMV meaning that anything more than mere ECB coordination, might require rewriting the ESA voting rules and even the standard procedure for calculating weightings (based on population, GDP etc.). Presumably, there should be a safeguard for non-Eurozone countries.

Do not adjust your television set, this is not a Spanish rescue (despite looking an awful lot like one...)

Well, that was the line that Spanish Economy Minister Luis de Guindos was spinning yesterday. Sorry Luis, this is essentially a Spanish rescue - external funding sources filling a gap which the state can't (check), monitoring of a large chunk of the economy (check), involvement of all the big international organisations (check - EU, IMF, ECB etc.), the list goes on.

Meanwhile, the oft absent Spanish Prime Minister Mariano Rajoy held a press conference today, declaring the package a 'victory' for the euro and stating that if it were not for the current government's reforms it would have been a full bailout package. If this is a victory (finally dealing with a glaring problem after four years) then we don't want to see a defeat, but at least Rajoy made a public appearance this time. That said, in the midst of the worst crisis his country has faced since the financial crisis hit, Rajoy is now jetting off Poland to watch Spain vs. Italy (a mouth watering prospect admittedly but his timing could take some work), while the likes of the Education Minister are heading to Roland Garros to watch Rafael Nadal - the Spanish government not quite in crisis mode then, we're not sure if that should inspire confidence or not...

In any case, as we predicted over two months ago, European assistance to help Spain deal with its banks is now official, so what does this rescue mean for Spain and the eurozone, below we outline some of the key points and our take:

The plan
Spain will access a loan from the EFSF/ESM (the eurozone bailout funds) which it will use to recapitalise its ailing banking sector. The money will be channelled through the FROB (the bank restructuring fund) but will still be a state liability (it will not go directly to the banks). However, unlike the other bailouts it will not come with fiscal conditions but only conditions for reforming the financial sector.

Open Europe take:
Firstly, the ESM will not be in place in time to provide the loan (the treaty is yet to be ratified by numerous countries and has faced many delays) so at least initially it will come from the EFSF. As others have pointed out, this is important because ESM loans are senior to other types of Spanish debt while EFSF loans are not. This may make things easier to start with (as it removes the threat of legal challenges based on clauses in other Spanish sovereign debt which could be triggered if it suddenly became junior), however, Finland has already raised concerns over its exposure and role in the rescue - an issue we tackle in more detail below.

The lack of additional fiscal conditions is fair given that Spain is already subject to a deficit reduction programme and that this is ultimately a financial sector problem. There are questions over conditionality and moral hazard though - we would like to see bank bondholders and shareholders sharing more of the burden (bail-ins) to ensure the necessary reforms take place. As things stand its hard to see how the banks will 'pay' for this capital, particularly given the Spanish regulators previous failures (during and after the property bubble).

De Guindos confirmed that the funds would be counted as Spanish debt, so Spanish debt to GDP could be about to jump by 10% in the near future and given its current path this could put Spain over 90% debt to GDP (the level beyond which sustainability becomes questionable) much sooner than had been anticipated. This will require adjustments in its reform programme and lead to increasing market pressure.
 
Size - is it enough?
This is the key question - the total amount has been put at "up to" €100bn. That is much higher than was suggested by the IMF assessment released on Friday night, which suggested €40bn.

Open Europe take:
It sounds like a big number, but upon closer inspection it may not stretch as far as many expect. Consider that Bankia requires €19bn, while three other very troubled cajas need around €30bn (Banco de Valecia, Novagalicia and Catalunya Caixa) meaning half the money could already be eaten up, leaving only €50bn for the rest of the huge banking sector.

This compares to around €140bn in doubtful loans, and a total €400bn exposure to the bust real estate and construction sector. Doubtful loans to this sector total around €80bn currently, but we expect house prices to fall by a further 35%, broadly meaning that the number of doubtful loans could easily double. On top of this we have further losses on mortgage loans as well as losses on other corporate debt and a decrease in the value of Spanish debt held by banks. So huge number of issues - putting a clear figure on it is difficult due to the difference between tier one capital and 'loss provisions' (tier two capital). But even if this €50bn is given in tier one capital and stretched to increase provisions its hard to see that it will be enough given the huge exposure to mortgages and the bust sectors, especially at a time when growth is falling further and unemployment continues to rise.

Finland and Ireland - flies in the ointment?
If the EFSF is used (which looks likely) the Finnish government is obliged to ask for 'collateral' as it did with Greece - the noises coming out of Finland suggest it will, especially given its objection to 'small' countries bailing out 'larger' ones. Ireland has also suggested that if Spain is able to avoid fiscal conditions on its bank bailout then it could request similar treatment (i.e. a loosening of 'austerity').

Open Europe take:
The Finland issue will get messy, as it did in Greece. It will add another complex layer to negotiations, while politically it will help the (True) Finns who are already launching a campaign against further bailouts. It could also lead to legal challenges - as we pointed out with Greece, it could trigger 'negative pledge' clauses on Spanish bonds given that they essentially become subordinated to Finland's claim on Spain. Not guaranteed, but a legal grey area which adds to the confusion.

As for Ireland, they have a fairly strong case here. Ultimately, their fiscal troubles stemmed from bailing out their banks, something Spain is now able to dodge thanks to external help. Ireland already feels that it is paying a huge price for protecting the European banking system - this will only add to this ill feeling. Given Ireland's perceived 'success' in Germany some flexibility may be forthcoming but we doubt enough to assuage Irish anger.

Impact on the UK?
The IMF will only play a 'monitoring' role, meaning the UK will not be liable for the money provided to Spain. However, given the links between the UK and Spanish banking systems it is imperative that the problems in the Spanish financial sector are finally dealt with - whether that will happen this time around is yet to be seen but given the points above it is not off to a great start.

Impact on the eurozone - Open Europe concluding remarks:
Markets responded positively to rumours of external aid for Spain on Friday afternoon, but, given the points above, a huge amount of uncertainty remains which will keep markets jittery and increase pressure on the eurozone. That is far from needed given the uncertainty surrounding the Greek elections. Given the ongoing assessment of the actual needs of Spanish banks the rescue will now enter a state of limbo as attention turns back to Greece, in the meantime Spain is likely to find it difficult to access the market (since this is broadly an admission it cannot raise any substantial funds itself).

Questions will also arise over the strength of the eurozone bailout funds - Spain guarantees around 12% of them, surely its guarantees are now worthless or would do more harm than good. Additionally, now that one of the larger countries has asked for support pressure will intensify on Italy (particularly with the falling support for the technocratic government and the slow pace of reform).

Stress Test 2011 initial results

The Stress Test results are out! It looks like 8 have been judged to have failed but interestingly 16 came close to failing. Given how lenient the adverse scenario is (especially given recent market turbulence relating to Spain and Italy) that is fairly surprising. See below for the table on how each country's banks fared...










We have to say that we're surprised more didn't fail... OK, well we would be if the tests were more credible, but you get where we're coming from.

The banks that failed are below (some with their capital shortfalls) courtesy of FT Alphaville:

Austria
Volksbanken

Greece
Atebank
Eurobank EFG (€58m)

Spain
CAM (€947m)
Catalunya Caixa (€75m)
Unnim (€86m)
Banco Pastor
Caja 3 (€140m)