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The banking union needs a guarantor of last resort

Governments act as guarantors of last resort of the financial system, as evidenced during the crises of the past 6 years. It will remain true in the future, even if a better regulation and the bailing in financial institutions by their creditors allow to better circumventing the risks born by the taxpayers.
By Christophe Destais
 Post, June 17, 2013

In all the developed countries where the financial sector was affected by the financial crisis of 2008-2009, government supported the activity to avoid or limit the depressive consequences of the crisis. They also acted as guarantors of last resort of financial institutions, in particular banks, whether the debtors to whom they were exposed were domestic or international. This intervention took diverse forms: debt guaranties, recapitalization, partial or total nationalization; government guaranteed bad banks for failing assets. Though in most cases these steps were taken by the ministries of finance relying on the fiscal base, they were in certain cases implemented by the central banks who, in theory, intervenes only as “the lender of last resort» in a liquidity crisis and not "as guarantor of last resort " in a solvency crisis.

Thus, public institutions substituted their own financial credibility to that of banks and other financial intermediaries. In parallel, complex reforms of the financial sector regulation were undertaken, with the ambition to limit the cost of future crises for public finances.

In the Eurozone, these various public interventions took complex forms because of the complex distribution of competences between Member states, the Central Bank and the European Union and because of the Euro crisis that followed the 2007-2009 financial crisis.

In broad lines, it is the member states that first came to the rescue of banks and other financial institutions following the crisis of 2008-2009. The ECB lowered interest rates, increased the refinancing of banks and softened the conditions to which it grants them. The financial regulation being handled in Europe under the umbrella of the "internal market" and not of that of the economic and financial policy, the reform of the financial regulation was undertaken in the framework of the Union at 27 rather than in the more restricted Eurozone. The competences on financial regulation being shared between the Union and the member states, the latter have also decided on reforms of their own. Stress tests on the banks’ balance sheets were coordinated at the European level with unconvincing results.

With the Euro crisis, the Member states of the Eurozone collectively granted their support to countries in crisis, via the Financial Stability European Fund (FSEF) which later became the European Stability Mechanism (ESM). These countries supported themselves their banking system. The ECB contributed at first to this effort by softening the conditions attached to the financing it grants to banks before bringing to the latter an exceptional support, at the end of 2011 and at the beginning of 2012, the long term refinancing operations (LTRO) program, with loans of an exceptionally long maturity and virtually limitless amount (1000 billion Euros approximately) at a very low rate. Finally, it was decided to allow the ESM to intervene in the recapitalization of the banking sector of crisis countries, first through the intermediary of the governments then directly. In parallel, the financial regulation reform continued, as a rather slow pace and according to the same modalities as previously, at the level of each state and of the EU at 27.
It is only in mid-2012, that the Eurozone has taken steps of its own to tackle financial regulation issues, with the decision of the European Council of June 28th and 29th, 2012 to implement a single supervision scheme of the Eurozone banks under the aegis of the ECB.

This decision was complemented by a communication of the Commission on September 12th, 2012 which proposes that the Eurozone establishes a banking union which would lean on three pillars: a single supervisory mechanism of banks, a common deposit insurance and a common procedure for the orderly management of the banks’ bankruptcies (or banks resolution).

This endeavor tends to put the Euro in the common tracks of monetary areas. However, the cornerstone on which currencies rely is still missing. Whatever the efficiency of the regulation and the financial supervision, whatever the volume of the reserve funds intended to face a possible financial crisis, whatever the ability of the ECB to tackle crisis situations, a currency needs a guarantor of last resort, as evidenced by the 2007-2009 crisis.

In other monetary areas, this role is played - in an implicit but clear enough way - by the economic, political and financial credibility of the government of the state that issues the currency, a credibility which owes at the same time to the quality of the management of government affairs and to the dynamism of the economy which would ultimately supply the resources that may be necessary to support the financial sector.

In the case of the EU "banking union", we do not know who would ultimately come to the rescue of the deposits insurance fund, if it ran out of resources, we do not know who would ultimately have the responsibility for mobilizing sufficient resources so that a banks bankruptcies do not lead to a systemic crisis. We can simply speculate that Eurozone member-states would find the means to face such a situation by trial and error, as it has been the case since 2010, maybe eventually mobilizing the balance sheet of the strongest of them.

The Germans obviously prefer that this question be clarified. They point out that the common management of the banking bankruptcies is not compatible with the current treaties (but, maybe, also with their own constitutional and political constraints) and assert their preference for national solutions, as they do in fiscal matters. A compromise was found on this point with France in a joint statement on May 30th, 2013. The latter proposes the preservation of national resolution (ie bankruptcies) authorities together with the creation of a common resolution council and, at the level of the Eurozone, a private sector based support mechanism itself based on member states private sector mechanisms.

This risks to be far from enough for the Euro to enjoy - even implicitly - the support of the guarantor of last resort that its sustainability requires.
Money & Finance 
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