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This is how the EU can fix its failed banks

Where now for European banks? MPD01605

The EU has made progress on the construction of a banking union, by agreeing on common rules for dealing with failed banks. The downside is that these rules won’t kick in until 2015: the Eurozone faces another year with weak banks, short of the funds they need to go about their business.

There are further problems. Funding for these new rules on “banking resolution” will be built up over the next decade, a long time in a sector where collapses can happen overnight. And it seems that the issue will still be handled on the national level, so that the deadly embrace of bank and sovereign fragility across the Eurozone periphery won’t be addressed.

Resolution tomorrow; funding even later? Many banks are still crippled by massive losses incurred over the past five years, and still have problems raising capital. This is today’s reality and it awaits urgent resolution.

Weak and fragile banking systems across Europe are holding back economic recovery. The current discussion continues to mix guarantees for future losses with resolution of legacy losses. A separate and more short-term solution to address Europe’s five-year-old banking crisis is urgently called for.

A Eurozone Restructuring Agency

We could resolve the crisis through the establishment of a new agency that we would term the Eurozone Restructuring Agency (ERA). This agency would focus solely on legacy issues – it is not intended to address any future failures within the banking union.

Once weaker banks are identified, the ERA would coordinate efforts throughout the Eurozone to rescue the viable banks and liquidate the non-viable ones. The agency should be a temporary vehicle, with a clear sunset clause, so that it ends its duty after banking union is completed.

The ERA would be created in two phases. The EU is currently investigating its banks to separate the weaker ones into the institutions it deems viable and those that are unviable. This process, involving an “asset quality review” and “stress tests” (where bank performance is modelled in a variety of unfavourable scenarios), is due to finish in mid-2014.

Unviable banks would be liquidated while banks that are weak but viable would be restructured, preferably by separating them into good and bad banks. This phase should also involve a “bail-in”, where unviable banks’ creditors are asked to contribute either part or all of the money necessary. Therefore the public funding necessary should be minimal.

In the second phase, the ERA becomes responsible for both the good and the bad banks that emerged from phase one. After the bail-ins, the ERA would inject capital in the good banks. In return, it would become a part owner of these banks by taking equity stakes.

The ERA would be jointly owned by the 17 Eurozone members, in the same proportion as their shares in the current safety-net for nation-states, the European Stability Mechanism. All liabilities, but also assets and equity stakes in the good banks, would thus indirectly be owned by European taxpayers.

Convincing the North and the South

For years now, a fix to Europe’s banking crisis has been held up by political deadlock between policymakers favouring a centralised solution, mostly in crisis countries such as Spain or Greece, and those favouring a country by country approach, most prominently Germany.

While European loans to states only involve down-side risk, our proposal has the advantage that positive returns will be redistributed back to the ERA shareholders in proportion to the capital they put in. Creditor countries will receive larger pay-offs if things turn out favourably, even if these revenues come from debtor countries such as Spain.

However, downside risks stemming from the bank resolution should be borne in proportion to country risks, at least in the long-run.

One option is that the European Central Bank’s revenue from issuing Euros (known as seigniorage) could be redistributed from debtor to creditor countries, in line with losses incurred on banks headquartered in the respective countries.

Another option is that countries whose banks receive assistance post collateral with the ERA, such as gold reserves or shares in state-owned companies. If the losses are greater than expected, these assets can be sold and the proceeds distributed among ERA’s creditors (and indirectly, Europe’s taxpayers).

To avoid a seizure of their collateral, debtor countries will have incentives to support the ERA and to assure that good banks and bad assets are sold at the highest price possible.

Working in practice

To implement its mandate, the ERA would be legally independent –- akin to the European Central Bank –- so as to insulate it against political pressures from European or national actors. The agency will have centralised decision power over the banks both good and bad. However, bank management and the liquidation of the non-performing assets are best done at the local level.

This proposal for a Eurozone Restructuring Agency has a number of advantages. It would mean distressed banks could be resolved quickly, speeding up the liquidation of bad assets and maximising returns for European taxpayers.

It would create a “clean slate” for a forward-looking Eurozone banking union. Certainty about the resources needed to resolve the crisis would re-establish confidence in the soundness of European banks.

The EU’s announcement is better than nothing, and progress has certainly been made. But the problem remains that the Eurozone still contains undercapitalised banks with massive losses still on their books. This must be resolved, fast. A new restructuring agency for Europe’s banks is the best solution.

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