European banking union moves a step closer to reality

It is almost 18 months since EU leaders pledged at the June summit of 2012 to break the link between sovereign and banking debt, and launched an ambitious proposal for a European-wide banking union.

Yesterday, after months of stalemate on a harmonised regime for dealing with bank failures, EU finance ministers appeared close to reaching agreement on a key aspect – the creation of a single bank resolution authority and accompanying fund.

So what does banking union mean for the shape of the European banking system and how problem banks are handled in future?

The fundamental principle underpinning banking union's three-pillar approach – the Single Supervisory Mechanism, Single Resolution Authority and Deposit Guarantee Scheme – is to end the kind of taxpayer bailouts of banks that occurred in countries such as Ireland.

Finance ministers have been thrashing out details of how to shift the burden of bank collapses away from taxpayers and on to the shoulders of private creditors; in other words, moving from a “bailout” to a “bail-in” model.

Hierarchy of creditors
A series of overlapping regulations are inching their way through the system which will set out strict rules for banks in trouble. The key piece of legislation – the Bank Resolution and Recovery Directive (BRRD) – which deals with the hierarchy of creditors to be bailed-in is the subject of negotiations between the European Parliament and the council of member states today in Strasbourg, with member states having agreed a general approach in June.

While it was envisaged not to come into effect until 2018, there have been calls to bring this forward to as early as 2015, with EU commissioner for internal market and services Michel Barnier arguing yesterday it should be workable from July 1st, 2016.

The Single Resolution Mechanism, the centralised resolution authority under discussion by finance ministers last night, will run alongside and apply these resolution rules.

In the interim, state aid rules on bank restructuring, introduced in August, will come into effect. These rules would apply, for example, in the case of Slovenia, if it is forced to intervene to save its banking sector when results of stress tests are published. The rules oblige states to tap private markets, before bailing-in junior bondholders and shareholders.

Burning bondholders
The BRRD goes further: it envisages losses on shareholders, unsecured creditors including junior and senior bondholders, and potentially deposits of over €100,000. A minimum bail-in equating to 8 per cent of total liabilities must be invoked before resolution or national funds can be used, according to the general approach reached.

In parallel to these new rules on creditor hierarchy, the EU is trying to implement a true "banking union", which will integrate the European banking system. The first phase – the Single Supervisory Mechanism which will see the European Central Bank supervising euro zone banks – is proceeding smoothly, with Frankfurt preparing to take over its duties towards the end of the year. The second and third phase – the resolution and deposit guarantee scheme – which deal with who decides when to wind down banks and how this will be funded – are more elusive.

Yesterday evening in Brussels, it appeared compromise was close, with Berlin prepared to sanction the European Commission’s involvement with curtailed power, while a fund would be created but with limitations; for example a requirement that decisions would require unanimity from member states. As Ireland prepares to exit its rescue programme it will be hoping retroactive direct bank recapitalisation will allow the State to recoup some of its investment.