Banking Union answer to EU debt woes? Experts discuss

Last week European leaders took the momentous decision to move towards a banking union. The leaders decided to separate the weak sovereign problem from the weak banks issue by deciding to recapitalise banks directly from ESM or the European Stability Mechanism. This would be preceded by making the European Central Bank the ultimate banking regulator in the eurozone.

ECB Chief Mario Draghi said that common supervision marked the ‘first step’ toward a banking union, with a resolution fund coming second and joint deposit guarantees third. The common deposit scheme would imply eventual mutualization of debt in Europe. Even further beyond banking unions were eurobonds, Draghi added. Professor Charles Goodhart former member of the Bank of England's Monetary Policy Committee and Shayamla Gopinath, former deputy governor of the RBI share their views on how long will it take to form a banking union and whether European governments will willingly give up their authority over their domestic banks. Below is the edited transcript of the interview. Q: Do you think the European Stability Mechanism, the ESM will have enough funds in the first place to capitalise all the banks? How long may it take for the ECB to become a regulator? Goodhart: Only for the weak banks will come out for the ESM and the ESM is not yet in operation because ESM can’t start operating until Germans have agreed. They can’t agree until their constitutional court agrees that it is consistent with the German constitution. So, that puts things back by about three months. Even after that, the ESM is not going to be able to provide recapitalisation money directly to the banks, until the ECB has got supervisory mechanism in operations. ECB has done no supervision whatsoever in past. It has got no staff, it has got no track record, it has got no experience in this field. So, how quickly can the ECB take on this role even after the ESM has been agreed is yet to be decided. A lot of what is suggested for the banking union is still to be worked through to be made operational. Q: Would you say that the first step of a trans-national regulator is at least one year away? Goodhart: Perhaps less than that, but almost certainly well into the new year. European summits tend to make sort of promises, and then you find out later that actual procedures are more complex and will take longer and will provide less than the original summit suggest. Q: What is your sense? Do you think there will be a lot of friction with governments not willing to give up their authority over the banks? How does it really work in Europe? Gopinath: Certainly banking and the fisc is pretty much correlated and issues of sovereignty would arise. But what is a greater concern here about the banking union is the mutualisation of the debt of all the banks. Given the situation of the European Union there the liabilities of the banking sector far exceed the GDP of the countries or even the public debt of the countries. Such mutualisation would be worrisome to a number of policy makers or economists. So, this particular step doesn’t seem to be such a great matter of concern as the much larger issue of banking union. The second is that as professor said that it’s only the weak banks that are being considered as of now. The other important issue is that the ECB doesn’t have the supervisory capacity like professor said. They will have to depend on the national supervisors. They will have to work out an arrangement where, certainly I don’t think they are going to close all the national supervisors; they would be using them for inspection and supervision. But there would be a reporting mechanism to the ECB, there would be some kind of a monitoring and surveillance by the ECB. So, all these are not very clear and we really need to see now this will shape out. _PAGEBREAK_ Q: That point is taken but do you see at any point in time a tussle between local governments and the ECB because it is a giving up of sovereignty? Gopinath: The other characteristic of the European Union is that a lot of the bank funding has come from cross border flows. Infact the monetary union did facilitate this cross boarder flows and by taking out the currency risk entirely, it made it so much easier to do. When you have a system with so much of cross border flows happening, a single supervisory mechanism for the group as a whole would be in the interest of the sovereign too. So, hopefully it shouldn’t be such a big issue. The other reason why I feel it won’t be such a big concern is that anyway now the regulations are harmonized. All the regulations are through the European commission, European parliament, Basel III is being implemented through the European commission. Therefore, with regulatory harmonization already happening, the issue is about the supervision. There is an expectation that the ECB will be independent, tougher and that ECB will not be beholden to the politicians or to the financial interest. Q: What do you think, will the various sovereign nations bow to a common banking regulator or will there be friction? Goodhart: There will be a degree of reluctance, but there is going to be a difference between the way the ECB deals with the banks that have received a recapitalization from public sources and banks that have not. Major banks from the big countries that have not received any recapitalization will be treated quite gently by the ECB. This is primarily to impose a tougher and stronger supervision on the banks in the weaker countries. Q: For the bigger banks the money has come from all over the world but for smaller banks, they could be more domestically domiciled. Do you think sovereigns of weaker economies may want their domestic banks to be more accommodative towards their home country borrowers, is it likely that the ECB will curb this or even prevent the banks from buying sovereign paper whose rating is lowered; could this be potential areas of conflict? Goodhart: There is a total inconsistency and a conflict of objectives in every country in Europe. Simultaneously, the supervisory authorities want them to raise their capital ratios and become stronger and safer. While on the other hand the same authorities want the banks to be more expansionary and grant more credit to the corporates and for housing purposes. These two objectives are somewhat contradictory. This occurs in every country whether they are weaker or stronger within Europe. Q: Do you think things will reach the level like our SLR, we also force our banks to bailout the fisc with a compulsory buying up of government bonds, do you think some such rule might come but the other way round like you cannot buy a minimum SLR, do you think that could be the contentious point? Gopinath: Here again, the regulatory jurisdictions are different now, the SLR or liquidity prescriptions. All that would again be something that the European commission would decide and prescribe to the banks. Certainly, that would be within their area to define what would be treated as instruments that are liquid and also the capital that has to be allocated to various sovereign debt instruments. The ECB comes into the picture is the fact that the ECB’s collateral policies influence a lot of investment by the banks. So if like now in this crisis period, the ECB did relax the collateral rules then you do have investments happening in the sovereign bonds and the banks are able to get liquidity.