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Fitch : Banking Union Progress Important to Underpin Confidence in Eurozone

Fitch Ratings says in a newly-published report that a European banking union - involving common supervision, deposit insurance, a resolution mechanism and a financial backstop - is necessary to make the eurozone a more stable and viable currency union, which would help support ratings of eurozone sovereigns over the medium term. A separate report to be published later this week will look into the potential impact on banks across Europe.

The long-term nature of the banking union project - and the political decision to rule out the mutualisation of "legacy assets" - means that it is unlikely to be a driver of sovereign ratings over the near term. However, its eventual completion would weaken (though not eliminate) the link between sovereigns and their banks, reduce the vulnerability of countries with large banking systems and improve the resilience and viability of the currency union.

Policymakers' medium-term aim is to ensure that banks are sufficiently strong and well-supervised to remain viable in times of stress, with enough "bail-inable" debt to be resolved privately if it comes to it. But how and when, and how to deal with bank failures in the meantime remains contentious and undecided. European leaders will meet later in June to discuss the next phase of the process of European financial integration. Fitch expects to see progress in a number of the key areas, including bank resolution legislation, a keystone for banking union. If policymakers were to fail to follow through their promises on banking union it could undermine confidence in the region.

In December 2012 the EU council came to an agreement on the single supervisory mechanism for eurozone banks centred on the ECB. The remaining elements of a full banking union remain less clear. European leaders have set themselves a timetable of mid-2013 to come to an agreement on harmonising national bank resolution and recovery regimes and deposit guarantee schemes. They are also due to announce steps toward a single resolution authority. However, current proposals from the European Commission fall short of recommending a common financial safety net to back these measures. Instead they will continue to be supported by national authorities, which will do little to break the sovereign-bank nexus. The European Stability Mechanism (ESM) could recapitalise banks once the single supervisory mechanism is fully functional and weak banks are recapitalised after a further round of stress tests. But with only a muted EUR50bn-EUR80bn set aside for bank support out of its EUR500bn capacity, it would be insufficient to deal with a future regional systemic crisis.

The maximum gross impact on government debt for supporting banks during the eurozone crisis has ranged from 0% up to 30% of GDP. Purely for illustration, the report estimates what would have been the impact on government balance sheets if the costs of bank rescues that increased public liabilities were mutualised across the eurozone. Countries that required large public bail outs relative to GDP such as Ireland ('BBB+'/Stable), Cyprus ('B-'/Negative), Greece ('B-'/Stable), Portugal ('BB+'/Negative), Belgium ('AA'/Stable) and the Netherlands ('AAA'/Negative) would have benefited from such a hypothetical common safety-net. In contrast, the adverse impact of sharing the costs would have been mostly felt by smaller member states, including Estonia ('A+'/Stable), Malta ('A+'/Stable) and Slovakia ('A+'/Stable), as well as France ('AAA'/Negative) and Italy ('BBB+'/Negative). It would have been roughly neutral for Germany ('AAA'/Stable).

It is impossible to predict how the next banking crisis in the eurozone will look, but Fitch believes that a combination of enhanced capital buffers and recovery and resolution planning mean that it will be less costly for the tax payer. However, history suggests governments will probably continue to have to extend their balance sheet to support insolvent systemic banks. The recent Cyprus bail-out programme demonstrates the desire of European policymakers to minimise the costs of bank rescues to eurozone tax payers. Managing future bank crises will likely involve bank shareholders and debt holders taking on the cost of stabilising banking systems before any public support, though in systemic crises fears over contagion would also be a policy consideration.

The report shows that, with the exceptions of Cyprus, Ireland and Greece, most eurozone banks that needed support during the crisis had more than enough equity, subordinated and senior unsecured bond debt (i.e. excluding deposits) to cover the bail-out costs incurred by the public sector.

The approach to bank support through the crisis has been ad hoc and inconsistent making it hard to gauge the distributional impact of a bailout before the event. One element of banking union is a common approach to bank resolution based on clear ex-ante rules. This would reduce uncertainty, but political calculations will inevitably continue to play a role, especially where potential cross-border support is concerned, and rules cannot cover every circumstance.

Despite moves on paper towards a banking union, the reality on the ground has been more of a "re-nationalisation" of banking systems. Cross-border claims have dropped dramatically since 2008. To a much lesser extent, deposits have been leaving riskier jurisdictions. A eurozone-wide deposit insurance scheme would help alleviate pressure on deposits in a future crisis, but such a proposal is not currently being considered.

The report also is available on www.fitchratings.com.

 

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