Friday, November 28, 2014

Europe’s Flawed Banking Union

PARIS – The European Union is now the proud owner of a Nobel Peace Prize. When the choice alighted on Barack Obama three years ago, the Norwegian Nobel Committee was criticized for honoring someone whose achievements were still to come. The Committee took that criticism to heart, and this time decorated an institution with a proud past, but a clouded future.

The eurozone is distinct from the EU of course, but it is the Union’s most ambitious undertaking to date, and it is still struggling to equip itself with the structures needed to bolster a currency union. A common fiscal policy remains a distant dream, as does a genuine political union.

But Europe’s policymakers claim to be making progress toward a so-called “banking union,” which means collective banking supervision, rather than a merger of banks themselves. In September, the European Commission announced a plan to make the European Central Bank the supervisor of all 6,000 of Europe’s banks.

The reaction among national politicians, central banks, and banks themselves was not universally favorable. The Germans want the ECB to focus only on large systemic banks, and leave smaller savings banks (like those that invested heavily in subprime mortgages) to national authorities. The United Kingdom and Sweden argue that they cannot be made subservient to a central bank of which they are, at best, semi-detached members.

The case for a pan-European supervisor is widely accepted, especially as the European Banking Authority (the EU’s banking regulator) proved feeble in carrying out financial stress tests: the first tests were so weak that even Spain’s now-bankrupt savings banks could pass with flying colors. Europe must break the vicious circle linking distressed sovereign borrowers with banks that are obliged, or at least encouraged, to buy their bonds, which in turn provide the funding for bank rescues.

But the method chosen by the Commission to implement a banking union is fatally flawed.  Moreover, according to a leaked opinion from the EU Council’s chief legal adviser, the proposed reform is illegal, because, according to the Financial Times (which received the leak), it goes “beyond the powers permitted under law to change governance rules at the European Central Bank.”

Throughout the crisis, European leaders have tried to respond to the gaps in the monetary union without proposing a new treaty, because they fear that any new treaty proposing more centralization of authority in Brussels would be rejected, either by national parliaments or by voters in a referendum. So they have tried to proceed by intergovernmental agreement, or by using existing treaty provisions.

In the case of the banking union, they plan to use Article 127(6) of the Lisbon Treaty which allows the European Council to grant authority to the ECB to perform specific tasks concerning “policies relating to the prudential supervision” of certain financial institutions in the Union. That is a thin legal basis for establishing a pan-European supervisor with direct responsibility for individual institutions, and it was clearly not intended for that purpose. Indeed, Germany agreed to the wording only on the understanding that the ECB could not be a direct supervisor.

The consequences of choosing this inadequate, if expedient, route are serious. For starters, the existing treaty cannot be used to create a single European resolution authority, leaving an awkward interface between the ECB and national authorities. Nor can it be used to establish a European deposit protection scheme, which is arguably the most urgent requirement, to stem the outflow of deposits from southern European banks.

There will also be potentially dangerous consequences for the ECB itself. The use of the Lisbon Treaty clause means that the ECB must be given these additional responsibilities. But it is impossible to create a separate bank-supervision entity within the ECB, as has been done in France, for example, with the Prudential Control Authority, or in the UK with the new Prudential Regulatory Authority, which has its own board and accountability arrangements within the Bank of England.

The importance of these structures is that they insulate the central bank’s monetary-policy independence from corruption by the tighter accountability requirements that inevitably come with banking supervision. Because supervisors’ decisions affect individuals’ property rights – and their actions or omissions can put taxpayers on the hook to bail out banks – governments, parliaments, and the courts are bound to hold the watchdogs on a tight leash.

That is why Germany’s Bundesbank, which always guarded its monetary-policy independence so assiduously, has once again found itself in the rejectionist camp, expressing severe doubts about the route that the Commission plans to take. This time, they are right.

There are other serious issues, too. According to the Commission’s model, the European Banking Authority will remain in place, and is charged with producing a single rulebook for all 27 EU member states. But, while its work is carried out under the normal qualified majority voting system, the 17 eurozone countries will have a single supervisor, so will have a block vote. The Commission is trying to find ways to protect the rights of the non-eurozone countries. But the very complexity of what is proposed shows just how inadequate the scheme is.

Non-Europeans, in particular, may find the entire topic impenetrably abstruse. But it illustrates a simple point: Europe is trying to achieve a stronger federal model that responds to the weaknesses revealed by the eurozone crisis. But it is doing so without addressing the crucial need to bring its citizens along. Indeed, the devices that the EU is adopting are designed specifically to avoid having to consult them.

The proposed construction of a banking union reveals this fundamental flaw at the heart of the European project today. It is difficult to be optimistic about the success of an initiative built on such flimsy legal foundations, and lacking democratic legitimacy. Europe’s banks and their customers deserve better.

Read more from our "Sticking with the Banking Union" Focal Point.

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    1. CommentedJoshua Ioji Konov

      Mr. Davies, your article is pretty good in showing the messy picture of the EU being as perplexing as it possibly could be. Adding to it, is the stubborn ideological attitude of a trickle-down economic approach engraved in the EU policies that puts debt and fiscal shortages above growth and prosperity..., bureaucracy above free entrepreneurship, big business above medium and small business.., I guess, how bad the economy in the EU should go down to trigger some adequate response.., it happened in China, the US and now Japan..., not unity would save the EU but diversity in business and market activities..., the large transnational corporations that have taken over from finances to manufacturing and retail are not the solution for a better future and economic development, but the small to medium businesses and investors are, which, however, are not promoted and empowered by the EU policies,
      Joshua Ioji Konov

    2. CommentedJohn Brian Shannon

      Hi Howard,

      I do appreciate how clearly you have laid out the present European situation although I respectfully disagree with some of your conclusions.

      Europe may indeed be responding "to the weaknesses revealed by the eurozone crisis" but it is inevitable that these measures would have been implemented at some point. The present situation has merely accelerated the timeline.

      In a Western context, the drive by purist democratic politicians to exuviate visionaries and populists from the political scene has resulted in a situation whereby people with visionary ideas and populist support are missing from this equation. And so are their great accomplishments.

      After all, Hitler was a populist. I get that, no one wants that again.

      Mind you, Winston Churchill was a populist leader and without him, Great Britain would have ceased to exist.

      The reason that some logical and much-needed initiatives are floundering due to lack of voter support, is because there are no great visionary and or populist politicians out there selling those initiatives to the masses -- the present (excellent) crop of leaders too devoted to the perfection of democracy to involve themselves in such vociferous and unseemly behavior.

      The skill-set of each is radically different.

      As raucous as a salesman's voice may sound, they are required in order for transactions to be successfully concluded. Leaving visionaries and populist politicians out of European politics has brought us to where we are now.

      Great administrators are not visionaries and conversely, great visionaries are deeply-flawed administrators -- often the worst on the planet. Nevertheless, for best results -- add both to the mix. Democracy is a messy business, isn't it?

      "It has been said that democracy is the worst form of government except all the others that have been tried." - Sir Winston Churchill

      Cheers, JBS

    3. CommentedMarten Klein

      The Commission proposes, not the member states. So the ball is in the Court of Mr.Barnier who four years later presents his regulatory package. More to come, for sure. Not only Art 127 but also all other canons get fired. I wish he were an ordoliberal.

    4. CommentedJ St. Clair

      ' to stem the outflow of deposits from southern European banks." many banks does this equate to....out of the 6,000

    5. Commentedde Lafayette

      From Charlemagne of the Economist 22/09/2012 edition: {The euro zone is heading towards the worst of both worlds—nation-states feel violated by Brussels’s ever-expanding controls, even as the European level remains too weak and opaque to have an impact or win popular allegiance. A better approach might be to set aside labels and think of a narrow set of core functions that need to be deeply integrated. A coherent banking union makes sense, as do some joint bonds. Germany rejects mutualisation of debt on the grounds that not even America expects states to guarantee each other’s debt. Yet America has federal bonds, backed by federal taxes, which in turn provide a safe asset for all banks to hold. American states go bankrupt, as do lots of banks. Call it what you want; integration, centralisation, federation, confederation—the objective should be to stabilise the system sufficiently to allow badly managed banks and states to go bust safely.}

      It is not obvious that the EZ is "heading towards the worst of both worlds". The Economist is indulging in "scare journalism" as it has often a wont to do.

      But the rest of the statement rings true. The foundation of a Lender of Last Resort to deal with circumstances where member states spend beyond their means of either repayment or even debt-maintenance must be found. That means both equal portions of regulatory oversight and the ability to make monetary policy - both of which need not be housed in the same place, but must exist tangibly somewhere.

      The former needs real teeth to prevent the present circumstance from repeating itself. The latter requires real Central Bank leadership who answers to a Central Authority duly elected by the EZ-member state electors, who in turn must relegate to that authority the control of monetary policy.

      Maybe the Two-speed Europe is, after all, the best alternative. Those not in Euro-Zone should perhaps content themselves as on-lookers to main game.

      One for all and all for one.

    6. Commentedde Lafayette

      Given the nearly calamitous use of "national referendums" in the past by the EU, it is easily understandable why its politicians want to avoid them in this particular case.

      And yet, given the crisis, something must be done to enforce oversight upon, at lease, EuroZone banks. So, rickety as it may appear, this present solution may be the only one that is feasible at the moment.

      When it could have done so, before the present crisis, Europe did not go far enough in developing a much needed central government. The European Commission is an unelected body, after all. Given the present economic turmoil in Europe, it is presently out of the question to ask Europeans to elect, for instance, an EU President who would establish a Cabinet to replace the Commission.

      This mistake was made out of shortsightedness of the EU leadership at the time but also, it may be argued, the inability of that leadership to surrender is sovereign authority to a European president. After all, that would relegate national leadership to a “governorship” status as exists in the US. Which is tantamount to a degrading of prestige.

      It will likely take, therefore, a different political class to take the leap forward towards creating an EU common leadership that would constitute the third leg in a tripartite governance of the EU consisting of an Executive, a Legislative and a Judicial institution (the latter two already extant).

      That class, however, will be many years in the making. It does not exist today.

    7. CommentedZsolt Hermann

      I think the last part of the article tells all:
      "...Non-Europeans, in particular, may find the entire topic impenetrably abstruse. But it illustrates a simple point: Europe is trying to achieve a stronger federal model that responds to the weaknesses revealed by the eurozone crisis. But it is doing so without addressing the crucial need to bring its citizens along. Indeed, the devices that the EU is adopting are designed specifically to avoid having to consult them.
      The proposed construction of a banking union reveals this fundamental flaw at the heart of the European project today. It is difficult to be optimistic about the success of an initiative built on such flimsy legal foundations, and lacking democratic legitimacy. Europe’s banks and their customers deserve better..."
      It is similar to renovating a house which started to be dangerous to live in, as it started to collapse.
      The wise renovation would start with the foundations, then the walls, the inside of the house and finish with the paining, decorating.
      The European Union in the Eurozone, and in fact the whole global economy tries to renovate, or maintain the other way around, they thing the process can start with painting, decorating and the rest can wait or it is not important.
      First of all the role of the financial institutions is way overrated, they have become the inflated bubble controlling everything, being the measuring stick for global health, while banks should simply remain in an assisting role for a natural trade relationship in between individuals and nations.
      But of course the expansive, constant quantitative growth economy requires the constant debt taking, going beyond one's means, thus the banks became the false pillars of our lives.
      At the same time the whole of humanity evolved into a global, interconnected network, where every decision and action affects even the furthest part of the network, thus we need to learn a completely new way of interaction in order to secure the well being of the whole interdependent system we live on.
      Thus in short instead of a superfluous, and futile banking union nations, not only in Europe but all over the globe would need to start building a new structure based on mutual responsibility, consideration and full integration with supra national democratic control, while the engine of this new structure has to be a natural necessity and available resource based economy and trade.
      Since we have already almost completely exhausted the natural and human resources, thus we do not have ore time to play games, or pretend we are doing something. We have to get down to the basics and start building, adapting ourselves to the new evolutionary conditions we find ourselves in.