Irish Economy Conference, Bankers Institute February
1st 2013
What Kind of Banking Union
for the Eurozone?
Colm McCarthy
Dubrovnik International University
‘Riddled with design flaws, the
euro zone came close to collapse
a mere decade after its launch.’
- Wolfgang Schauble, Wall Street Journal, 12 December 2012.
What Design Flaws?
- An incomplete currency union is vulnerable to
non-uniform banking bubbles
- These transform into sovereign debt crises if
haircuts of bank creditors are prohibited
- There are (still) no bank crisis resolution tools
- European Central Bank designed to act like a
multilateral currency board
- Critical missing component is a Banking Union
Europe has Big Banks…
2011
EZ
USA
Japan
Total bank sector assets (€ trn)
33.9
8.6
7.1
Total bank sector assets (% GDP)
357%
78%
174%
Source: Liikanen Report; Open Europe
….in poor shape
European banks’ price-to-book averaged
about 70% through H2 2012, versus long
term average of 150%.
Estimates of capital requirements run to several
hundred billion.
…and Indebted Sovereigns
Gross Debt as % of GDP, Q3 2012
Eurozone 17 in aggregate:
5 states are over 100%:
Belgium 102
Ireland 117
Greece 153
Italy 127
Portugal 120
.
90%
‘Core’ States:
France 90
Germany 82
Netherlands 70
Dwindling Fiscal Headroom
• The capacity of Eurozone states to fund
bank rescues has been eroded.
• Some now have none. Even Germany has
limited fiscal capacity relative to the size of
the Eurozone (or even the German)
banking system.
• Fiscal costs of bank rescue can easily bust
sovereign states.
How Big are Systemic Bank Busts?
Fiscal Costs* of Bank Busts, % of GDP, IMF Data
%
0-4.9 5-9.9 10-14.9 15-19.9 20-24.9 25-29.9 30-34.9 35-39.9 40+ Total
Cases
31
15
15
7
3
2
5
0
7
84
*Non-Zero Fiscal Costs only
Source: Laeven, Luc and Fabian Valencia (2012): Systemic Banking Crises Database: An Update,
IMF Working Paper 12/163, at http://www.imf.org/external/pubs/ft/wp/2012/wp12163.pdf
Fiscal Costs of Bank Rescue
Cumulative Probabilities
Fiscal Cost % GDP
>0
>5
>10
>20
>30
>40
>50
>60
* Cases with zero fiscal cost excluded
Probability
100.0*
61.3
38.9
19.8
11.9
7.8
5.5
4.0
Completing the Monetary Union
• The United States is a proper monetary
union, because it is also a banking union.
• Credit availability and interest rates are
uniform throughout the 50-state dollar
zone
• But the US has centralised supervision
and federal arrangements for bank
resolution and deposit insurance.
Bank Assets in a Monetary Union
Bank Assets to GDP, Selected US States, 2010.
Alaska 0.10
North Carolina
Arizona 0.05
Delaware
Sources: FDIC, BEA.
3.78
16.29
Designing a Banking Union
• Structure of the banking system depends
on regulatory incentives
• TBTF banking is a creature of policy
• Policy affects size and structure
• The taxpayer guarantee to bank creditors
is the source of TBTF banking.
• TBTF banks receive an 80 bp subsidy
The Subsidy to TBTF Banks
The funding subsidy has been estimated at 80 bps
Ueda, Kenichi and Beatrice Weder di Mauro (2012): Quantifying Structural Subsidy Values for Systemically Important Financial
Institutions, IMF Working Paper 12128,at
http://ideas.repec.org/p/imf/imfwpa/12-128.html
And at three notches (roughly the same)
Andrew G Haldane, Executive Director, Bank of England, On being the right size, 25 October 2012, at
http://www.bankofengland.co.uk/publications/Documents/speeches/2012/speech615.pdf
The subsidy can only be removed through
ending the guarantee to TBTF banks, which
means an end to moral hazard, and smaller
banks.
Which components matter?
• Of the three components, bank resolution is
more important than either supervision or
deposit insurance.
• Only resolution breaks the bank-sovereign
doom-loop. Supervision will fail more often with
a poor resolution system.
• Strong resolution cuts the cost of deposit
insurance.
Progress to Date
• There has been political agreement to
centralise supervision.
• No progress has been made on bank
resolution or on deposit insurance.
• A robust resolution regime would be
instrumental in shrinking the size of the
banking sector and ending TBTF.
Capital Structure, Resolution
Regimes and Deposit Insurance
 High bank equity plus bailed-in bank bonds permits
resolution with less risk to treasuries and cheaper
deposit insurance.
 Let P be the actuarially fair deposit insurance premium
and C the capital-at-risk as % of assets.
 P = P(C) declines rapidly in C for a left-skewed loan-loss
function.
Alternatives to Business-as-Usual
• The UK’s Independent Commission on Banking and the
Liikanen report support higher bank capital, including atrisk debt.
• This permits a stronger resolution regime, an end to the
TBTF subsidy and self-funding of deposit insurance
without high risk of fiscal transfers.
• The arguments are summarised in John Vickers, Some
Economics of Banking Reform, at
http://www.economics.ox.ac.uk/index.php/Department-of-Economics-Discussion-PaperSeries/some-economics-of-banking-reform.html
• But there seems to be little support.
Jorg Asmussen - Bank Resolution
‘….if the banks are to be kept going, private sector sources should be
exhausted first – meaning bailing-in of shareholders and bondholders, and if
needed, use of the bank-funded resolution financing’
‘….if there are still capital shortfalls, the financial resources of the beneficiary
Member States should be drawn on’
‘….only in the very last step, would European public funds be used’
‘….European support should only be granted to banks that are systemically
relevant, or pose a serious threat to European financial stability, and
therefore affect the common good.’
ECB Executive Council member Jorg Asmussen, 19th December 2012.
This Would Make Things Worse
• Asmussen is proposing that the TBTF
subsidy be strengthened, through ‘federal’
backstop.
• It would mean extra contingent liabilities
for sovereigns already bust.
• No change to the banking structure, and a
re-invigorated moral hazard machine.