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The European Banking Union – a road to reforms or a dead-end road?

The European Banking Union – a road to reforms or a dead-end road?

The euro sign landmark is seen at the headquarters of the European Central Bank (ECB) in Frankfurt

How did it all start?

The European Banking Union is the core topic in this paper. The reasons for its formation, essence and operational effects sought for are directly related to the historic genesis of the Eurozone institution-building. That is why we need to go back in recent history and look for an answer to the question how and why the single European currency was introduced.

The notion of having a single European currency was conceived in the Middle Ages, but its actual implementation came to life much later, in February 1969, when EC Vice President Raiman Bahr “put on the table” a strategy for economic and monetary collaboration between European countries. The plan followed immediately after the crisis of November 1968. On the 6th of March 1970 the Prime Minister of Luxembourg and Minister of Finance Pierre Werner took on the responsibility to shape the notions and procedures for creating an economic and monetary union. The Werner Plan underwent numerous adjustments under the pressure of international political and economic stand-offs. One of the main obstacles was the lack of a consensus position on setting up a supranational institutional infrastructure.

Step by step the monetary systems went through some serious changes. Unfortunately, the political elite were very successful in promoting an erroneous idea that totally controlled fiat money was of much higher quality than commodity money. The single currency project had been consistently and actively defended in a skillful way by French experts. Such a project would have achieved a number of objectives. It was based on the obsession to remove the German mark from the European arena, i.e. to reduce Germany’s economic domination brought about by the strong German currency. This would have opened an even bigger opportunity for an accelerated inflation to the interest of governments and the banking sector. A broad monetary union would have provided the scale needed to diminish hyperinflation options because inflation would be distributed over a larger economic
territory.

Germany weighed the benefits of such a project and gave its consent. That was how on the 1st of January 1999 the European monetary union was formally brought to the public arena. The single currency, named euro, replaced the ECU. The euro became a legal tender in all twelve Member States, and in 2002 the first euro coins and euro banknotes were put in circulation.

As any non-commodity-based monetary system, initially the Eurozone was quite unstable. At the very onset of this monetary union it became apparent that Maastricht criteria would be violated, albeit quite soon. The Stability and Growth Pact requirements were, to put it mildly, marginalized, mostly by the ‘engines’ of Europe – Germany and France. In the fall of 2003, the Council of the Ministers of Economy and Finance had to serve them with a formal warning about deficit reduction, but it simply did not do it. In mid-2004, the 3% deficit criterion was exceeded by Italy, Greece, Portugal and the Netherlands as well.

The Eurozone was brought down to its knees not long after the overseas financial fiasco, with the aggravation of so-called ‘debtcrisis’. In panic, new institutional mechanisms were sought for in order to strengthen the banking sector and the monetary union of the Old Continent. The European Banking Union is one of the mechanisms that are considered to be crucial in the struggle to survive and gain stability and future progress.

The European Banking Union – the life-belt of the Eurozone?

The economic issues of Europe can be resolved only by very profound structural reforms. Unfortunately, for the time being it is the ‘monetary artilleryman’ Mario Draghi that has taken on the fight against low inflation rates and poor economic growth. When structural reforms are replaced by printing money, any trace of optimism is doomed to oblivion.

The European Banking Union has come up with some constructive ideas as to how to re-fence the fenceless yard of Europe’s banking sector and stabilise it. It is a different cup of tea, though, whether the objectives are realistic and sincere. The important issue here is that, though few, there are some correct approaches towards reforming the system of fractional reserve banking and this move deserves admirations.

The formal objective of the Banking Union is to strengthen the banking sector and the financial system as a whole. In turn, a stable financial system is a precondition to achieving sustainable growth of the European economy in the future. Regaining confidence in banking institutions will support a proactive loan market and stir up economic activity, investments and, respectively, economic growth. There is no doubt that trust and confidence are the key words to sustain banking system stability because the current fractional reserve banking suggests fast and deep crises. In the recent years generation of trust has rested in the hands of central banks. They have been and continue to be wrongly assigned with the task of regulating banking sector processes and intervening actively where necessary. This is a mistake because a central bank intervention does not lead to positive outcomes. On the contrary, it postpones the required reforms thus raising the social price of ongoing issues.

The European banking union has to aim at limiting such central bank interventions so as to enforce sound banking which is created by the market for the market. In other words, bank responsibility and personal risk-taking upon failure. The Banking Union’s only chance of becoming a successful project is to reformulate its objectives within these lines.

Another mistake in the formulated objectives, as they stand today, is the notion of having a similar mechanism put in place to take care streaming more loans to the real sector and generating economic growth. This task is the duty of the real sector itself, of the competing companies that produce and sell more effectively and efficiently. It is important to understand that a bank loan does not create resources, its function is to direct already existing resources towards companies that need them. Stimulating the lending process artificially may lead purely and solely to creating a balloon-effect in the sectors, just like in the mortgage market back in 2001-2007.

To achieve a valid success, the Banking union has to be perceived not simply as a tool that brings stability in the current situation and adds just a bit of trust in the hesitant operations of the economy’s circulatory system in the Old Continent. It has to focus its efforts on reviving the classical banking principles of higher responsibility, intolerance to risks and categorical break between taxpayers and future banking sector rescue operations.

Structure of the European Banking Union

There are four structural elements in the European Banking Union:

1) The Banking Union foundations are built on harmonised rules and powers across EU28 countries. The Single Rulebook represents a single set of rules that will support comparative analysis and supervision of national banking institutions. This is a necessary condition to treat the main bank rates about adequacy, liquidity, etc. The single rules set the basis also for the remaining Banking Union pillars such as the single supervision, crisis management and more efficient deposit guarantees.

2) The Single Supervisory Mechanism is the most criticised element of the Banking Union. It is based on the notion of establishing an institution that will exercise centralised supervision over the European banking system. The European Central Bank will take charge. It will have to set up broader and more detailed financial supervision while being entrusted with a larger set of powers and control options. Such a powerful supranational regulation to enforce harmonised rules, norms and a comprehensive common approach over the entire European banking system is devised for the first time in the history of the Eurozone.

The new ‘super’ bank assumed its new powers on the 4th of November this year. The European Central Bank will monitor some of the largest credit institutions, namely, 131 institutions in 19 Eurozone Member States, and Lithuania. The scope covers 85% of the bank assets in the Eurozone. At any time ECB may conduct extraordinary audits to control bank balance sheets.

This is the first time in the history of the Eurozone that an attempt to exercise a detailed quality control over bank institution operations has been made. There is a level of discontent in ECB itself in view of the big risk the Bank is taking in terms of its image, should this endeavour be a failure. Such a scenario may seriously shake up the entire
monetary system in Europe. In close cooperation with the national supervisory bodies, ECB has the task to watch over the correct evaluation of bank collaterals, adequacy of bank provisions, and capital and liquidity ratio levels.

There are some ‘hot potatoes’ in the European banking system but their scale and distribution remain unknown (at least, to the general public). For that reason, ECB with the support of national central banks and audit institutions conducted audits of bank assets and performed stress tests of bank stability under various economic scenarios. The results were announced on the 26 October and at first glance looked disturbing. Later on it became apparent that for 2013 the capital shortage of EUR 25 bn established was considerably higher than the current one amounting to about EUR 10 bn. Out of the 25 ‘problematic’ banks only a few had more tangible issues.

Stress test adequacy is of immense importance to ECB, and should test efficiency be similar to the one of the former three, then the black clouds over the monetary union may get thicker very quickly. Will the political nature of bank testing give way to financial transparency and radical pragmatism? Was the selection of parameters set out in the tested scenarios adequate? Isn’t it odd that deflation is not included in the negative scenario while annual deflation of only 0.30% has been reported as of September this year? We are about to learn the answers to these questions in the near future.

It is important to emphasise that future implications stemming from a possible cover-up of the truth will fall on ECB. Here the question is yet again whether it is politically possible for ECB to be entirely honest regardless of being aware that any covering up of the extent of the problems will have a backslash effect on it?

3) The centralised supervision approach is accompanied by a centralised approach to meeting the costs of future bank failures. According to the EC it is not possible to have supranational supervision while failure costs are covered nationally. The Single Resolution Mechanism is a set of rules and procedures to secure smooth and flexible decision-making regarding bank failures, decisions that have the least possible price for taxpayers and real economy. This single mechanism aims to improve effectiveness and efficiency in resolving issues of international bank relations, emerging inevitably in view of the heterogeneous European financial system. This mechanism is brought to life under the EU Bank Recovery and Resolution Directive. The new institutional framework broadens the options to have a more systematic and efficient bank failure procedures or resolution.

The Single Resolution Mechanism applies to banks that fall within the scope of the single bank supervision. Should there be a supervision failure and the bank is faced with an issue, the Single Resolution Mechanism will be put in motion. It will be managed by the Single Resolution Board, a legal entity not part of ECB. Funding will be provided from the Single Resolution Fund, with financing generated from the banking sector and amounting to EUR 55 bn for a period of 8 years. Its main purpose is to minimise the use of taxpayers’ money in restructuring or bank failure procedures.

The European Central Bank has issued an opinion that the amount is negligibly small in comparison to the banking system scale. Indeed, these EUR 55 bn which in fact are missing today, are just ‘dust in everyone’s eyes’. Let us recall Bankia when some EUR 22.5 bn were poured into the 2011-2012 saving operations. Once again we touch on the issue of moral risk, and the genuine truth that anyone involved in the banking sector has to bear responsibility. Let us leave the worries and fears of systematic risks to the political arena.

4) The Deposit Guarantee Schemes aim at reimbursing a limited amount of deposits to depositors whose bank has failed. From the depositors’ point of view, this provides full or partial protection of their wealth in the form of deposits. Brussels’ bureaucrats emphasise on a larger scale notion, namely, the prevention of a chain reaction, panic and a systematic risk for the entire system. At first glance this may serve as an adequate argument but in fact the fractional reserve banking system cannot be strengthened by way of administratively imposed level of deposit guarantees.

The position of Bulgaria

Following the domestic bank turmoil, the topic of Bulgaria joining the European Banking Union and taking steps towards entering the Eurozone has gained pace. Such a route seems quite logical in view of the political issues and the case of Corporate Commercial Bank. Still, it is important to account for the fact that Europe experienced and continues experiencing banking problems of no lesser magnitude. Therefore, there is no reason for us to deem flawless the supervision put place in the West. Moreover, even if we are to come under the umbrella of the new ECB supervision, the Central Bank will work in close cooperation with the Bulgarian National Bank because there is no other team with the expertise and sufficient number of staff to do the job.

Europe’s economic development goes through strive, will and awareness of some basic objectives: achieving efficient competition, lesser government intervention in economy, quality of education… I am an optimist that this is attainable but we need to be clear on one thing – we are on a thorny and a very narrow path.

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