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The ECB’s 'Financial Integration’ (link) and the Commission’s 'Stability and Integration' (link to EFSIR) Reports were published – and debated at a Brussels conference. Some concerns surfaced. The original three-legged structure – Single Supervisory System (SSM) + Single Resolution Mechanism (SRM) + Single Deposit Guarantee System (DGS) - has already had one leg chopped off as the pan-eurozone DGS has been shelved. Germany has now suggested that the SRM may need a Treaty change to have full legal strength and the SSM mechanics are being questioned.
The concerns centre on three issues: national discretions, the asset quality review (AQR) and the ability of national governments to absorb major loan losses.
► National discretions still remain in CRD IV/CRR and the ECB may have a serious task in supervising a large bank that has parts of it still subject to these discretions. The expectation is that the national supervisors who demanded the discretions in the first place will be more amenable when they have to justify them to their peers in the ECB Supervisory Board. If the SSM cannot cut through the thicket of national vested interests that demanded the discretions, then the idea of a single bank that branches throughout the eurozone may remain a dream. That implies a potential failure to ensure that the ECB’s single monetary policy operates effectively everywhere – a major source of concern in many peripheral economies.
►The asset quality review could turn out to be a fatal flaw in the euro rescue. The group of directly-supervised banks accounts for [80 per cent] of the euro area’s deposits. The exchange-listed banks within this group trade at around [50 per cent] of their book value. This suggests that shareholders do not believe the published accounts. However, in his speech (link) last week to ECON, ECB Vice President Constancio discussed the suspicion that banks’ balance sheets need more repair. He was explicit that “no-one has provided clear evidence that this is true…” Perhaps shareholders are looking into the future to evaluate the impairments to loan books they expect to materialise – a key function of such stakeholders. Correspondingly, bondholders and depositors would have good reason to be nervous about the value of their claims and the potential for being bailed-in.
The massive discount to book value suggests that investors believe some combination of the following: the accounting standards are wrong in their treatment of expected impairment; the auditors are incompetent; or regulators are allowing excessive forbearance within national 'rule books'. All these factors have been controlled by the public sector for many years so affected citizens will expect those who permitted the build-up of the problem to make a major contribution to rectifying it.
This risky, game-changing moment is now set to occur at some stage within the next year as the ECB takes over day-to-day supervison. That action gives a one-off opportunity to correct these perceptions, or actual errors. The accounting treatment of expected losses is a well-known issue so it should be open to the ECB to announce well in advance the supervisory rules that it will follow on impairment when it conducts the Asset Quality Review (AQR) of assets that it will take under its supervision. That gives bank management an opportunity to inform shareholders – again, in advance - of the potential additional `special charges’ against profits that will be reported. This process would be quite distinct from a stress test as that simply measures what will happen to 'reported' losses under particular economic scenarios. The AQR must go to the heart of the problem: the belief that there are heavy, hidden losses that threaten the stability of some banks.
► National government contributions to the write-offs: The 'bad' assets would have to be sold - at the realistic 'market' value envisaged under the Recovery and Resolution Directive (RRD) - to a 'bad' bank. It is conceivable the bad banks/assets would have to be aggregated at a national level. Some of the now-realised losses are anticipated already by shareholders so they can bear some of the burden. The moral problems intensify as the losses move down the 'order of priority', perhaps reaching depositors. It is likely that public capital will need to be injected into some banks and their home states may need an ESM programme to enable the particular state to provide that capital. But the ESM is structured to be able to lend only to states with sustainable public finances. Who decides that, and how?
The IMF appears to have come up with an extraordinary new doctrine that ratios of gross public debt to GDP above 100 per cent are unsustainable. Such a definition would make six euro area members 'unsustainable' next year. As the aggregate debt ratio for the whole bloc is set to exceed 95 per cent of GDP, socialisation of significant bank losses could make the entire euro area be deemed by the IMF to be 'unsustainable'. This definitely must be addressed urgently so that the ESM can lend to states that have to bear particularly heavy bank losses.
So a central risk to the eurozone remains: without a robust 'single resolution mechanism', loan losses identified by the AQR could yet render some government's debt 'unsustainable'. But a soft approach to the AQR could leave bank creditors unwilling to believe the results. The crisis would have completed another full circle.