European Banking Union Problems Due To Nature Of Fractional Reserve Banking

• demanded that in times of liquidity crises central banks lend freely at a penalty rate against good collateral to commercial banks.
• Banks that have made bad lending decisions and see their assets and capital sharply reduced or destroyed by write-offs cannot be helped by the central bank. They need to be recapitalised, restructured, or unwound with the help of another institution. Ideally, this institution is funded by contributions from the industry during good times. But to make its guarantee effective it needs a solvent state in the background which can foot the bill if it is too great for the privately funded institution.

In a recent article in Global Economic Perspectives we have reviewed the consequences of the need for the state to back the banking sector. Banking crises in advanced and emerging market economies between 1970 and 2011 on average created fiscal costs in the amount of 6.8% of GDP and led to an increase in public debt by 12.1% of GDP (see “Financial Crises: Past and Present”, Global Economic Perspectives from 15 May 2013).

The Problem With Banking Union

In Banking Union, banks should be centrally supervised, centrally restructured or resolved, and benefit from common deposit insurance. Initially planned to begin in early 2013, the start of Banking Union has been postponed to the second half of 2014. A key reason for the difficulties in building Banking Union is that the authorities are discovering that separating banks and states at the national level only reunites them at the euro area level. As we argued above, this is due to the fact that fractional reserve banking needs a state as ultimate financial backstop in a systemic solvency crisis. If this backstop is not provided at the national level, it must be there at the euro area level. But as we do not have a euro state, it is next to impossible to provide a full supra-national backstop.

The recent negotiations highlight the dilemma. At the Council meeting of June 2012 it was agreed in principle that the ESM should be able to directly recapitalize banks in need, once the Single Supervisory Mechanism was established.

However, authorities quickly discovered that this could lead to very large transfers from stronger states with healthier banking sectors to weaker states with banks in trouble. As a result, in a meeting by the Eurogroup on June 20 this year it was agreed to put a EUR60bn limit on the contributions by the ESM to bank recapitalization. Moreover, costs are to be shared between national states and the ESM under a complex regime:

1. When it is found that a bank has insufficient equity to reach the legal minimum Common Equity Tier 1 (CET1) ratio of 4.5% under a sufficiently prudent scenario of a stress test, the requesting ESM Member will be required to make a capital injection to reach this level before the ESM enters into the capital of the institution.
2. If the bank already meets the above-mentioned capital ratio, the requesting ESM Member will be required to make a capital contribution alongside the ESM, equivalent to 20% of the total amount of the public contribution in the first two years after the entry into force of the instrument and to 10% afterwards.
3. If the contribution in this first part is lower than would have been required in the second part, the requesting ESM Member would be asked to inject an additional amount alongside the ESM to cover the difference.

Banking Union Availability Of Funds

Funds from the ESM will only be made available when

1. the state requesting support is unable to provide support on its own;
2. providing assistance is essential for safeguarding financial stability in the euro area as a whole;
3. no private capital is available; and
4. the bank is systemically relevant or poses a serious threat to financial stability of the euro area as a whole or the state requesting help.

At its meeting on June 27, the Council agreed on a rule for bailing in bank creditors in case of bank failures.2 Exempted from “bail-in” would be insured deposits in amounts of less than EUR100,000. In the bail-in hierarchy, deposits from natural persons and micro, small and medium-sized enterprises, as well as liabilities to the European Investment Bank, would have preference over the claims of ordinary unsecured, non-preferred creditors and depositors from large corporations. However, there would also be a number of general exclusions from bail-ins other than insured deposits: (i) secured liabilities including covered bonds; (ii) liabilities to employees of failing institutions, such as fixed salary and pension benefits; (iii) commercial claims relating to goods and services critical for the daily functioning of the institution; (iv) liabilities arising from a participation in payment systems which have a remaining maturity of less than seven days; and (v) inter-bank liabilities with an original maturity of less than seven days.

More problematic is the ability of national authorities to exclude liabilities from bail-in on a discretionary basis for a number of reasons: (i) if they cannot be bailed in within a reasonable time; (ii) to ensure continuity of critical functions; (iii) to avoid contagion; and (iv) to avoid value destruction that would raise losses borne by other creditors. This opens the door for the neutralization of the general bail-in rules on a fairly large scale. In the event, the mix between “bail-in” (through loss participation) and “bail-out” (though official assistance) of the holders of bank equity and debt is open to a considerable degree of discretion and will in practice probably be determined by the amount of official financial backing at the euro area level.

To provide insurance for deposits up to EUR100,000 the Council wants member states to set up resolution funds, which over 10 years should reach a target level of 0.8% of the covered deposits. Help from the resolution fund would be capped at 5% of an institution’s total liabilities. In order to limit exemptions from bail-ins creditors could only be bailed-out after having absorbed losses of at least 8% of total liabilities (or where applicable 20% of risk-weighted assets).

Banking Union Without A State

Is Banking Union bound to remain incomplete because of the absence of an effective public financial backstop of the banking sector at the euro area level? The answer would seem to be “yes” as long as fractional reserve banking in its present form remains the business model of the banking industry. As one of the authors of this article has recently pointed out, this need not be the case when fractional reserve banking is modified (see T. Mayer; “A Copernican Turn for Banking Union”, CEPS Policy Brief No. 2090, 14 May 2013). The following modifications would seem to be needed:

1. A 100% reserve requirement for safe deposits: We start by defining the risk-free asset for a euro area resident with short-term and long-term financial liabilities (e.g., living expenses and nominal debt): This is the asset that can be converted into legal tender at face value at any time and under any circumstances. In a fiat money system the only legal tender is by definition central bank money. It is easy to see that only few assets would qualify as risk-free. Most importantly, the debt of governments that do not control the issuance of legal tender, as is the case in EMU, or deposits of banks that are backed by credit to entities that also do not control the issuance of legal tender, are not risk-free. All these assets are risky because the debtor may not be able to convert them into legal tender at any time and under any circumstances. Hence, in EMU the only risk-free asset is cash issued by the central bank and deposits that are fully backed by central bank reserves. From this follows that we need to establish safe bank deposits as deposits that are fully backed by banks’ holdings of central bank reserves. In other words, we can effectively insure deposits by introducing a 100% reserve requirement for this type of deposits.