Germany – complete or counteract the European banking union?

Carlo Beks, Thomas Smal, Hidde Prijs

December 2017

The regulation of the banking industry has been dominating the top of the European legislative agenda for the past few years. During the European sovereign debt crisis, it became clear that Europe’s financial framework was not built with the appropriate institutional architecture in order to absorb a financial crisis. In the European Union (EU), each country had different financial rules, causing an uneven playing field and weakened the overall regulatory framework (Enria, 2015). Subsequently, the interconnectedness between banks and the high government debt possessed by banks led to the potential sovereign debt defaults of Greece, Portugal, Spain, Ireland and Italy.

In response to these devastating events, the European Commission came to the conclusion that the banking system needed a deeper integrated structure. The aim of this integration is to create a safer and more stable financial sector for the single market, in which distressed banks cannot longer rely on bailouts of their governments and tax payers (“What is the banking union,” 2017). Namely, the Mediterranean European countries and Ireland were the countries that survived their potential defaults at the expense of the costly bailouts of the EU. But which plan had the European Commission in mind in order to convert the egocentric strategies of the banks into a less risk-taking but still competitive ones? As a response, the European Commission established the European banking union – a project in which the financial actors in the European countries are stronger and better supervised by one singular supervisor.

The elements of the banking union

The European banking union is built on three pillars, namely the single supervisor mechanism (SSM), the single resolution mechanism (SRM) and the European deposit insurance scheme (EDIS). Since the autumn of 2014 the SSM has been put into operation, which entails that the European Central Bank (ECB) is the central supervisor of the largest banks of the countries that joined the SSM. The small and medium-sized banks are still monitored by their national supervisors (“Completing the Banking Union by 2018,” 2017).

Large banks are supervised by the ECB, because these banks are often highly interconnected and are therefore of great importance to the stability of Europe’s financial framework. Yet, the ECB and the national supervisors work closely together in order to check whether the small and medium-sized banks comply with the European banking rules (“What is the banking union,” 2017). The ECB could eventually put small-sized banks under its supervision when these banks are in financial distress.

In the spring of 2014 the European member states reached an agreement about the second pillar of the banking union – the SRM. The SRM applies to the orderly restructuring process of a bank by a resolution authority when a bank is defaulting or likely to default with the purpose to minimize the impact of a (potentially) default on the broader economy and taxpayers (“What is the banking union,” 2017). Financial distress costs will initially be at the costs of the banks’ creditors and shareholders themselves. However, when a bank is under strong supervision by the SRM and it still defaults, then the single resolution board could decide to finance the deficit through a single resolution fund. This fund is financed by all the financial institutions in the banking union.

Although the SSR and the SRM are fully implemented nowadays, there are still a lot of issues to tackle regarding the introduction of the EDIS. The third pillar of the banking union is a continuation on the national deposit guarantee scheme, which already protects savings up to €100.000 per account in the event of a bank’s default. However, the ultimate aim is that the EDIS will fully finance these guaranteed deposits of all banks in the European banking union in order to weaken the link between banks and their national sovereigns. Moreover, by introducing the EDIS the level of depositor confidence in a bank will not depend on a bank’s location anymore (“What is the banking union,” 2017). You might expect that this scheme will bring the EU to an even closer union at forehand, but is this initiative supported by all countries in the EU?

Germany’s reluctance

In response to the problems at Banco Popular, Veneto Banca and Banca Popolare di Vicenza, the influence of the European banking union has been seriously tested this year. The precarious state of these banks resulted in significant reluctance and criticisms towards the EDIS in particular. Especially Germany is digging heels in the sand regarding this proposal, because it is afraid to see their national budget draining to the savings depositor in Greece (Walsh, 2017).

The reluctance towards the deposit insurance proposal has caught stagnation in the completion process of the European banking union for months. ECB President Mario Draghi supports the tough position that Germany takes, since countries with unstable banking systems should first deal with their stockpiles of non-performing loans before savers’ deposits can be insured (Jones, 2017). Yet, the EU prefers to reach a consensus on the banking union at the end of this year. Although the cooperation of Germany, as one of the main financial players in Europe, is key regarding the completion, yet it is still the question to which extent the banking union could possibly harm the German economy. Therefore, the important question raises whether Germany should complete the European banking union despite its uncertainty and possible negative consequences.

Counteraction

The fact is that the net effects of the European Banking Union are negative for German banks regarding the associated costs and benefits (Schoenmaker & Siegmann, 2013). On the one hand, the costs of the European banking union are divided in proportions relative to the size of the countries participating in the banking union. This means that the costs for German banks are relatively high compared to the costs for banks in smaller countries. On the other hand, the benefits for German banks associated with the European banking union are too small compared to the distributed capital (Schoenmaker & Siegmann, 2013). The attitude of Germany towards the European banking union could change if a different cost structure would be implemented. The current cost structure is based on the national GDP and the population share. In contrast, Germany would prefer a cost structure based on a mix between the GDP and the European banking assets (Schoenmaker & Siegmann, 2013).

Moreover, Southern European countries with shaky banking systems cause too much risk within the European banking union (Guariscio, 2016). Countries like Italy and Portugal should first clean-up their mess within their banking system, before joining the European banking union. Italian banks prioritize supporting the local financial institutions over profit-making, which results in a lack of growth. The combination between the lack of growth and the fact that Italy is widely overbanked, causes an increase in the distribution of bad performing loans. Germany is not willing to take responsibility for the risks contributed by other poorly performing countries (“Italy’s banking system needs intensive care,” 2016).

Furthermore, the European banking union is illegal under the German Law, because the European banking union has been developed without the required changes in the treaties. European leaders have avoided the treaty changes in every possible way, because changes in these treaties could cause political risks. In this way, European leaders and especially the German Minister of Finance are misleading people by not mentioning the associated risks. The constitutional court of Germany still needs to make a decision on this case, but it is clear that the European banking union introduced additional legal issues as well (“Banking union faces legal challenge in Germany,” 2014).

In sum, these counteracts effects cause reluctance in the full completion of the banking union by the German government. The financial and legal consequences regarding the completion of the banking union are still ambiguous as explained above. But is the German banking system itself as stable and well-structured as claimed to be?

German (misplaced) arrogance

The answer to this question is possibly no, because Deutsche Bank – the largest bank in Germany – have also encountered several setbacks in recent years and might not be as healthy as expected beforehand. Recently John Cryan, CEO of Deutsche Bank, hinted at thousands of job losses. The crisis in combination with some well-known scandals are the source of decreased operating performance for Deutsche Bank in previous years. The most eye-catching scandal has to be the mirror trades between 2011 and 2015. Identical trades were placed by different corporate entities. In case of the Deutsche Bank, these entities were located in Russia and the UK. In this way, Russian rubbles were exchanged for dollars without any supervision of tax regulators and Anti-Money-Laundering controls (Caesar, 2017; Arons & Henning, 2017). Deutsche Bank is just an example to show the misperception of German banks to be rock solid. Germany glorifies their national banking system and their banks, but this could be misplaced arrogance (“Deutsche Bank chief hints at thousands of job losses,” 2017).

Stability and contagion

According this potentially misplaced arrogance, the banking union does certainly have some great advantages for Germany. First of all, the European banking union creates financial stability, which ensures that a parent bank can work in a more efficient way. Subsequently, a stable and efficient parent bank has a positive effect on the other banks operating in that specific country (Bruno & Shin, 2013). The top 25 European banks all benefit from the increased efficiency, including the banks in Germany. German banks could have an efficiency improvement of at least 70%. So, the costs could be reduced on the one hand and the profits could rise on the other hand. Subsequently, higher profits stimulate the German economy, resulting in higher employment opportunities (Schoenmaker & Siegmann, 2013).

Moreover, the European banking union reduces the damage of possible bailouts. A national economy could be harmed extensively when a national government fails to bailout a bank. But it does not harm the economy on a national scale only. The interconnectedness between banks can ensure that a bank’s default could lead to a series of failing banks. This causes much more trouble, which we have already experienced in the period of the sovereign crisis. Therefore, these failures will affect the economic growth in the EU and will subsequently have a negative impact on the German economy as well. So, this is why a failure of Veneto Banca and Banca Popolare di Vicenza can cause a lot of damage. Hence Germany advocates for a tighter monetary policy. A rescue ensures a more stable and growth-oriented Italian economy, which accelerates the process of getting this tighter monetary policy (Krauss, 2017).

German banks needing bailouts themselves is another threat to Germany and therefore an advantage of the European banking union (Dakers, 2016). In 2016, Deutsche Bank received a large fine from the United States which puts the bank at risk. The bank is considered to be ‘too interconnected to fail’ and therefore it might need to be bailed out (Smith, 2016). This would cost the German government and ultimately the taxpayer a lot. The burden could be shared by the members of the European banking union. These banks would suffer terrible losses if such a bank would default.

Together strong

Finally, the German government together with the French government have opted for deeper European integration among its members. German chancellor Merkel stated that we must think about how we can deepen the existing European Union and especially the Eurozone (Carrel & Rose, 2017). A next step in deepening the European integration would be a strong banking union. In the short-term, Germany may benefit less from the European banking union than less developed members, but even the German banking system may not be as stable as Germany claims it to be. By agreeing to the banking union, Germany would make a powerful statement regarding both the future of the Eurozone and the European banking union. Therefore, it would definitely be a step in the right direction if Germany supports the completion of the European banking union.


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Carlo Beks

MSc DHP QRM at VU Amsterdam

Thomas Smal

MSc Finance at VU Amsterdam

Hidde Prijs

MSc Finance at VU Amsterdam