03 March 2018

Paul N. Goldschmidt: Completing EMU – Negotiating « Brexit »

[...]Saving the single currency, completing EMU, deepening the EU and reaching a satisfactory agreement with the British in the area of “financial services” after Brexit are deeply intertwined matters which require coordination at each step of these different parallel processes; while this should be evident, it does not appear to receive the necessary attention.

If, so far, in the Brexit process, Michel Barnier has managed to preserve the unity of the EU 27, this situation has been greatly facilitated by the continuous squabbling among the British and their incapacity in formulating concrete proposals apt to meet the minimum requirements of the Union.

In the financial sector, in particular, the current situation, which ascribes a privileged position to the City of London, offers multiple advantages to other Member States whose domestic financial markets remain woefully underdeveloped. The main question raised by the Brexit process does not boil down to a reciprocal access to each other’s financial markets based on the principle of “equivalence” (negotiable within the framework of an FTA) and whose elimination is liable to lead to a considerable loss of available expertise as well as generate substantial additional transaction costs; rather, the main point of contention concerns the supervision of financial institutions based in London which is the main market for billions of derivative contracts referring to the € and where most of the transnational transactions denominated in € are settled (clearing). As owner of the second most important “reserve currency” it is unthinkable that the Union would delegate its responsibility for financial stability to a third party country.

In these negotiations, the City is a Trojan horse, serving the American interests in order to strengthen their dominance of world capital markets (from which most European, including British, actors have withdrawn), and thus obtain a privileged access to the considerable savings accumulated on the continent. The sullied reputation of the City within the English public opinion, following the 2008 financial crisis, justifies partially the apparent lack of interest shown by the British government to defend these sectoral (and privileged) interests and explains the enormous lobbying effort undertaken by the Americans.

In the context where negotiation on the future relationship between the UK and the EU have not yet properly started, it has been relatively easy to maintain the façade of a united EU front.However, when looking closer, there appears to be a number of incoherencies in the way that the emblematic Union of Capital Markets (UCM) proposed by President Juncker is being painstakingly put together.

First of all there is the fierce competition between several European financial centers to attract operations that will have to be delocalized following Brexit. Despite the fact that the numeric revolution should somewhat attenuate the consequences of such fragmentation, no European center, however successful, will be able to replicate credibly the advantages of the concentration of skills and the expertise offered by the City. The latter is therefor certain to continue to play an important part next to other centers such as New York, Singapore or Hong Kong which will all join the fight for the spoils.  

Additionally, the European financial sector suffers from a structural weakness compared with its international competitors. European banks continue to fight desperately to maintain their model of “universal banking” which unites under the same roof traditional deposit/lending activities and investment banking. This model worked perfectly well within the framework of “national markets” too small to develop profitably both activities separately; it also contributed to consolidate the incestuous relationship that developed between the banking sector, their supervisors and their political masters. Today, such a model no longer meets the requirements of a single currency shared by 19 Member States.

As a result, there are two major obstacles that are hindering the completion of EMU (while acknowledging the progress made): the first concerns the uniform treatment and the prudential limits concerning bank holdings of their government’s sovereign debt within the framework of the supervision by the ECB. The second is the systematic delaying of setting up a Eurozone-wide mutualized system of bank deposit guarantees. 

The limitation of the risk linked to sovereign debt holdings should contribute to break the incestuous relations referred to above, and is supposed to be a “shared” objective of the 19 EMU members. However, by delegating the supervision of a large number of medium-sized and small banks to “national” supervisors, the EU allows the latter to disregard the fundamental right to the “free movement of capital” within the EU/EMU. Indeed, as long as the long term survival of the € continues to be challenged periodically by the political classes (recommendations to withdraw from EMU), bank managers will be compelled to seek an appropriate geographical balance between the source of their deposits and their use, in order to avoid the implicit “exchange risk”; for similar reasons, supervisors oppose certain trans-border loans in order to preserve the stability of their national market for which they remain accountable. This prudence is easily understood by the implications of a total or partial dismemberment of EMU which would require as a first response the instauration of “exchange controls” followed by a severe economic and financial crisis.

It is therefore quite clear that there is a tension between the fragmentation of the banking market and the implementation of the free movement of capital, which is all the more significant within EMU that banks remain the major source of financing of the economy (in contrast with the USA), a situation that the CMU (first including the EU28 then 27) was supposed to correct. This contradiction is aggravated by the intention, precisely outlined in the CMU “Green Paper”, which puts squarely the European universal banks at the center of CMU creating from the outset a conflict of interest situation as each institution must arbitrate between having recourse to direct internal financing (deposits) and opting for alternatives (market).

Concerning the vexed question of an acceptable deposit guarantee scheme, I have long recommended the limitation of the guarantee to a single account per taxpayer within EMU, subject possibly to increasing the maximum amount currently set at €100.000 per account.

Such a step would bring several advantages: it would significantly limit the risk – and thus the cost – to be borne by the taxpayer if the “Guarantee Fund” to which banks must contribute, ran out of funds. Indeed, the great majority of depositors are far from owning liquid funds approaching the current insurable ceiling. On the other hand, wealthy citizens can, by dividing the deposits among several institutions, benefit from an unlimited government guarantee which was neither the intent nor the objective of the legislator; it was instituted at national level to protect small savings and the immediate needs of citizens in a crisis. 

Of course, the banking sector is strongly opposed to such an approach because it could diminish significantly the capacity of many of them to attract deposits for their lending operations. The consequence (beneficial) would be to encourage the concentration of the banking sector within the EMU creating both larger and safer transnational units; this is also an aim pursued by the Union. 

Limiting the amount guaranteed per taxpayer has also the advantage of encouraging wealthy individuals to diversify their investments, contributing thereby to achieving one of the aims of CMU to rely less on the traditional banking sector to finance economic growth and investment.

Finally, by separating clearly banking from financial market transactions supervisors might be more lenient towards banks whose competitivity is under pressure by the higher capital requirements induced by investment banking and related financial market operations.

Conclusion

The British waffling over Brexit has largely contributed to hide the deep dissensions within the EU banking/financial sector. Restoring competition must entail the separation between deposit and investment banking, if one wishes to avoid the absolute American domination of world capital markets. In order to achieve this one must build, instead of a “Capital Markets Union”, a “Unique Capital Market” based on the €. Similarly to the USA, the EMU – and in due course the EU 27 – represents a sufficiently large and diversified market to support the profitability of both pillars of the financial market, so that they become competitive in world markets, including in the USA. [...]

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