European Banking Union and Systemic Risk

by Don Alexander, MBA

Associate, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com

 

There is increasing agreement between policymakers and academics that a banking union, along with some form of fiscal union, is necessary if Europe is to emerge from the crisis and stabilize.  Currently, politicians tend to focus on a short-term fix and avoid making hard decisions.  Nicholas Veron, addresses some of these issues in a recent VOXEU communique dated May 23^rd, Is Europe ready for a banking union?

 

As the global financial system has become more complex, concentrated and interconnected, Europe’s vulnerability to systemic risk has increased.  The fragility of the European banking system was revealed in the subprime/Lehman shock of 2007-2008 and has never been properly addressed since then – despite several stress tests.

 

Policymakers now agree a banking union (federal framework) is required in order to break the feedback loop between sovereigns and banks, essentially through risk sharing across borders in the banking system.  The monetary union needs to be supported by stronger financial integration in the form of unified supervision, a single bank resolution authority with a common backstop and a single deposit insurance fund. 

 

Policymakers now agree that a banking union, together with a fiscal union, is a necessary condition for a sustainable Eurozone monetary union and a resolution of the current crisis.  The action taken to date is modest.  Veron notes there are certain impediments to banking integration:

 

1.      the UK, Europe’s largest financial hub, is a non-euro member and resists encroachment on supervisory authority

2.      a number of euro-member states continue to resist any encroachment on local banks closely linked to local politicians

3.      EU member states continue to resist risk-sharing agreements or cross-border transfers.  These constraints prevent Europe from a first step toward establishing a consistent architecture for its banking union.

 

Certain reforms should be urgent priorities:

 

1.      banks must share risks as widely as possible

2.      Europe also needs the ability to restructure banks without national politicians or regulators 

3.      A cross-national guarantee is needed for national deposit insurance systems to prevent a retail bank run. 

 

European-level supervisory structures should eventually be established to prevent moral hazard.

 

European authorities would like to have time to fine-tune complex legal and financial issues to combine with different pieces into a consistent banking policy framework.  However, the current moment calls for less fine-tuning and more swift and bold action to contain systemic risk.

 

What is your exposure to European banks?

 

For more on this, follow the link: www.voxeu.org/index.php?q=node/8027

 

Risks on new Bank Capital Standards

by Don Alexander, MBA

Associate, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com

 

Bankers, policymakers and regulators continue to debate on the content of new bank capital requirements rather than setting global standards.  In the view of recent losses by JP Morgan and recent research reports calling for more bank capital, the need for global harmonization of standards takes on a new sense of urgency.

 

Nicholas Veron, in a recent VOXEU communique of May 4^th, The European Debate on Bank Capital is Not Just About Europe looks at the European experience.  European officials are deciding on the legislation to implement Basel III agreement on bank capital, leverage, liquidity and risk management. 

 

Officials, however, have severely underestimated the importance for reaching a global standard for financial regulation.  There are two unresolved issues in Europe: (1) the legislation’s departure from Basel III provisions; and (2) whether member states would be allowed to impose their own core requirements in regards to bank capital ratios. 

 

The first issue exists for both Europe and globally since it is about the definition of bank capital and how it should be applied to subsidiaries.  EU institutions regard global harmonization as overriding good, superseding misgivings about individual provisions or national authority.  Although, EU banking regulations are done at the national level and are not standardized creating a problem to see what is “liked” or “disliked”.  This makes the regulations vulnerable to special-interest groups. 

 

The crisis has changed the dynamics between the EU and global standards.  Institutions are now focused more on content than global harmonization.  This is complicated by a lack of a consistent approach by EU policymakers and the U.S. SEC’s delay in endorsing the proposed implementation schedule for global financial reform.  An American proposal that is compliant with Basel III would encourage EU and other doubters to comply. 

 

Global harmonization would help minimize competitive distortions inside the EU.  The main problem specific to the EU is that banking services remain under national authorities.  This results in a lack of a unified approach to bank supervision/resolution and pegs banks financial health to national authorities.  A more timely U.S. response combined with a unified EU approach could help reduce risk.

 

Although, Basel III requirements do not resolve all financial regulatory issues, a global harmonization of regulatory standards would be far better than our current fragmented system.  Perhaps the losses by JP Morgan Chase might force regulators to focus on implementation of a global standard.  The alternative of a fragmented regulatory environment could be costly.

 

For more on this simply follow the link: http://www.voxeu.org/index.php?q=node/7948

 

European Banking System – Systemic Risk Accident?

by Don Alexander, MBA

Associate, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com

 

 

Basic research is like shooting an arrow into the air and,

Where it lands, painting a target (Homer Adkins)

 

The euro is heading toward an abyss. The sovereign debt crisis is evolving into a full-fledged banking crisis with global consequences.  Nicholas Veron, of the Peterson Institute, has written a short-article on issues facing European banks   “Europe Must Change Course on Banks” (Dec. 19^th).

 

The crisis is evolving along multiple dimensions.  On the sovereign debt, Greece’s debt restructuring remains unresolved, and Italy and Spain face major refinancing needs in early 2012.  Eurozone countries may have to refinance between euro 1.2-1.5 trillion in 2012.   The Eurozone summit on December 9^th, fell short of delivering a true fiscal union, and raised tensions within the euro area and with the United Kingdom.  On the growth front, a possible deep and prolonged recession looms, especially as countries place emphasis on fiscal austerity.

 

The banking system is a crucial piece of the puzzle and epitomizes the contradictions of Europe’s experiment with monetary union.  Since 2007, the system has exhibited gaps in risk management, and massive supervisory failures in some countries.  The banks are exposed to an agency problem – they are under national control, but pose risks for the euro. To keep on favorable terms with local authorities, they are often buyers of last resort after failed auctions.  In the past two years, deteriorating sovereign creditworthiness has increased the system’s fragility, especially since they depend on wholesale money markets for funding.  CDS premiums remain elevated for European sovereign debt  

 

Political affirmation of the integrity of the euro area banking system does not require new treaties, but major resistance comes from, among others, individual banks fearing the loss of national privileges or protections.  However, the creation of a “banking union,” parallel to the fiscal union now advocated by German Chancellor Angela Merkel, would not mean the end of all national and local specificities.  A euro-area-level banking policy framework that will transcend interdependences between banking and political structures at the national and local level is a necessary condition for the survival of the monetary union.

 

As the euro crisis continues to unfold, there is increasing risk that the crisis could move across the Atlantic.  The near-term conduit from the banking system through money markets, derivatives or some other under radar surprise.  A longer-term mechanism is through a severe credit contraction that could induce a global recession.

 

The problem for global banks, especially for European banks, is that Basel I and II encouraged banks to hold sovereign debt as risk-free.  Basel III imposes more capital requirements and it will require additional euro hundred billions of capital over that suggested by recent stress tests.  The question is how European banks can meet the new capital shortfalls without causing growth stagnation?

 

The immediate goal for European authorities is provide standardization of regulation across the Eurozone such as national interests do not subvert the euro.  Long-term European banks have to be recapitalized without causing a severe credit contraction.  It will require prudent central bank policy and cooperation between national regulators.  The failure to implement prudent reforms could result in a near-term freeze in bank funding or a global recession.  Neither outcome is provides a favorable target for a sustainable US recovery.

 

For more on this follow the link: http://www.piie.com/realtime/?p=2581