VoxEU: Completing the Eurozone banking union - What must be done

04 May 2016

To resolve the problems of current proposals, authors argue that legislators should stop discussing debt restructuring and instead enhance the borrowing capacity of the European Stability Mechanism.

Although the Bank Recovery and Resolution Directive rules and the reduction of the over-exposure to domestic public debt are necessary, their implementation in the absence of some complementary measures would require too much time and effort. Along the transition, banking activity could experience serious troubles possibly jeopardising the final full recovery of the Italian economy. The very recent institution of the government-sponsored Atlante Fund, a privately managed investment vehicle that should buy non-performing loans and capital of troubled financial institutions, exemplifies these risks. In fact, its main shareholders, the largest Italian banks and insurance companies together with the state sovereign fund, stated that they plan to invest in shares and assets they believe are ‘under-valued’ by other investors and European institutions. The risk is that the fund exacerbates the exposure to domestic risks of financial institutions without addressing their under-capitalisation.

Below is a list of complementary measures that could speed up, or save, the of the banking union.

• First, we should stop discussing debt restructuring and instead, as suggested by Pisany-Ferry (2016), enhance the borrowing capacity of the European Stability Mechanism to provide guarantees for effective fiscal stabilisation in case of severe recessions in countries with limited fiscal capacity. Eurobonds could resolve the uncertainty about the ability of Eurozone institutions to manage macroeconomic risks, as the ECB unconventional policies, in a time of low inflation and zero interest rates, become ineffective.
• Second, a programme to buy capital in financial institutions unable to raise it directly on the market, using Eurozone-wide resources, should be set up. This recapitalisation fund, following the experience of the Troubled Asset Relief Program in the US, would use public resources to buy non-voting shares, with senior status, in financial institutions, conditional on the full implementation of the Bank Recovery and Resolution Directive and the diversification of the exposure to sovereign risk. The recapitalisation fund should sustain all banks, not necessarily insolvent ones, that need to raise equity along the transition to the banking union without triggering the Bank Recovery and Resolution Directive clauses, and supplement the European Stability Mechanism that can already inject equity in systematically important institutions in a crisis, but only after existing stakeholders are penalised according to the Bank Recovery and Resolution Directive rules.

Eurozone countries with more solid banks could oppose these two tools, arguing that taxpayers’ money would be used to subside banks in the Eurozone periphery. However, the alternative is a continuing instability of the monetary union, whose dissolution would be very costly for all member countries. Since the idea of a EU recapitalisation fund is novel, we spend the remaining part of this column justifying its proposal, and refer to Pisany-Ferry (2016) and other commentaries in Baldwin and Giavazzi (2016) for convincing arguments in favour of enhancing the borrowing capacity of the European Stability Mechanism.

• First, recapitalisation has the benefits of breaking the ‘deadly embrace’ between sovereigns and banks without violating state-aid rules as any banks can rely on it. In particular, if banks obtaining funds through recapitalisation must comply with tough rules imposed by the EU supervising authorities and reduce exposure to domestic risks, then the risks faced by recapitalisation are limited, and the moral hazard and the deadly embrace problems would be reduced quickly.
• Second, given the high leverage of financial institutions, the resources required to buy equity in Eurozone banks are far smaller than those required to buy troubled assets directly. Even though banks will require more capital along the transition to a full banking union, they could find it expensive because stock prices tend to be low when uncertainty is high. To speed up banks’ recovery, and avoid losses of taxpayers’ money, some constraints should be considered till banks repay public funds: limits to dividend distributions, caps to management compensation, increasing the number of independent board members. In addition, the repurchasing price of recapitalisation stake should increase over time.
• Third, the institution of recapitalisation could postpone the creation of the European Deposit Insurance Scheme to a time when banks are safer, more capitalised, and less exposed to domestic sovereign risk.

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