The euro area and EU finance ministers have struck two major political deals as part of the European banking union. The first was on the European Stabilization Mechanism (ESM) direct bank recapitalization instrument [pdf]. The second was on the new EU directive [pdf] on bank recovery and resolution. Both decisions are far-reaching steps forward for the integration of Europe’s financial services industry and regulatory framework. But there is a long road to travel for a complete banking union to be in place.
In this posting, I will discuss the ESM direct bank recapitalization. A second posting will discuss bank resolution and the next steps in the banking union.
The most important element of the banking union launched in June 2012 for financial markets was the possibility of direct equity injections by the ESM, seen as a way to keep the Spanish sovereign solvent by shifting the burden of bank recapitalization from the national to the euro area level. Following the subsequent intervention of the European Central Bank (ECB) through the Outright Monetary Transactions (OMT) program, the Spanish issue receded, and political concerns over moral hazard and legacy assets took over the debate. As previously discussed on RealTime, access to ESM direct banking recapitalization is not a supranational insurance policy against the full costs of a banking crisis. Rather it is a less comprehensive insurance against loss of market access by a euro area sovereign. The cost of a banking crisis will continue to be largely borne by the national authorities and bank creditors.
The euro area agreement of this June was along these lines. Direct ESM recapitalization [pdf] is an option only if “other alternatives would have the effect of endangering the continuous market access of the requesting ESM Member and consequently require financing of the sovereign needs via the ESM.” It would be politically feasible only to avoid even larger ESM loans to a troubled sovereign.
Several additional restrictions were placed on the direct recapitalization instrument. The maximum amount available for this purpose would be €60 billion. In addition, two types of national government cofinancing are envisioned. First, national governments will have to inject sufficient capital to get the beneficiary institution up to the legally required minimum Common Equity Tier 1 (CET1) ratio of 4.5 percent in a stress test established by the Basel III framework. Thus the first money to flow into any troubled bank will come from national governments or from costs imposed on creditors (see Part II, to be posted next.) Only then can ESM cash be considered for capital needs above the 4.5 percent threshold. In addition, for capital injections above the 4.5 percent threshold, direct ESM recapitalization is possible, but only with a 20 percent member state copayment.1 Accordingly, ESM direct recapitalization can amount to no more than 80 percent of capital needs above a bank’s 4.5 percent minimum regulatory capital threshold in a stress test.
In principle, the moral hazard hawks have won a sweeping victory on the ESM by severely restricting the ability of this common fund to directly recapitalize euro area banks. Consequently, the European Union’s new rules for haircuts imposed on bank creditors—and not ESM equity—will sever the doom loop between banks and sovereigns.
Now, of course, this is Europe, and German elections are in the offing. The actual political options for the ESM are considerably wider, as European leaders have granted themselves latitude to do what needs to be done for euro area financial stability.
For example, the nominal €60 billion maximum for recapitalizations is a largely meaningless figure because it “can be reviewed by the [ESM] Board of Governors, if deemed necessary [pdf].” The German government can point to the €60 billion maximum in the current election campaign. When discussing these issues with its Constitutional Court, euro area finance ministers could find a way to be of assistance in the event of a banking crisis in Europe requiring recapitalizations above €60 billion. Put another way, if the alternative is worse, a direct ESM bank recapitalization in excess of €60 billion would be possible. Because such a step would have to pass a number of national parliaments, some unspecified political conditionality would be required.
A similar amount of political discretion for the ESM Board (made up of the euro area finance ministers) is present concerning the national cofinancing requirements. As the agreement stipulates [pdf], direct recapitalization “leaves flexibility to the Board of Governors to partially or fully suspend such [national] contribution by mutual agreement in those exceptional cases in which the ESM Member is not able to contribute up-front due to its fiscal position and significant implications for its market access.” Translated, this euro-speak means that if a member state cannot afford its share, it can get off the hook through mutual agreement, implying again that additional unspecified political conditions will be part of a deal.
Finally, access to ESM direct recapitalization is separate from the issue of when the ECB takes over as the euro area banking regulator. As the statement [pdf] of the European finance ministers put it, “the potential retroactive application of the instrument should be decided on a case-by-case basis and by mutual consent.” If the political conditions are right and the alternative is worse, bank recapitalizations previously implemented by national governments—e.g., in Ireland, Portugal, Greece, Spain, and (arguably) Cyprus—can be revisited. This means that if a country’s IMF program does not succeed in regaining full market access, the euro area can extend the program and provide financing for another year or two, or reduce the country’s debt burden by shifting some costs to the ESM. This will matter for Ireland and other countries.
Like retroactive interest rate reductions on loans and maturity extensions, retroactive ESM direct bank recapitalizations are yet another example of stealth fiscal transfers, accompanied by appropriate discretionary political conditionality. One clear implication is that if and when Greece has implemented its daunting list of structural reforms by 2015–16, the option of reducing its total debt burden by including the €40 billion to €50 billion injected into the Greek banks will be available. Such a step would certainly not be politically easy. But it would be preferable to outright debt relief and principal write-downs in most euro area capitals, including Berlin.
In the end, the deal on the ESM direct bank recapitalization reinforces the impression that the ESM has no rules, and its Board of Directors has complete discretion to implement whatever deal they see as politically acceptable. Given that the board is made up of the euro area finance ministers, this may not be a bad thing. At least it ensures political oversight over ESM decisions. As an intra-governmental organization, the ESM entrenches the political power of the largest euro area members.2 It does nothing to increase the independent political legitimacy of pan-European institutions.
Perhaps this flexibility is inevitable for a crisis institution that has deployed taxpayers’ bailout money to stabilize the euro area. EU institutions like the European Commission do not have the jurisdiction under the EU Treaty to channel taxpayers’ money in a crisis. Only democratically elected governments can do that. Whenever crisis decisions have to be made that cost money (and most do), the European Commission will lose any argument it picks with member states. Only major revisions to the EU Treaty will change this fundamental political fact in Europe.
At the same time, the discretionary political power of the ESM Board made up of euro area finance ministers illustrates the need for euro area parliaments to have ample democratic oversight over their own government’s actions. The real discussion about the ESM’s democratic accountability is therefore about national parliaments’ power vs. their own governments.
1. This threshold drops to 10 percent after two years in 2016.
2. Only Germany, France, and Italy have the ESM voting power to individually block decisions under the 85 percent qualified majority “emergency procedure” and only Germany and France have the weight to individually block decisions under the regular 80 percent qualified majority vote decisions. See ESM Treaty articles 4 and 5 [pdf].