Progress toward EU fiscal union remains slow

Reforms in the European banking system needs to go hand in hand with fiscal reforms to support financial stability, according to a new report form Qatar-based QNB Group received here.
A recent meeting of European finance ministers yielded agreement on an initial step toward a centralized banking union and approved a 37-billion-euro bailout tranche for Greece. However, a two-day meeting between European leaders in mid-December delayed decisions on fiscal union until June 2013.
On December 13, EU finance ministers formally appointed the European Central Bank (ECB) to oversee the “single supervisory mechanism” (SSM), an initial step toward the banking union.
The agreement will give the ECB powers to take over the direct supervision of banks from national authorities.
It is expected to come into force in 2014, although no deadline has been given.
The agreement only covers 200 of the 6,000 financial institutions in the euro zone that were initially expected to be included.
It excludes banks with assets of less than 30 billion euros, or 20 percent of national GDP. This leaves most of Germany’s retail banking sector and its politically powerful savings and cooperative banks under the oversight of national authorities, a key requirement for Germany’s consent to the plan.
However, the ECB still retains the power to intervene in any bank, if required, and to deliver instructions to national supervisors.
The SSM is intended to provide transparency, rigorous oversight and standardized requirements and capital ratios across the region’s largest banks.
Once the SSM is enacted it will clear the way for Europe’s 500-billion-euro rescue fund to be used to directly recapitalize struggling banks without unanimous national approval.
According to QNB Group, this is preferable to providing the funds through national governments, which would increase sovereign debt levels. However, the SSM will require parliamentary approval from the European Parliament and from some individual member states, notably Germany, which has been reluctant to give up national oversight.
The SSM also allows the Eurozone to move to the next phase of establishing a banking union.
This will be to create a resolution mechanism to deal with winding up failing banks.
This would centralize the management of crisis resolution to ensure that it is swift and effective, avoiding the slow decision-making of multiple national governments that has drawn out the European sovereign debt crisis.
A euro zone deposit insurance framework is also being advanced but no formal agreement has been announced.
The driving force behind the banking union is to increase the stability of Europe’s financial system.
Europe has faced an intrinsic conflict of interest with national authorities overseeing banks that hold large amounts of the debt of the national governments.
This has led to “cosy relationships” between national authorities and their banks with supervisory controls that are perhaps more lax than they should have been.
Additionally, the single currency made European banks more interdependent on and exposed to each other, increasing the risk of cross-border financial contagion.
The banking union aims to bolster confidence in Europe’s banks by standardizing supervision, regulations and capital controls and improving capacity for crisis management.
This should help lower borrowing costs for banks, particularly in crisis-ridden countries in Europe’s periphery, and should also support cross-border lending, easing any liquidity issues.
However, the SSM is not as extensive as originally intended as it excludes a number of smaller banks. This is a serious shortcoming.
As the European Commission has stated, systemic risks can originate in smaller banks and a two-tier system is inherently unstable as it encourages depositors and banks to move to the segment that is perceived as safer, creating volatility.
The implementation of the SSM has also been pushed back from the beginning of 2013 to an undefined date in 2014.
According to QNB Group, reform of the European banking system needs to go hand in hand with fiscal reform to support financial stability.
To ensure more sustainable sovereign debt levels, the EU has plans for greater fiscal union with a joint Eurozone budget and for binding contracts to enforce economic reform and budget targets. However, at a European Council meeting on December 14, all decisions on these possible measures were postponed until June.
Greater fiscal and banking union are fundamental for a permanent solution to Europe’s sovereign debt issues.
Although these reforms have been pushed back, financial markets have generally responded positively with the Euro rising to three-month highs against the dollar, perhaps relieved that some material progress has been made with the banking union.
This may have helped the Euro recover in mid-December.
Also supporting the euro was the successful buyback of a portion of Greece’s sovereign debt, which enabled the release of a 37-billion-euro tranche of bailout funds on December 13.
Although the banking union should enhance the stability of the European financial system, it could also lead to stricter regulation.
The ECB may enforce more stringent capital requirements than those currently enforced by national authorities.
This could lead to further retrenchment and de-leveraging by European banks, continuing a trend that is currently ongoing.