European Banking Union: A far fetched dream

India Forex Advisors

Last summer, at the height of the panic over Spain's banks, the Euro zone embarked on an initial step - in the direction of a banking union. European finance ministers have agreed to a deal to give the European Central bank new powers to police Euro zone banks, embarking on the first step of a new phase to create closer integration so as to help underpin the Euro. Leaders agreed that the European Stability Mechanism (ESM), the zone's bailout fund, could be used to recapitalize banks that have gone bust, but only once an effective supervisory mechanism was in place.

However, looking at the current scenario, the plan appears deeply flawed. The Cypriot catastrophe shows just how distant the Euro zone is from creating its much-touted "banking union". There was: (i) no Euro zone supervision of Cyprus's big banks, (ii) no transnational approach to put them into controlled bankruptcy, (iii) no common deposit insurance, and (iv) no flow of bank rescue funds from overseas. Instead, there was weak supervision of the Central Bank of Cyprus.

The core countries seemed to regret the approval they gave for this deal. Rather than focusing on banking system stability, the junk is diverted only to the free money flow from the asset buying by the ECB. This diversion is led by the optimism spurred by the ECB president Mr. Draghi, who promised to do whatever it takes to preserve the single currency. While paying lip service to the principle of shareholder liability and creditor burden-sharing, the current draft falls woefully short of protecting European taxpayers and could cost them hundreds of billions of Euros. Further lobbying by banks is likely to make things only worse.

The backdrop of the banking union lies in the appointment of a single supervisor and ignorance of deposit insurance. A single supervisor's independent decision makes the task difficult and large scaled, as the ECB won't be able to supervise effectively if there is no authority to which it can hand over a bank that has gone bust.

In the Euro zone, deposits of less than 100,000 Euros are supposed to be guaranteed by national schemes. In the wake of Cyprus's crisis, the Euro group re-emphasized that these savings should be protected. Euro zone leaders are in the process of setting up a single resolution mechanism. The European Commission is supposed to come up with a plan this year with the idea that legislation will be passed before the European elections in June 2014. However, the snag is that it is devilishly difficult to set up such a resolution authority,

The flaw is identified in the agreement because it does not answer the question: "How this authority should fund bank failures if there isn't enough capital to take the hit?"

The existing loopholes in the system, if overlooked, can lead to the following problems for the Euro zone.

• If the burden is passed on to the struggling taxpayers, it would destabilize the sound countries. This step will act as a firing up channel rather than a firewall, which will enable the flames of the debt crisis to burn through to the rest of the European government budget.
• It has been noted that the asset ownership in bank equity as well as bank debt tends to be extremely concentrated. Some of the richest households in every country own these stakes. Not bailing-in these households would amount to a gigantic negative wealth tax for the benefit of wealthy individuals worldwide, at the expense of Europe's taxpayers, social transfer recipients and pensioners.
• Misallocation of capital in the banking system will not only bloat the banking sector but also perpetuate the overly risky activities of these banks signaling a slower recovery in the long run.

The need of the hour is formation of a centralised supervision and resolution authority to address the European banking crisis. This bank resolution should be subject to binding rules for shareholders' losses and liabilities. If the banking sector continues with its lethargy and the commission's proposal passes the European Parliament without adequate revision, Europe's taxpayers and citizens would have to contend with a bigger hit of public debt - such an event could pave the way for another economic decline.