Spain and Banking Union

Currency in Crisis

Reports suggest that Spain is coming under increasing political pressure to seek assistance. Yet the stigma is too much and Spanish officials recognize that if asks for assistance, many investors will conclude that the country is insolvent and would aggravate the economic and financial pressure it is already facing.

Instead Spain has a two-prong strategy. 1) Seek to pressure the ECB to resume its SMP program of sovereign bond purchases. The ECB has not bought sovereign bonds since March. 2) Join forces with others, including Italy and France seeking to allow banks to borrow directly from the ESM. ECB's Draghi also supports efforts for governments (funding ESM) to support banks rather than the central bank.

Just like Greek crisis initially led to the innovation and institutional changes that let to the SMP and EFSF, so too will the Spanish crisis spur additional innovation and building institutional capacity. The immediate focus is a banking union, but long game push is toward fiscal union. Over the weekend, Spain's Rajoy called for an EMU body to run national budgets. Van Rompuy, Barroso, Draghi and Juncker have been tasked with proposing a blueprint/road map toward greater integration.

A banking union appears to have three components: single supervisor, recapitalization fund and a insurance fund. Rajoy, Borroso and Draghi are among the most vocal advocates for a centralized mechanism that can directly recapitalize banks. The ESM, which is not yet up and running, has been the focus. Germany, which will contribute a bit more than a quarter of the funds, has not yet ratified the agreement.

Merkel will need support from the opposition to ensure ratification and this may require some concessions. Yet the discussion of allowing banks direct access without having to go through the sovereigns may weaken support. The ratification vote could be as much as a month away. The main argument against allowing banks direct access to ESM funds is that it removes a source of leverage over sovereigns to implement structural reforms. There are also moral hazard arguments.

The European Banking Authority already exists. It is dependent on national regulators. As Draghi noted recently in terms of Spain (but also France-Belgium handling of Dexia), national supervisors have repeatedly under-estimated the costs associated with the banking problems. Some greater institutional capacity and authority is needed for the EBA, but the scaffolding exists.

There are many hurdles to a pan-European guarantee of deposits. Merkel rejected this is 2008 in the immediate post-Lehman period. Instead national deposit insurance schemes were strengthened in 2009 to cover at least 100k euros (previously were as low as 20k euros).

The EC is likely to make proposals in this space on June 6, but the early indication suggest will likely stick to the national level. Part of the problem, however, is that such guarantees from weak sovereigns may not reassure depositors. Consider for example, that at the end of March, Spain had 931 bln euros in deposits, Italy 1.1 trillion euros, and Portugal 164.7 bln euros.

Italy's deposit insurance scheme appears to be unfunded, though banks promise to contribute to a fund if and when needed. Portugal's deposit insurance fund can cover a little more than 10% of Portuguese deposits. Moreover, another source of investors angst is redenomination risk. This is that the savings are converted by force of law to a new and weaker currency--such a a new Greek drachma.

Some proponents have argued that the deposit guarantee programs should insure the euro value of savings. Because of the potentially incredible cost, this component will likely prove highly controversial. Yet without it, weak sovereigns may find it difficult to stem the shift of depositors.

The problem as we have noted is that officials have helped fan speculation that monetary union is reversible. Officials need to make a strong stance that it is irreversible. Even if they were so inclined, it would be difficult to make this compelling this side of the Greek elections.