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Eurozone Banking Union: Who Pays for Past Mistakes?

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Yves here. This article by Daniel Gros highlights a potentially insurmountable obstacle in dealing with the escalating Eurocrisis. Germany is insisting that agreements be made on medium term measures, such as implementing European banking supervision, as a condition of any further loosening of its purse strings. While Germany isn’t necessarily wrong to insist that policy makers not lose sight of the need to agree on how to achieve more integration, the emphasis seems a bit cart-before-the-horse-ish. There won’t be a medium term if the Eurocrats don’t deal with the immediate problems more decisively.

Gros points out that one matter that will need to be resolved before implementing a banking union is how to deal with existing losses, particularly those of Spanish banks. That is an issue no politician is likely to want to touch.

By Daniel Gros, Director of the Centre for European Policy Studies, Brussels. Cross posted from VoxEU

The EZ crisis – born as a debt crisis (Greece) – has grown up into a banking crisis (Ireland, Cyprus, Spain, …). This column argues that Spain is symptomatic of larger banking problems, so the EU Summit decisions on banking union are welcome and critical to any long-term solution. Yet someone must pay for Spanish bank losses. Spanish politics is shielding Spanish creditors, European politics is shielding EZ taxpayers, so the Spanish government will pay – and in doing so may go the way of Ireland. This crisis is far from over.

Banks were “international in life, but national in death” in the first couple years of the Global Crisis. Large, internationally-engaged banks had to be rescued by their home government country despite the rescue being in the interest of many nations.

How times change. European banks are now “national in life, but European in death”. In Spain, for example, the banks’ problems were all national – local savings banks (cajas) financed a huge real estate boom. As the boom turned to bust and the losses threaten to overwhelm the capacity of the Spanish state, the problem became European. An Irish-like failure of Spain triggered by a collapse of its banks would threaten the euro’s very survival and this core economic interest of all EZ members (De Grauwe 2012).

• The Spanish case is symptomatic of a larger problem.

National supervisors have always a tendency to minimize problems on their own turf.
In the case of large international banking groups the instinct (and the bureaucratic self-interest) of the home country supervisor is to defend the ‘national champion’ abroad. But the resistance of national supervisor to recognize problems at home is even stronger.

This tendency was very much in operation in Spain. Until very recently, Spanish authorities maintained that the real estate problems were temporary.

• Spanish banking regulators did not want to own up to the reality that they had, for more than 10 years, been engaged in oversight – in both senses of the word.

The tragic sense of the word is that they overlooked the build-up of a huge construction boom whose bust now threatens to bankrupt the entire nation.

The Irish case was not much different to start with. When the problems started to surface, the Finance Minister first claimed that this would become “the cheapest bank rescue ever”.

Systemic weakness of national bank regulation

Given this predictable tendency of national supervisors not to recognize problems at home it seemed natural that the cost of cleaning up insolvent banks should also be borne at the national level. At first sight it thus made sense that even in the Eurozone banking supervision remained largely national, with only some loose coordination at the EU level. A ‘European Banking Authority’ was created recently, but it has only very limited powers over national supervisors whose daily work remains guided be national considerations.
This ‘national problem and national responsibility’ notion, however, is not tenable given the vast negative spillovers that would come from systemic bank failures in large EZ nations. The problems might arise at the national level, but they quickly threaten the stability of the entire system.

A nascent banking union

The need to rectify this situation has now finally been recognized by Europe’s leaders who decided at their last summit that the responsibility for banking supervision in the Eurozone should be transferred to the ECB.

They naturally put the ECB in charge given that the integration of the financial system is particularly strong within the Eurozone. Moreover, the ECB is already de facto responsible for the stability of the Eurozone’s banking system. But at present it has to lend massive amounts to banks without being able to judge their solidity because all the detailed information about the health of the banks is still in the hands of national authorities who guard this information jealously. And, as we saw in Ireland and Spain, these are the authorities who tend to overlook the problem until it is too late.

The ECB already de facto started to assume some supervisory power in a little noticed step when it announced that government guaranteed bank bonds would be accepted as collateral for new lending only if the banks draw up a funding plan which indicates how they will be able to finance their operations without excessive recourse to the ECB.

Creeping dis-integration of the EZ banking sector

Putting the ECB in charge would also help to stop the creeping disintegration process which is not visible in public, but very real. There are several cases of large international banking groups headquartered in countries which today are under financial stress. These groups are being torn apart by the conflicting pressures from national supervisors.

Consider the case of a bank headquartered in Italy, but with an important subsidiary in Germany. The German operations generate a surplus of funds since Germany saves more than it invests at home.

• The Italian parent bank would of course like to use these funds to reinforce the liquidity of the group.
• The German supervisory authorities consider Italy at risk and thus oppose any transfer of funds from the German subsidiary to the Italian headquarters.
• The supervisor of the home country (Italy) has of course the opposite interest. It would like to see the ‘internal capital’ market operate as much as possible. Here again it makes sense to have the ECB in charge which would be neutral with respect to these opposing interests.

Putting the ECB in charge of banking supervision thus solves one problem. But it creates another one. Can one still hold national authorities responsible for saving banks which they no longer supervise?

This is not a new problem. The De Larosiere Report (2009), which became the basis for the creation of the European Banking Authority (EBA) and the Systemic Risk Board (ESRB), argued that the ECB should not be involved in ‘micro’ supervision mainly because banking rescue and resolution involves tax payer money, which they assumed had to be national.

First comes EZ bank regulation then comes EZ bank rescues

Banking regulation and restitution are difficult to separate – no wants to pay for things they cannot control. Economic (and political) logic thus requires that the Eurozone will soon need also a common bank rescue fund.

Officially this is not fully acknowledged yet, except for a hint in the EZ summit statement of June 28/9 which says that once a system of supervision involving the ECB has been created it would become possible for the permanent rescue fund, the ESM, to inject capital into banks.

This is how European integration often advances. An incomplete step in one area later requires further integration in related areas. In the past this method has worked well. The EU of today is a result of such a process. But a financial crisis does not give policymakers the time they used to have to explain things to their electorate. The steps will have to follow each other much more quickly if the euro is to survive in its current form.

Problems ahead

The worrying thing is that the terrain EZ leaders must cross is heavily mined. Europe does not have the luxury to construct its banking union from a stable situation. This new institution is being set up in the midst of a banking crisis.

There are clearly large losses that have to be realized and allocated.

• This means serious distributional conflicts both within and between member countries.

The most difficult case is going to be Spain. The local savings banks are the weakest part of the Spanish banking system because they specialized in mortgages and lending to developers, i.e. the areas where very large losses are to be expected. A number of these were recently ‘privatized’, often in the context of mergers. These new institutions then had to raise capital in various forms (shares, preferred shares, subordinated debt).

Given that institutional and especially international investors were not willing to invest in these instruments (not surprising given that the state of the Spanish real estate market) the new capital was raised mainly from domestic investors, often the depositors themselves.[1]

Who pays for past mistakes?

This leads to the first conflict: Who should bear the losses the (Spanish) investors or the Spanish government?

As retail investors are also voters, the government (and the management of the cajas) have now incentives to pay back as quickly as possible all instruments that would otherwise be loss absorbing. This seems to be happening on a broad scale. It is thus possible that by the end of this year the weakest banks will have repaid all of their hybrid instruments at par or close to par. At that point the loss absorption capacity of the Spanish banking sector will be much reduced.

But this leads to the second distributional conflict: Will the European tax payers want to pay for past losses? As the answer is presumably no, there is thus a danger that by the end of this year it will become impossible to inject European capital into Spanish banks unless either a number of banks have gone into informal insolvency (to bail in other creditors) or the Spanish government has put enough into the system to cover past losses (which it might not be able to do). The road towards banking union is going to be difficult.

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38 comments

  1. psychohistorian

    Who are the parties that don’t/won’t have chairs when the music stops?

    How come there is not more discussion about the folks that set up the Spanish building bubble and sold those Spanish investors that scam? I think those folks should pay all they have and be sent to jail.

    1. Anon

      Many of the investors into the bubble are German, and much of the benefit of the boom already transferred to Germany.

      Today Germany wants to distance itself from the mistakes of the past, which Germany caused as well via free transfer of capital that Spanish authorities had no right to stop. Yet Germany would like to keep the profits it drew from those gigantic bubbles: over a trillion Euros.

      That won’t work.

      1. Hans Maier

        “Many of the investors into the bubble are German, and much of the benefit of the boom already transferred to Germany.”

        Oh, is that so – mind to provide some reputable sources for this claim?

        1. Anon

          Just sum up the German trade balance, 2000-2012. Where do you think those 1.5 trillion Euros came from? They were mostly fresh debt, created on the periphery and transferred to Germany…

          1. Hans Maier

            “Just sum up the German trade balance, 2000-2012″

            Hm, we were talking about the spanish property bubble and who fueled it, right? Your remark, no matter if it has substance or not, has no apparent connection whatsoever with the issue in question.

            Plus, I was explicitly asking “mind to provide some reputable sources for this claim?”

            I ask again “mind to provide some reputable sources for this claim?”

          2. emptyfull

            I think Anon is using a really big macro argument — the same that Krugman uses and that Germans almost always reject.

            His point is that the the macro success of Germany in the last few years was largely the result of property bubbles in periphery states. These bubbles (whoever directly financed them — and yes, I too would like to know how much of the malinvestment originated in German banks) allowed peripherals to buy more German stuff for a while, expanding intra-EU trade imbalances. Because of the currency union straightjacket, and EU institutions which strongly supported German economic interests for the past decade (because it was the “economic engine of Europe”), the peripherals could not rebalance and have descended into debt traps that they cannot escape on their own.

            Thus Germany’s gains in the past few years (which Germans, of course feel they earned all by themselves — after all, at a micro-level they did!) came in part because of horrible design problems in the EZ that are dragging other European nations into horrific depressions.

            Now that the bill is due, who is going to pay? My guess is everybody, either through some controlled unwinding of all the banking and sovereign debts in the EZ, or through a chaotic collapse of the peripherals which will quickly take down the seemingly “healthy” economies of the core. As banks (and their deposits) disintegrate, every nation will be under intense pressure to bailout their banks. Then the big question will be if the most culpable individuals (the top bankers everwhere and those who serve them) continue to be allowed to rig the system in their own favor, or if the taxpayers rise up to make sure the richest and most powerful share the pain.

            P.S., That’s my understaning right now, but I’m a layman, so I welcome correction if I said anything wrong or stupid!

          3. Anon

            Hans: just check the Bundesbank reports on German bank held foreign assets: north of 2 trillion Euros. Those figures do not include the directly held foreign real estate property held by millions of Germans – trillions of Euros worth.

            emptyfull: bingo …

            Germany was the main driver of the bubbles but wants to extract itself from paying for the cleanup.

            That won’t fly.

        2. econ

          Please check out the Financial Times, posted on 21 June 2012
          an article by Simon Hinrichsen titled “Koo on German Bubbles.”
          Richard Koo of Nomura is not alone on this position of a balance sheet recession striking the German economy in 2001 and the implications.

    2. thelonegunman

      Well, who was I power at that time?

      Oh! That would be the PP… Just like how conservatives were in power in Greece… and Ireland.. And Italy… And the US…

      Hmmmm I’m starting to see a pattern…

      Conservatives came in… Cut taxes (and regulations – who can forget The Celtic Tiger!!!!!))… Loaded up the government with debt… Then ‘lost’ elections right before the bills came due… Then pointed fingers as the houses of cards they concocted came crashing at Them Dirty Fiscally Irresponsible Liberals (sneer)… And now cry ‘austerity’ (aka Starve the Beast)…

      Sounds like a unified gameplan by folks in power (and I don’t mean the governments)…

      Oh, forgot to menton the global bailouts of the banksters and the MASSIVE transfer of private losses onto the public taxpayer…

      Ja, nichts zu sehen … bewegen sich entlang …

      1. psychohistorian

        We are witnessing a global Shock Doctrine event or combination of events meant to break the social safety nets of all “Western Democracies”.

        It is a race to the bottom where the only winners are the global inherited rich. It is way past time they are laughed out of control of our world.

  2. Min

    Who pays for past mistakes? Generally those who did not make the mistakes, when the consequences of the mistakes are large and widespread. But wait! There is an entity that can greatly alleviate the burden of millions of innocents. The European Central Bank, which can create as many Euros as necessary. But it won’t.

  3. Ruben

    “While Germany isn’t necessarily wrong to insist that policy makers not lose sight of the need to agree on how to achieve more integration, the emphasis seems a bit cart-before-the-horse-ish.”

    I don’t think so. Spain has to surrender sovereignty first, openly and shamelessly, to a certain degree (as Greece has to apologize on its knees and ask for forgiveness for lying to become a EMU member). I’m talking of what could work.

    “The most difficult case is going to be Spain. The local savings banks are the weakest part of the Spanish banking system because they specialized in mortgages and lending to developers”

    This gives the impression that the cajas just did bad business decisions, and thus overlooks the widespread (and arguably enormous) corruption that the local savings banks funded, particularly in favour of the party currently in government. Their boards were populated by large numbers of party parasites and careerists.

    Northern countries politicians know this very well. How can they put their resources at risk to save incompetent and corrupt Spanish cajas BUT without affecting the credit of the government party that infected those cajas with so much incompetence and corruption?

    Isn’t it too much to ask?

  4. Hans Maier

    “Who pays for past mistakes?”

    As always: those who didn’t profit as these mistakes were made.

    As for the spanish housing bubble: the spanish banks reaped the profits and distributed them to their shareholders and employees.

    Now, as the going gets tough, the taxpayers from all over the eurozone (well: from the countries who are not yet on the receiving end of one of the countless resuce funds and schemes) are being plundered to plug the holes.

    This is completely wrong. Whenever a bank goes bust, it should be allowed to do so. To keep zombie banks alive is the greatest mistake ever.

    Of course, the deposits of the average people, of real economy businesses, and of public entities must be secured.

    To do so, before touching taxpayers pockets agen, 1st get the managers wealths, the shareholders dividends, the employees huge salary packages (there is no reason why in the finance industry the average salary is 3…4 times higher than what is being paied in the real economy). Only for the rest, ask the taxpayers, but politely…

          1. auskalo

            Lenovo,

            The chart is in Italian. Regno Unito in Italian means United Kingdom in english, Reino Unido in Spanish, Royaume Uni in Frech, and so on.

      1. Hans Maier

        I know who’s being bailed out. It’s the banks all over the place.

        But most of all the french. Since they were and still are the most exposed to potential losses in the troubled countries. That’s why w/o exception, all of the bazookas, rescue progams and so on were designed to support french banks – France has by far the most influence in EMU politics.

        At the beginning of 2010, French banks had an exposure to GIPS debt of a whopping 33 billion € more than German banks. Then their deleveraging on taxpayer’s cost was just between Q1 and Q4 ten times higher. During this period, they transfered 45,5 bn € of risk to the taxpayers, the German banks only 4,3bn €.

        (Source, for instance: http://www.spiegel.de/fotostrecke/grafiken-bankenflucht-aus-den-krisenlaendern-fotostrecke-68964.html)

        1. auskalo

          Here you have an answer:

          http://ibexsalad.blogspot.com.es/2012/06/mopping-up-behind-germany.html

          I’d put upside down all bank and cajas, audit them and declare bankruptcy where necessary. And a big hair cut to bond holders, share holders and all north-european banks.

          But Spain is unable to pay with taxpayer money, the gambling money of german and french banks. That’s paying with good money the gambling of foreign banks.

          Spain is not asking for german taxpayer money, it’s just asking to the ECB to flip some figures on their computer screens.

          If the Taliban of ECB don’t accept any fair solution, the € is gone.

          And beware, the new Deutsche Mark will have a hard prize for you, too.

          Time will say.

  5. Jose Guilherme

    Let’s face it: without monetary sovereignty Spain – its government and banking sector – is simply a bankrupt entity where no investor would willingly inject funds except at prohibitive interest rates to compensate for the risk.

    Plus, the austerity imposed upon the country guarantees that it will never generate the necessary cash flows to satisfy would-be creditors.

    So the only way out within the euro system seems to be, at first sight, for the ECB to take charge of the country lock, stock and barrel.

    The ECB can create euros at will – without the limit of 500 billion euros that cripples at birth the effectiveness of the ESM – and is thus the only entity capable of “saving” Spain. The price it would charge tor this would quite logically be the end of the country as a sovereign entity. After all, here as much as in any other comparable situation, he who foots the bill gives the orders – right?

    Unless, that is, the Spanish government takes advantage of the loophole provided by the present rules of the intra-eurozone payments system: the overdraft, limitless facilty that the national central banks have at their disposal at the ECB.

    This provides every government of the eurozone with the opportunity of issuing any amount of euros it desires through the back door, without leaving the eurozone. All the euros they need to save banks, issue public debt, cut taxes, increase spending and solve the crisis and the depression.

    Of course,it would take a really macho politician (man or woman) to dare defy the euro establishment by using the existing rules to subvert the system and save his or her own country in the process.

    Any takers – in Spain, Greece, Italy, Portugal or Ireland?

    1. Woody in Florida

      Yes the ECB can “generate” the Euros needed to bail out Spain and/or anyone else in the EZ they care to. And yes, Spain could give up their sovereignty in exchange for all these Euros. But could anyone really feel good about giving up something in exchange for something that is really nothing. The ECB doesn’t actually have the money they use to buy things. They just “create” it. I find it hard to imagine how the idea of a central bank was ever sold to the people. I understand the politicians going for it, but not the people. And so in exchange for the banks completely screwing up the EZ, and everyone blaming somebody else, we are to give more powers to the banks? No Thanks.

  6. anon48

    Who pays for past mistakes?

    The author is spot on. There’s no way taxpayers from other countries will want to take on that responsibility.

    Obviously the Spanish banks and Spanish government can’t afford to ante up.

    So who SHOULD pay?

    Why not a separate real estate property tax, transfer tax or capital gains excise tax surcharge or some combination thereof on all Spanish R/E transactions? This would require significant financial and legal analysis as to which combinations are actually viable and might work best. While there will be howls of protest from Spanish real estate industry, it WAS that industry which was the primary driver of the current crisis, wasn’t it?

    Why not throw in an excise tax surcharge on all salaries paid in the Spanish banking industry, since it’s that particular industry that requires rescue now. (a really significant source of revenue.)

    Wished they had done something like this as part of the US bailout- i.e. Because of the desirability of climate and other favorable factors in Florida, California and Arizona, those markets will eventually come back strong, and large numbers of speculators will flood back in, and again benefit from the inflation of future R/E bubbles in those states. But it’s also a certainty that some of those speculators, will also again be indirectly bailed by the rest of us, when the music eventually stops.

    SO, who should pay for past mistakes?

    How about that part of the economy that gave rise to the mistakes. It’s worth consideration if only to decrease the likelihood of socialization of future losses.

  7. Synopticist

    The bank bond holders should pay.
    Don’t bail out the banks, the bondholders, mostly extremelly wealthypeople,dont get their assets made good.

  8. aono48

    Two additional points:

    1. A dedicated revenue stream could give non-Spanish politicians the cover to allow the ECB to take the Spanish debt onto its own balance sheet(assuming the agreement has the appropriate put-back and other protective provisions)

    2. Why not throw in an excise tax on Spanish real estate sales commissions

  9. LeonovaBalletRusse

    Is Luxembourg Nut indespensable?

    http://www.bloomberg.com – see how French+German NEXUS is the sine qua non for success in the New EU.

    See significance of RHEIMS with quiktrip to Wikipedia. It’s all there.

  10. trint

    “Here again it makes sense to have the ECB in charge which would be neutral with respect to these opposing interests.”

    No it doesn’t. The ECB board can be overruled by a simple majority. Guess what, the bankrupt southern nations connive to overrule Germany and loot its pockets. So the ECB is anything but neutral.
    That’s why any scheme which yields jurisdiction to the ECB gives the German taxpayers the creeps.

  11. ebear

    What percentage of buyers of Spanish real estate were actually Spaniards? Seems to me there were more than a few British and Germans on that bid, no? Also, someone had to lend developers the money to build all that (now surplus) property. Were they all Spaniards? Don’t think so. When I make a bad investment, I suck it up and move on. North Europeans have to accept their part in all of this and do likewise.

  12. They didn't leave me a choice

    What kind brain damage do these eurocrats have? The EU already suffers from massive democracy, credibility and legitimacy deficits. What makes them think that we europeans are going to simply accept more transfers of power to brussels without even so much as a national vote on it? Criminal scum, that’s what the eurocrats are, traitors and betrayers.

    “The need to rectify this situation has now finally been recognized by Europe’s leaders who decided at their last summit that the responsibility for banking supervision in the Eurozone should be transferred to the ECB.”

    Leaders my ass. Just a bunch of clowns in suits pretending to have legitimacy to represent me or just about anybody outside of the 1%. Thieves, rat bastard thieves every single one of them.

  13. thelonegunman

    ‘who pays for past mistakes?’

    Well now, THAT’S an easy question: the taxpaying public of course… We’ll need more austerity and the banksters will need more public bailout financing which they’ll use to pay bonuses to themselves…

  14. mac

    Many people and institutions profited from these bubbles. There were the workers at the bottom of the chain who drew wages, there were the providers of materials, there were , yes banks and others who for some time made money on origination of loans and collecting of interest.
    There were those who profited from the wages and profits that were spent on products and services.
    So how exactly do we nominate the truly guilty parties and who exactly owes for correcting the problem? What guilt can be assigned to those who believed the bubble would go on forever?

    1. Hugh

      Nice use of the moral equivalency argument: everyone was doing it, if everyone is guilty, no one is guilty, etc. Any transient profits gained by ordinary Spanish are long since gone and been replaced by debt. So if you want to use this argument, then fine, go after those whose profits have not yet been disgorged or annihilated: the Spanish 1%, the Northern banks and the Northern 1%s behind them.

  15. Hugh

    European 1%s (German, Greek, Spanish) created bubbles, profited from them, and now are dumping the downside losses on the 99%s.

    The author does a real deservice by portraying this all as a purely national banking crisis. The only way a bubble could have been blown in Spanish real estate is if Northern banks were backing the action of the Spanish banks.

    If this had been a purely Spanish affair, there would not be any international ramifications. It would be Spaniards owing other Spaniards money. In such a case, the best policy would have been for the Spanish government to let the banks go bust, put them through bankruptcy, wipe out the equity holders, stiff the bondholders, protect small depositors, and then reconstitute and capitalize new banks. This would have forced the losses back on to the 1% who created the bubble and was in the best position, both morally and financially to bear its losses.

    But this is not what happened because the Spanish banking crisis is as much a German and French banking crisis. It bears repeating because it doesn’t seem to be getting through to some people that the efforts to date of the Northern governments led by Germany to funnel funds to the southern countries like Spain are not to help these countries and their peoples but are instead a backdoor bailout of their own Northern banks and by extension the rich bondholders of those banks. And this remains the heart of the matter. It is not Germans against Spanish or Greeks. It’s about European 1%s against their 99%s.

    Put as simply as possible Europe’s 1%s created this mess, let them eat its losses.

  16. Paddy

    Hmmm, getting warmer.

    “The EZ crisis – born as a debt crisis (Greece) – has grown up into a banking crisis (Ireland, Cyprus, Spain, …).”
    (Shurely shome mishtake. Ed)

    Just to get yer collective goats (sic).. Even the Irish done a better job… better builders too.. :)

    NAMA, RTC, Sweden, Norway, RBS. Pick a model and get on with it.

  17. Kunst

    It’s all going to fall apart because everyone is going to look out for their own immediate narrow interests.

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