Ifo Viewpoint No. 143: The eurozone’s banking union is deeply flawed

Hans-Werner Sinn
Munich, 15 February 2013

Largely ignored by public opinion, the European Commission has drafted a new directive on bank resolution which creates the legal basis for future bank bailouts in the EU. While paying lip service to the principle of shareholder liability and creditor burden-sharing, the current draft falls woefully short of protecting European taxpayers and might cost them hundreds of billions of euros. Further lobbying by banks is likely to make things only worse.

The new banking union plans may thus turn out to be another large step towards the transfer of distressed private debt on to public balance sheets – something which pleases the capital markets and may help to explain their new confidence.

The European Central Bank (ECB) has already provided extra refinancing credit to the tune of EUR 900 billion to commercial banks in countries worst hit during the crisis, as measured by its payment system known as Target. These banks have in turn provided the ECB with low-quality collateral with arguably insufficient risk deductions. The ECB is now in the same position as private investors. It is guaranteeing the survival of banks loaded with toxic real estate loans and government credit. So the tranquillity is artificial. Ultimately, the ECB undermines the allocative function of the capital market by shifting the liability from market agents to governments.

But do the European Stability Mechanism (the eurozone’s rescue fund – ESM) and the banking union plan not ask for more from private creditors? If so, they do not go anywhere near far enough. Plans to protect investors from the consequences of their wrong decisions are being pushed forward. Take the “bail-in” proposals suggested by the European Commission as part of a common bank resolution framework.

These plans “should maximise the value of the creditors’ claims, improve market certainty and reassure counterparties”. Senior creditor bail-ins are explicitly ruled out until 1 January 2018, “in order to reassure investors”. But if bank creditors are to be protected against the risk of a bail-in, somebody else has to bear the excess loss. This will be the European taxpayer, standing behind the ESM.

The losses to be covered could be huge. The total debt of banks located in the six countries most damaged by the crisis amounts to EUR 9,400 billion. The combined government debt of these countries stands at EUR 3,500 billion. Even a relatively small fraction of this bank debt would be huge compared to the ESM’s loss-bearing capacity.

We see this flawed institutional architecture leading to the following problems for the eurozone:

First, the write-off losses imposed on taxpayers would destabilise the sound countries. The proposal for bank resolution is not a firewall but a “fire channel” that will enable the flames of the debt crisis to burn through to the rest of European government budgets.

Second, imposing further burdens on taxpayers will stoke existing resentments. Strife between creditors and debtors is usually resolved by civil law. The EU is now proposing to elevate private problems between creditors and debtors to a state level, making them part of a public debate between countries. This will undermine the European consensus and replicate the negative experiences the US had with its early debt mutualisation schemes.

Third, asset ownership in bank equity and bank debt tends to be extremely concentrated among the richest households in every country. Not bailing-in these households’ amounts to a gigantic negative wealth tax to the benefit of wealthy individuals worldwide, at the expense of Europe’s taxpayers, social transfer recipients and pensioners.

Fourth, the public guarantees will artificially reduce the financing costs for banks. This not only maintains a bloated banking sector but also perpetuates the overly risky activities of these banks. Such a misallocation of capital will slow the recovery and long-run growth.

In July, about 500 German economists wrote to Chancellor Angela Merkel to protest against the protection of bank debt. But the proposal for European bank resolution exceeds our worst fears.

A centralised supervision and resolution authority is necessary to address the European banking crisis. But that authority does not need money to carry out its functions. Instead bank resolution should be subject to binding rules for shareholder wipeout and creditor bail-ins if a decline in the market value of a bank’s assets consumes the equity capital or more. If the banking and creditor lobbies are allowed to prevail and the commission proposal passes the European parliament without substantial revision, Europe’s taxpayers and citizens will face an even bigger mountain of public debt – and a decade of economic decline.

Hans-Werner Sinn
Professor of Economics and Public Finance, University of Munich, 
President of the Ifo Institute

Harald Hau
Professor of Economics and Finance at the University of Geneva

Published under the title “Die gefährliche Dimension der Bankenunion”, Frankfurter Allgemeine Zeitung, No. 18, 22 January 2013, p. 13 and in an abridged under the title “The eurozone’s banking union is deeply flawed”, Financial Times, 29 January 2013, p. 9.