With his pledge last year to do “whatever it takes” and the unveiling of the outright monetary transaction bond-buying programme, Mario Draghi and his colleagues at the European Central Bank saved the euro once. The Single Supervisory Mechanism, approved last week by the European Parliament, presents an opportunity to do it again – and this time for good. But the ECB president cannot do it alone. For investors to have confidence that the eurozone is finally on the path to stability, Europe’s politicians must support him with a credible and binding route to capital-raising for those eurozone banks that are viable but remain undercapitalised.
The SSM, which empowers the ECB to carry out banking supervision in the eurozone, is not some arcane piece of financial market infrastructure. Before taking banks under its supervision, the ECB will – in tandem with stress tests that the European Banking Authority is undertaking – conduct an asset quality review of eurozone banks. There are three reasons why, if done correctly, the AQR can be a potential game-changer, putting the eurozone crisis behind us.
First, it will ensure banks have sufficient capital to lend. In an economic area heavily dependent on banks to mediate between savers and borrowers, there can be no robust growth without the credit flows emanating from solidly capitalised banks. Any delay in tackling capital shortfalls will delay the European recovery, so desperately needed after years of severe austerity.
Second, a credible, tough and transparent health check of the European banking system, conducted by the most credible European institution on the basis of facts rather than politics, will be an important symbolic landmark in the necessary journey towards a more deeply integrated eurozone.
Third, the AQR will break the links between national politics and national banking systems, links that have aggravated and unnecessarily prolonged the eurozone crisis.
What has to happen for the AQR to be such a game-changer?
First and foremost, the reviews of the banks’ balance sheets have to be independent and tough, and seen to be so. Only then can they dispel uncertainty and cynicism over the true state of Europe’s banks. Crucially, the ECB must ensure that a template of transparency emerges from the AQR that allows investors truly to compare balance-sheet data across banks and across member states.
Moreover, the ECB will need a clear and credible path for dealing with any banks that fall short on capital. Ideally, balance sheets will be measured against fully loaded capital ratios as defined by Basel III global regulations, plus some additional buffer – perhaps another 2 per cent of risk-weighted assets – to deal with uncertainty about eurozone sovereign risk. No one can know in advance the extent to which capital shortfalls will be revealed. But current price-to-book ratios for European banks suggest a need for more capital in some cases.
Capital shortfalls will mean different things for different banks. Some may well turn out to be non-viable. Their licences will have to be revoked and they will need to be wound down. This will require an effective and broadly accepted Single Resolution Mechanism.
For those banks judged to be viable but overleveraged, the ECB will need to be able to direct them to raise more capital. Contrary to what is often heard from market participants, there is no reason to believe these banks will not be able to do so in the private market. Indeed, the process has already begun – since April, European banks have raised €14bn of new capital. Of course, existing shareholders will complain about dilution effects on their existing holdings. But the ECB should not be concerned about that. Properly incentivised, investors will want the banks to be robustly capitalised.
And this is where European politicians need to act to give the ECB the support it needs. Plans for dealing with banks that are viable but have not raised adequate capital privately need to be in place by the time the AQR is finalised in a year’s time. That is the only way in which the AQR will be seen to be credible.
That capital-raising can take one of two forms. In principle, European Commission state aid rules require bailing-in of banks’ junior bondholders to make good any capital shortfall identified by regulators. But exemptions are foreseen in cases where this would endanger financial stability. So, in addition, public funds need to be in place – at a European level, if necessary – to take equity stakes in banks on punitive terms for existing shareholders.
Either path to enforced recapitalisation will face resistance. In that sense, the game-changer cannot be bought for free. But there are two clear reasons for Mr Draghi to put his personal credibility, and that of his institution, to work to ensure Europe’s banks rebuild their capital. First, the alternative – a continued shortage of credit, leading to a Japanese-style decade of little or no growth – would be much more expensive for Europe’s citizens. Second, there is no reason why some degree of public recapitalisation, should that be the route taken, would entail significant losses for Europe’s taxpayers. As credit begins to flow again, and recovery becomes entrenched, there should over time be healthy returns on investing in Europe’s banks, assuming that the AQR has been done properly, and that public funds have been injected on sufficiently punitive terms.
As Mr Draghi made clear at the time, the OMTs, while necessary, could only buy time for eurozone policymakers to resolve the crisis. If the AQR is successful then, after a frustrating delay, policymakers will finally have addressed the challenges facing the banking system, and investors can at last be confident that Europe has begun to putits existential crisis of the past three years behind it.