29 March 2013

Paul N Goldschmidt comments on Véron's article in the FT

I believe that the handling of the Cyprus bail in/out raises a number of fundamental questions, some of which I already raised in my latest paper:

1. The main problem is rebuilding trust in the banking system which, having been seriously shaken, is bound to take a considerable amount of time.
2. The sanctity of deposits up to € 100,000, reiterated by President Hollande last night, raises two questions that need clear answers:
   1. Will the guarantee apply to each beneficial owner of an account or to each account held by the same beneficial owner? Will this apply within each country or within the eurozone as a whole?
   2. Will the guarantee expressed in Euros continue to apply in euros if an EMU Member exits? One would imagine that “local” accounts will be converted automatically in the new currency and that the guarantee will also be redenominated!
3. It is essential to have a single “hierarchy” of claims applicable throughout the eurozone detailing the order of “bail-inable” liabilities, for instance: equity – quasi equity – subordinated debt – senior debt/uninsured deposits/interbank borrowing – insured deposits. Haircuts should only be applied to the most senior layer of debt bailed-in after wiping out in total all more junior claims to avoid moral hazard.

The consequences of a clear answer to the above questions are manifold:

1. There is a clear risk of capital flight both from weaker to stronger EMU Member States and from the eurozone as a whole, especially by large depositors.
2. Funding costs of banks are bound to increase as lenders adapt to the new environment with the following consequences:
   1. The overall offer of credit will be limited as the deleveraging process of the banking sector proceeds, impairing economic growth prospects because of the heavy reliance of the European economy on bank credit.
   2. The cost of credit will reflect the higher funding costs both in the interbank and bond markets.
   3. Profitability of banks will be significantly impaired making capital raising difficult both through retention of earnings and issuance of shares.
3. Recourse to “secured” borrowing will increase to circumvent the risk of bail-in. This will apply increasingly to bonds and interbank lending, limiting severely a bank’s ability to access unsecured funds. The amount of eligible collateral (for accessing the ECB window) will also be constrained limiting a bank’s overall lending capacity.
4. The process of fragmentation of the bank market will increase, reflecting more closely the risk differentiation between the sovereign risks attached to cross border lending.

A particularly sensitive question will be the attitude of the ECB in its role as Supervisor: will it penalise lenders for taking “cross-border risks” (including in the interbank market) or insist on matching assets and liabilities in each jurisdiction of operation? The latter would severely penalise the most fragile EMU Members but may be considered by bank boards and senior management to be the most prudent course. Clear conflicts of interest could appear with the objectives pursued by the ECB in terms of monetary policy. It is also to be feared that many of the advantages of the “single currency” might be reduced if credit conditions in different EMU Member States varied significantly. This in turn might reinforce the willingness of Members to risk an “exit”.

Conclusion: Unless a fully fledged Banking Union is completed, implying a “federal” model with full discipline and solidarity (regulated and enforceable mutualisation), is agreed upon rapidly and accompanied by a credible implementation timetable, the eurozone is bound to fumble along from one crisis to the next. Each crisis will increase the risks of the final implosion of EMU leading also to the end of the EU as we know it.

The Cyprus rescue has seriously complicated the implementation of all three pillars of the Banking Union. This augurs badly for the short- and medium-term future. I fear that the likelihood of President Hollande’s prediction of an election win by a populist/nationalist party was reinforced by his own ultra “nationalist” approach to the whole European question. Public opinions must be squarely confronted with the dire consequences of an EMU break-up. Only then is there a chance to make the necessary reforms with the support of the citizens.

The time to act decisively is now!                                        

Paul N Goldschmidt, Director, European Commission (ret.); Member of the Advisory Board of the Thomas More Institute

Tel: +32 (02) 6475310 / +33 (04) 94732015 / Mob: +32 (0497) 549259

E-mail: paul.goldschmidt@skynet.be / Web: www.paulngoldschmidt.eu

Véron's article

© Paul Goldschmidt