18 July 2016

Impact of Brexit on Banking Union

Banking union is probably the flagship policy of Euro area financial integration in response to the 2008-10 Crash and most of it is already operational. The underlying political strategy to deal with the financial and economic problems is clear, even if contentious. Even at this late stage, could Brexit scupper the drive for `more Europe’ and thus de-rail the completion of banking union – a financial project to de-link governments from their banks?

Banking union is ambitious: underpin financial stability by transferring the responsibility for banking supervision (and resolution when necessary) to the European level. It will also weaken the nexus of sovereign debt and banking crises by separating any weakness of domestic government finances from spreading contagion to its entire banking system via large holdings of the government’s own debts. In addition, the banking union should reverse to some extent the fragmentation of financial markets in the euro area as depositors should no longer fear redenomination of their deposits, pushing banks to focus on their home markets.

Such are the aspirations. How close are we to reaching these goals? Banking union will be the capstone sitting on its three pillars: Supervision, resolution and deposit guarantees.

Supervision at the European level flows from the Single Supervisory Mechanism (SSM) which came into force in late 2013. This gave the ECB overall control of supervising the euro area’s 6000 banks – with direct supervision of more than 120 banks – covering 85% of euro area bank assets.

Resolution powers came from the Bank Recovery and Resolution Directive (BRRD) – now fully in force and operational. This requires banks to have `living wills’ and the European resolution authorities to have resolution plans for each bank. BRRD provides for `bail-in-able’ liabilities but carefully excluded a number of deserving categories such as electors with less than €100,000 deposits and also SMEs. BRRD also set up the Single Resolution Authority (SRA) – with the Single Resolution Fund (SRF) to provide any bridge financing during the resolution process.  The SRF will build up over eight years to a target of at least 1% of covered deposits of all banks in the participating member states – through annual bank contributions. To even their own surprise, the Brussels think-tank CEPS calculated that the €72 billion eventual size of the fund would have been enough to deal even with the recent crisis.

However, the third pillar - “European” deposit guarantees – still remains only a proposal. The Euro area Deposit Insurance Scheme (EDIS) would progressively fold the existing national deposit insurance schemes (DGS) into a “European” liability by 2024. The first three years would be a period of re-insurance by Europe, followed by four years of co-insurance and full insurance only in 2024.

The hesitancy reflects the potential scale of potential liabilities. Greece is only 2% of the EU’s GDP and its banks saw a “deposit run” to the tune of 50% of GDP/€100 billion as depositors correctly spotted that the Greek Government could not possibly backstop its national DGS. The ECB reports that household/not-for-profit deposits are nearly €7 trillion and non-financial corporations are a further €2 trillion. Understandably, underwriting such vast sums is a major political concern. For reference, total government debt in the euro area is just short of €10 trillion.

The economic strategy is to de-risk both governments (with improved public finances) and banks (with higher capital) so that any possible blow to depositors becomes a very remote risk. The corresponding political strategy is the string of agreements after the Greek crisis exploded in 2010 to give Europe much greater powers to oversee the competitiveness of the euro area economies. The latest phase of the politics is set out in the Five Presidents’ Report proposing closer political integration over the next decade to provide the democratic accountability for the economic and financial integration. If the risks really are reduced AND the political drive for `more Europe’ continues, then EDIS can happen and banking union be complete by 2024 – economic necessities but also symbols of a strong political integration.

The Brexit referendum has exploded a grenade in the middle of this thinking: will electors permit the integration momentum to continue? Already many states face significant popular support for parties at the extremes of the spectrum. Though there are national specifics, there are common threads of dissatisfaction with the “establishment”, especially amongst those who have lost out from globalisation combined with years of “austerity”. Will they become the majority of voters, or remain as a minority – though substantial?

However, no vote can escape from the hard reality of public debts that average more than 90% of GDP and that are a core asset of a still-highly leveraged banking system. If the public will not support the servicing of those debts, a financial melt-down is inevitable. As sterling crashes and the UK’s financial system trembles in direct response to the Brexit vote – let alone the reality of departure – opinion polls in some Scandinavian countries are showing a sudden resurgence in support for “Europe”. Perhaps Britain’s plight will focus electors on the need to improve political accountability in Europe rather than throw it all away and jump into a now-frightening unknown.

© Graham Bishop