Financials Watch – The Banking Union sees the brakes applied

by: Tom Kinmonth

  • Creation of the final pillar of the Banking Union meets resistance in Europe
  • Now a political leap is needed to complete the deposit guarantee scheme…
  • …in order to continue the European project for Economic and Fiscal Union
  • Non-performing loans and sovereign holdings are the main issues
  • However, both the journey and the destination will be credit positive for banks
  • But deposit guarantee scheme to have limited impact on core bank funding costs

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Five years ago, European Union (EU) leaders decided to start strengthening the European banking sector by formulating the Banking Union. Now, we take a closer look at the last step, a European deposit guarantee scheme. We discuss the recent roadblocks to the future, and what this can mean for the banks in Europe. A recent potential softening stance by the European Central Bank (ECB) on non-performing loans (NPLs) shows the challenges ahead. As the banking union gets closer to finalisation, every country has their wish list of what they would like to be fixed in order to complete the task.

The Banking Union: The catalyst for reforms in banking

For the creation of a European Banking Union, two of the three pillars have been already created, the Single Supervisory Mechanism (SSM) and the Single Resolution Mechanism (SRM). The third pillar is currently under construction, the European Deposit Insurance Scheme (EDIS).

The creation of the Banking Union would be a significant step towards the European project of a complete full Economic and Monetary Union (EMU), a task that the European Commission would like to see be done by 2025 at the latest. Authorities are pushing now to create the union while the sun is still shining; well at least while the economic data from eurozone has started to improve, a component we discuss here.

The desire for the European project is pushing through a huge amount of improvement, and destruction, of the European banking sector. As authorities begin to tighten the screw for large-scale improvements, we have seen four banks in the last twelve months fail under the pressure; Banca Monte dei Paschi di Siena, Banca Popolare di Vicenza, Banco Popular and Veneto Banca. As demands from regulators increase, consolidation of the sector follows.

EDIS provides stronger and more uniform protection for depositors

The focus is therefore now on the remaining pillar of the European banking union, the European Deposit Insurance Scheme (EDIS). Principally, the EDIS would deliver a stronger and more uniform degree of insurance cover across Europe. It would offer protection for deposits below EUR 100,000 for all the banks in the European Banking Union. An item that would increase financial stability in Europe.

The two main benefits from the current state would be;

  • Greater protection of depositors in a bank failure: The level of protection would increase from current levels, and reach 0.8% of covered deposits of the banking union. This in turn, should assist against large-scale deposit withdrawals and bank runs.
  • A reduction in the link between banks and their home sovereign: Depositor protection would be supplied from a European level fund, and not a national one. If a bank was in trouble, the contagion to the national government should now consequentially be reduced. Furthermore, it would also ensure that the level of depositor confidence in a bank would not depend on a bank’s geographical location.

Clear benefits, but a problem arises

Despite the benefits, the third pillar has recently become a thorny issue, and is being met with resistance across Europe. Fundamentally, there is a demand for risk reduction before risk sharing. The structure of the deposit scheme requires that all banks contribute, but essentially, the weakest banks would stand to benefit the most. Many better positioned banks, and even nations, do not want the risks shared at this point when they believe that many banks across Europe are still weak.

There are a selection of risks that are demanded to be reduced, but there are two reoccurring items; a need for a reduction in both non-performing loans and in sovereign holdings.

1.Non-Performing Loans

NPLs amount to roughly EUR 900bn across Europe, and there is an agreement that something has to be done to address the failing loans. However, the solution to the problem is causing conflict. To tackle the non-performing loans the result would be that banks would have to provision far more aggressively in the coming few years, costing more capital. The initial impact then significantly restrict the ability banks have to lend to the economy and stunt growth.

Naturally Italy, which has over one third of the European failing loans, has provided strong opposition to the proposal. Indeed, the trio of Greece (40% of loans), Italy (15%) and Portugal (16%) still have elevated levels of gross non-performing loans.

In October this year, the ECB published for consultation an addendum to its guidance on how to deal with bank NPLs, see here. In particular, the eurozone supervisor wishes for banks to provide full coverage for the unsecured portion of new non-performing loans within two years, and for the secured portion within seven years.

This new framework could have profound affects. In fact, the ECB rules could have more of an impact on the recovery timeframes in Italy than a potential change in bankruptcy proceedings. From our perspective, a desire to cover failing unsecured loans will always find supporters. However, the desire for a secured loan coverage of 100% after seven years does seem very strict. Chiefly because a secured loan does have a value after seven years, due to the collateral. The subject is ongoing and recent discussions appear to indicate that the ECB could be prepared to water down its proposal, and either delay the implementation timeframe or the strictness. This is in response to the deluge of opposing views on the proposal, just one example supplied in the box to the left.

However, Mario Draghi and numerous members of the European community have been clear, a severe reduction to NPLs still has to be found in Europe. Once a proposal is agreed, then the European nations will decide if the new proposals are essentially strong enough in risk reduction to warrant risk sharing.

2.Sovereign Holdings

The second issue, is one that might be even tougher to solve. It is about the treatment of sovereign holdings, which is another hugely contentious and politically charged issue. An eventual reduction of government debt holdings would directly cut the link between a government and a bank, another element to assist in financial stability.

The topic of sovereign holdings is not a new issue. The predicament even pre-dates Banking Union discussions, and has been raised by various parties on a regular basis in the wake of the Greek crisis in 2010. Once again the focus will be predominately on the periphery nations to reduce their holdings of sovereign debt. Italian banks have euro sovereign holdings at 10.8% of their assets, while Portugal has 11.5%. This is in contrast to Germany and the Netherlands which have sovereign holdings under 4% of total assets.

It is interesting that on a global scale, the European authorities have actually been very soft in regard to sovereign debt holdings. The supervisors have granted institutions exemption from the internal ratings-based (IRB) approach in relation to exposures to their domestic government and to the majority of governments of EEA Member States. This exemption means that such exposures may be treated as they would be under the Standard Approach, which can result in banks being able to hold sovereign debt at a 0% risk weighting, discussed here. Furthermore, banks do not have to limit their exposure to a particular sovereign. Numerous periphery politicians have pushed back on any potential changes, most emphatically Matteo Renzi announced in February 2016 that the Italian government would;

“Veto any attempt to put a ceiling on the amount of government debt in banks’ portfolios, and we will show exemplary strength and consistency on this, without fail”.

So, as such we meet a subject that is politically charged, resulting in some polarising responses. The reduction of sovereign holding is another issue where compromise is needed, incorporating significant political will, in order to continue on the path for the Banking Union.

Great progress has been made, the bigger picture is bright

Finding a common ground for risk reduction will take time, and until these above issues are addressed the European project is being hindered.

However, we should not be too fearful. The two issues are causing quarrels, but the bigger picture is brighter. The European banking narrative has taken huge leaps forward, even more so, over the last few years. The issue of completing the third pillar should not be taken in isolation. The application of the bail-in legislation (BRRD), a pan-eurozone supervision creation (the SSM), and the creation of a new debt class in the bank creditor hierarchies are some great achievements. All of these changes were done in combination with a huge push for stronger balance sheets across the sector. The result is that banks are also significantly stronger in capital and have de-risked in the process.

Future to benefit from EDIS, but the journey there may bring bigger results

Overall, the completion of the banking union will be positive for banks in the long-term. The focus from authorities continues to be strong and the driving force across the sector.

However, we like to focus on the journey to get to the EDIS. Regardless of which of the solutions come out of the recent wrangling, the final result will be credit positive for the banking sector. In satisfying demands for removing risk from the sector, progress is being made. As banks remove the NPLs and sovereign holdings, the sector will strengthen.

EDIS in isolation will have benefits, but we do not expect any significant impact on the cost of funding for the larger European banks. EDIS will provide more confidence, and its size of roughly EUR 45bn would be enough for large isolated failure, but not enough to deal with a systemic issue. The key benefit, in our view, could come from enhanced depositor confidence that could reduce a panic liquidity situation. Indeed, a sudden removal of deposits recently brought down the Spanish lender Banco Popular, discussed here. However, as we also saw with with the recent Catalan situation, just because deposits are guaranteed it does not mean that depositors do not swiftly transfer their deposits to another institution when trouble arises. Furthermore, with new technology allowing for faster removal of funds, deposit withdrawals can occur at a frightening pace going forward.

A solution to a liquidity issue is one of the outstanding issues in the new banking world. At present there is no defined European plan to deal with a large removal of deposits and for example, the Single Resolution Fund (SRF) would not have the funds to assist in a medium or large sized issued. A sudden liquidity scenario will be on the supervisors agenda in 2018.

In the end we think that a solution for a common ground in regard to NPLs is likely to be found. Meanwhile, even a very soft law in regard to addressing the high sovereign holdings is likely to be applied with time. It will then be up to the other countries to decide if the risk reduction is enough to then take the leap into the EDIS.

The Banking Union has had huge positive changes recently and more changes are to come. The completion of the third pillar to the Banking Union will be the icing on the cake. The overall solution will work hand-in-hand with the immense amount of supervision, and huge bail-in volumes, to help protect nations from a too big to fail scenario.