Fifteen years after its birth, the European Central Bank has set out on one of its most difficult journeys. Over the next year, the ECB will scrutinise the balance sheets of more than 120 eurozone lenders. This is a Herculean task and almost certainly the largest clean-up in banking history. To make things harder, Frankfurt lacks any supervisory experience. So far, its mandate has been limited to monetary policy. The eurozone has a history of botched bank assessments and some investors are sceptical that this time will be different.
Nor could the stakes be any higher. The ECB is putting its reputation on the line. So is the eurozone as a whole. Awarding the central bank the power to supervise eurozone lenders is the first step in the path to a “banking union”. If the ECB fails on its debut, markets will conclude that the currency union is not serious about breaking the lethal embrace between the lenders and the sovereigns that has sunk countries such as Ireland and Spain.
Two weeks ago the ECB released the initial guidelines on how it intends to run this complex exercise. They are encouraging. Frankfurt will use a higher capital yardstick than the one enshrined in the Basel III banking regulations. The central bank will rely on the expertise of national supervisors but will back them up with its own staff and private consultants. This should ensure that past supervisory failings are not swept under the carpet. The final recommendations on each bank will be signed off by ECB staff alone, which should lessen the risk of undue influence by governments.
While the ECB’s direction of travel is clear, its final destination remains hazy. By some accounts, the exercise is expected to reveal that eurozone banks need between €50bn and €100bn in fresh capital. The hope is that enough private investors will step in to plug this hole. But were markets to react less enthusiastically, it is unclear who – whether it be creditors, individual governments or the eurozone as a whole – should be asked to chip in first.
According to new rules approved by the European Commission last summer, holders of subordinated bonds must be “bailed in” before taxpayers contribute. The ECB agrees this rule should apply to banks that are deemed insolvent. However, Mario Draghi believes solvent banks that require an additional capital injection should be treated differently and their junior creditors spared from losses. The ECB president fears Europe’s fervour for “bail in” may turn investors away from its banks.
Yet raiding the public purse to protect investors from their punts is manifestly unfair. Nor is there much evidence that “bail-in” clauses sap markets of their appetite for junior debt. In countries where these rules have been applied, such as Spain, banks are still able to sell subordinated bonds.
Mr Draghi is right, however, to demand that the politicians put in place credible backstops to fill in any residual shortfalls. This is essential for the credibility of the exercise. But individual governments should not be expected to bail out their own frail banks. A eurozone-wide pot of money – such as the European Stability Mechanism – is needed to safeguard, in particular, weaker sovereigns.
Most importantly, eurozone leaders should give the ECB the political cover it needs to get to the bottom of Europe’s banking problems. Some institutions – such as Germany’s regional Landesbanken – will seek to use their formidable influence to rebuke Frankfurt’s intrusiveness. But letting banks continue to hide losses is not a viable strategy. As Europe strives to return to growth, the prize of having a properly functioning banking system is huge. Governments should support the ECB wholeheartedly.
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