Europe: Your Rope

European finance ministers will meet tomorrow ahead of the Summit that begins Thursday afternoon in order to see if more progress can be made on the banking union. Talks broke down at the end of last week, without resolution. There are four dimensions to the issue and, like a Mobius strip or an Escher drawing, it is difficult to know what comes first and what is last.

The four elements are a single supervisor, a single bank resolution authority, direct bank recapitalization from the ESM and new rules to regarding how the costs would be distributed between investors, creditors, depositors and tax payers.

There has been some, albeit limited progress, though much remains up in the air. What we can be fairly certain about is the banking union will most definitely not come into effect this year, as was initially anticipated by officials a year ago. In fact, these four components are unlikely to be in place before the end of 2014 at the earliest.

The single bank supervisor appears to have been agreed upon and that is the ECB. However, rather than supervise all banks as some initially wanted (perhaps some want this in some Machiavellian way to tie the ECB up and its resources), the ECB is likely to be responsible for around 200 of the largest banks. The ECB, however, is insisting that it has some authority to shutter insolvent institutions and that a rigorous examination of the financial condition of the institutions it will be responsible for before it accepts its new mandate.  What the ECB has in mind appears to be more than the unconvincing stress tests seen in recent years.  

Direct recapitalization of banks is an important step to break the link between the sovereign and the banks, which has produced horrible contagion throughout the  European periphery.  However, direct recapitalization from the ESM requires the single supervisor to be in place and for the magnitude of the problem to be fully understood.  Again, this seems virtually impossible this year and even another 18 months may not be sufficient.  

The issue that bedeviled the finance ministers at the end of last week were how the losses should be distributed.  The disagreement is more fundamental than the role of senior creditors and depositors.  The key dispute that reportedly pitted a German-led bloc against a French-led bloc was who should make the decision.  Germany and its allies find comfort in agreed upon rules that can be uniformly applied.  France and its allies see this at too more encroachment upon their sovereignty and want national leaders to have a wide berth to decide these issues. 

In some ways, the tension between national sovereignty and central authority (integration) continues to cut across all important issues in Europe.  This issue remains intractable and European agreements seem to end up as some compromise formation.   We have argued that one way this issue would be resolved is in strengthening the link between sovereign and solvency.    This has been the case in Greece, Ireland, Portugal, and Cyprus most acutely.  France remains the sticking point.

France had neither the fall of the Berlin Wall to force it to restructure, as Germany did , nor the capital strike, that forced the periphery to capitulate and reform.  It bonds continue to trade like (somewhat) higher yielding bunds.  Consider that here in Q2, French  10-year yields have risen a little less than Germany's (44 bp vs 48 bp). 

Without resolving this issue and the so-called "bail-in rules", the fourth component of the banking union, a single resolution entity makes little sense.The EU Summit, of course, has other issues to address, including Cyprus and Greece, but the failure to make more progress on a banking union undermines investor confidence.    German Chancellor Merkel may have hoped for a quiet period before the German national elections in late September, but the dramatic backing up of interest rates threatens to cut short the cyclical recovery that the PMI surveys suggested was unfolding, and the failure to show more progress toward a banking union threatens to renew investor angst.