December’s Real Top Event – By Far – Happens This Week: Part 1
The EU’s SRM banking pact to be finalized December 18: new beginning, or beginning of the end?
Part 1 of 3: Introduction, Background, Central Themes (if you haven’t been paying full attention)
The following is part 1 of a special feature on the coming a single resolution mechanism (SRM – get to know this acronym) for dealing with troubled EU banks. It will be used to handle banks that fail the coming ECB banks stress tests in 2014 and other problem banks thereafter.
In our weekly fxempire.com analysts’ meeting, in which we share thoughts and conclusions about the weekly outlook for global equities, currencies, and commodity markets, we noted that the results for past week’s Euro group and ECOFIN meetings’, which hammered out all but a few final details of the SRM deal, were far too underreported relative to their importance.
Speculation about fed taper timing may be the top market mover in the near term, but far more important decisions are due to be finalized this week. Their final form could cause markets to forget all about the taper, the holiday shopping season’s results for retailers, the China-Japan dispute, everything.
Insolvent banks have repeatedly threatened to topple the EU and global markets. They could do so again. You can’t say that about those other events.
The SRM pact, due to be finalized Wednesday December 18th, is the EU’s solution to removing a razor from the throat of the EU and global economy.
It’s no exaggeration to say that their success of failure to conclude a deal, and the details of that deal, could well determine whether the EU crisis returns in 2014, the fate of the EU, and thus of the global economy.
Nothing matters more in the long run, not the taper’s timing or anything else noted above.
If the EU crisis returns, then forget all the rosy recovery predictions spewing out of Wall Street.
The following article is to fill in the gap left by most of the mainstream media, so that our readers can be prepared and positioned to profit, or at least avoid losses. Either one makes you richer.
Part 1 includes:
- Central Themes
The conventional wisdom was that this week’s economic calendar was a light one given the dearth traditionally market moving events, particularly after last week’s bonanza of major US data and central bank rate statements. Indeed many have said that, in addition to the ongoing taper speculation, the only event of note was US retail sales on Wednesday.
Nonsense. This week’s Euro group and ECOFIN meetings were arguably the most important events in the EU since the summer of 2012 in determining whether the EU survives or dies.
In 2012 Draghi’s combination of bold talk (“we’ll do whatever it takes”), Spain bank aid and the option of the new OMT program calmed markets and thus bought the EU valuable time. Even though nothing has been fixed in the EU, just maintaining calm has been a feat in itself. The OMT program was never used, so it remains one of the great feats of verbal intervention to save the EU.
This week however, the EU attempted to move beyond words and promises to take the kind of actions and commitments needed to save it.
In negotiations during the Euro group and ECOFIN meetings that stretched beyond their originally scheduled Monday and Tuesday all the way to Thursday, officials finalized most of an agreement on a single resolution mechanism (SRM – get to know this acronym) for both supervising and funding the recapitalization or closing of banks that fail the coming ECB bank stress tests, and any other troubled EU banks that appear in the future.
As discussed below, this may well be the EU’s last chance to restore enough of the EU banking’s credibility that’s needed to save it when the next crisis hits.
Why The Stakes Are So High
1. Restore EU’s Credibility
The EU plans to rigorously stress test most of its banks in 2014. Earlier tests were widely considered to be thinly veiled PR exercises that proved the EU incapable of managing its banking system. The results supported this claim. Banks that passed the tests included:
- Dexia, the French-Belgian bank, after having already needed to bailouts, soon after passing the tests needed a third rescue.
- Laiki, a Cypriot bank that was later doomed by its heavy Greek bond holdings (as sovereign bonds they had been deemed automatically risk free despite their Greek issuer’s obvious weakness that lead it to a de facto default in 2012)
- Bankia, the Spanish lender, whose collapse later helped force Spain into a bailout.
In June 2011 Jochen Sanio, head of the German financial watchdog BaFin, told his fellow regulators at the European Banking Authority they lacked legitimacy and risked falling into “disrepute”. See here for details.
2. EU Banking’s Last Chance?
With private sector lending plunging, most of the region’s economy in recession and periphery countries facing far stricter lending conditions than the core nations, the Eurozone’s financial markets are still fragmented.
EU officials hope that by turning the ECB into a single supervisor at the heart of a revived banking sector they will be able to break down the regulatory and capital obstacles that have grown up across the single market and hampered growth.
Jörg Asmussen, an ECB executive board member, was quoted by FT.com here saying the coming ECB supervised bank stress tests, a needed prerequisite final cleanup for centralized banking supervision, was Europe’s “last chance” to clean up the banks and revive lending.
However before the ECB can run rigorous tests that fail banks yet don’t risk panics and new crises, there obviously must be a credible plan, backed by funds in place, to recapitalize or close banks that fail.
3. Breaking The Doom Loop
To prevent the banking unification and stress tests from causing the very panic they seek to prevent, the SRM must prevent the kind of chain reaction seen in the past, of sovereign and band bank solvency crises that quickly threaten to spread to other EU nations.
- Banks Drag Down States: Troubled “too big to fail banks” forcing their cash strapped governments to pay for huge bailouts that threatening their own solvency. EZ governments, unlike others, don’t have the option of simply printing more money in such emergencies because they don’t control their own money supply.
- States Drag Down Banks: The resulting questions about the government’s solvency drive up its bond yields (borrowing costs) that force the government into bailouts, and bringing the associated austerity plans and recessions that have characterized much of the EU crisis. This connection between banks that threatened the solvency of entire nations came to be called the “doom loop.” Further ramifications included:
- The cash strapped sovereign’s bond values plummet as markets see higher default risk. Its banks hold large amounts of those rapidly depreciating bonds, so its banks become more troubled, even those that were previously stable, as the value of their bond holdings plunges.
- Causing turmoil in all major global financial markets, stocks, bonds, currencies, not only in Europe, but in Asia and the US, as doubts about sovereign creditworthiness sparked fears of national economic and banking system collapses that could spread in like a contagion or plague because no one knew which banks or nations were overexposed to that shaky sovereign and its banks. This ability to drag down the entire EU and possibly the global financial system (quite conceivable if a big economy like Italy went down) was what moved the EU crisis into focus. It was and remains the leading source of risk of a global financial collapse.
In sum, rigorous stress tests risk ending rather than restoring EU banking’s credibility if there aren’t clear measures to deal with failed banks, backed by more than enough funding.
Reaching an agreement with clear terms and funding would mark the EU’s first substantive step to breaking the “doom loop,” and healing itself and preventing future EU crises that could threaten the EU and global economy.
A few key details couldn’t be finalized, so they’re scheduled to be resolved next Wednesday December 18, on the eve of the EU Summit.
On November 17th we wrote in some depth here the background, risks and issues involved, and how failure to achieve this deal was arguably the biggest threat to global markets in the coming months.
The following 3 part article includes:
- Introduction, background, central themes of the SRM deal
- A summary of the key terms of the deal, as well as of the problems associated with them in their current form.
- Summary And Conclusions: why little has changed, why its bearish for the EUR and risk assets
After months of negotiations, the Monday December 9th Euro group meetings and December 10th – 11th ECOFIN meetings, EU officials made further progress towards forging a single resolution mechanism (SRM) that will define how the EU deals with troubled banks.
The SRM needs to be in place before the next big steps towards unification of EU banking can take place:
- Final ECB led EU bank stress tests, a final chance to uncover bad banks before they theoretically become the EU’s responsibility. Uncovering additional undercapitalized banks without a funded plan in place to recapitalize or close them would solve nothing and risk renewed EU crisis fears, or even a new chapter (and accompanying spike in EU borrowing costs and dive in stock prices) in the EU sovereign debt and banking crisis.
- The EU assumes overall supervisory and regulatory control of all or most of EU banks (depending on the final SRM draft), as described below, and is then stuck with final cleanup responsibility.
Final decisions about key details concerning funding and control over disbursements of SRM funds (see below) were deferred until a December 18 meeting. Their goal is to finalize a deal before the EU’s self-imposed December 31”soft” deadline.
If they miss that deadline, there are no huge consequences other than some minor embarrassment. However early May is very much a “hard” deadline, because if no deal is reached by then a variety of bad things happen, including:
- Further progress could be deferred for up to 9 months due to EU parliamentary elections in Mid-May.
- Thus the ECB bank stress tests and the entire process of EU banking unification would be delayed for longer than that. At minimum a failure to reach a deal and a delay of that magnitude would be a blow to EU credibility and cast doubt on its ability to repair itself before another, potentially fatal crisis.
- The EU is currently unprepared to cope with a new banking crisis if it arises. The OMT program of 2012 remains an untested solution, as Spain refused to ask for it, as conditions for using it included outside bank audits that could be potentially so embarrassing as to destabilize the government, markets, or both. Meanwhile it has no central bank supervisor or bank bailout fund – that’s what the current deal is meant to provide. The only common funds the EU has at this time, the ESM, is reserved for bailing out governments only, not banks. Germany firmly opposes using the ESM for bank bailouts.
Thus the pressure is on to finalize a deal before year’s end, or at worst case no later than May 1st.
CENTRAL THEMES OF NEGOTIATIONS AND FINAL TERMS
The key themes that run through the negotiations and their key conflicts for now and probably in the future include the struggle between:
- Poorer EU members trying to get the wealthier ones to pay more of the ultimate cost of future aid to EU banks, and those core funding nations trying resisting these attempts or minimizing their liability for the mistakes, mismanagement, or corruption of others.
- Wealthier funding nations seeking greater control over disbursements of common EU funds in proportion to their greater financial burden, compared to that of debtor nations.
See Part 2 (terms) and Part 3 (summary and conclusions)
To be added to Cliff’s email distribution list, just click here, and leave your name, email address, and request to be on the mailing list for alerts of future posts.
DISCLOSURE /DISCLAIMER: THE ABOVE IS FOR INFORMATIONAL PURPOSES ONLY, RESPONSIBILITY FOR ALL TRADING OR INVESTING DECISIONS LIES SOLELY WITH THE READER.