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ECB Announces Schedule for Next Banking Crisis

“The ECB will complete an assessment of top banks' assets early next year, a source familiar with the matter told Reuters on Thursday. The ECB is due to become the single supervisor for eurozone banks and before it takes up the task it plans to conduct an asset quality review as part of a broader balance sheet review of the region's largest banks.”
--Reuters, Aug. 1, 2013

Europe plans to form a Eurozone Banking Union (EBU) next year. The plan provides for a Single Supervisor for big banks (the ECB), and for a Single Resolution Mechanism that would be able offer ESM assistance in failed bank resolutions. The ECB agreed to take on this thankless task on one condition: that sick banks must be resolved prior to EBU. In order to fulfill that condition, the ECB will supervise comprehensive portfolio reviews for the big banks. Unlike prior reviews which were macro and top-down, these reviews will be loan-by-loan, and will utilize third party professionals uncontaminated by local political pressures.

This situation is analogous to the nursing home agreeing to admit Grandma, so long as she can run a few laps around the track. The purpose of EBU is to break the credit linkage between Club Med governments and banks. The idea is that, once EBU is up and running, banks will be much less of a contingent liability for the governments and their debt ratios. But the plan assumes that the bad banks will be resolved now, before the linkage is broken.

There are two reasons why this plan won’t work:

1. If the reviews are honest, the recap bill will be in the hundreds of billions. By honest, I mean marking bond portfolios to market or assigning loss reserves against them. Plus the big real estate cover-up will have to end: no more refinancing with new money; no more accrual of unpaid interest; no more sanitizing toxic exposures by converting them into covered bonds. So, if the reviews are honest, and the price tags are dumped on the governments (or bondholders) the crisis will resume.

2. Even after EBU, the government credit linkage will remain because (1) the governments will still be expected to contribute in future resolutions; (2) the ESM is tiny in relation to the scale of the system; and (3) the SRM is predicated on depositor bail-ins which will destroy the banking systems, as it has in Cyprus.

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Draghi is acutely aware of this problem, and he wants to know who is going to pay the big bill and how. This from Reuters:
“ECB President Mario Draghi has stressed several times that political leaders need to come up with a sufficient backstop before the ECB can embark on its asset quality review in order to cover potential capital shortfalls. So far, this issue is still not entirely solved.”

Not entirely solved? How about, entirely not solved.