The Consequences of a Failed Banking Union

by Dechert LLP

photo of Rick JonesI told the Blog team that I had sworn off writing about Europe for a while; but really. The FT opinionized last week that the EU ministerial decision to agree on a standard “bail-in” to fix broken European banks was a good thing. The editorial ended with a ringing endorsement “something is, however, better than nothing.” Really? It reminds me of Wile E. Coyote bravely trying to use a handkerchief as a parachute as he falls off the butte, again. Beep, Beep.

I don’t think this is good news at all. The new bail-in proposals, which are yet just a product of ministerial discussion and will require signoffs from the respective governments, are, in fact, going to make matters worse. Assuming it is adopted; the EU will have embraced what amounts to your basic US FDIC approach to insolvency without a fully federal system. In this version, the equity gets blown out, then bondholders, then the big depositors holding funds in excess of each nation’s deposit insurance cap.

If the new resolution plan had been combined with an agreement on European-wide deposit insurance, comprehensive bank supervision and a robust backstop bailout fund, it may, indeed, have been worthy of celebration. But that’s not what happened. In an editorial across the page from that ringing endorsement of something’s better than nothing, Mr. Wolfgang Munchaü, who writes a weekly column on the EuroZone for the FT, said, “the EU has effectively buried the idea of a banking union”. Mr. Munchaü is regrettably right and the consequences are dire. So now when banks across Europe become terminally troubled, they are going to get resolved like the Cypress banks and instead of breaking the link between sovereigns and banks, they have reinforced it. Most EU banks have a broad base of domestic creditors, shareholders and depositors. Resolving banks by haircutting vast sectors of such banks own national investor base will deepen the financial problems of many if not most EU countries. Moreover, holders of transnational deposits and creditors with half a brain are going to withdraw funds from weak banks in weak jurisdictions when there’s again a whiff of grape in the banking sectors battle to prevent broad recognition of the reality of bank undercapitalization. How long is the interbank lending process going to survive when unsecured bank lending is at the top of the table to be wiped out when banks fail? Where is critical liquidity then? Where are deposits?

So the banks are not going to be a driver of the end of the European recession and, in fact, they’re going to continue to be sand in the saddle bags of the European periphery trying to work its way out of the quicksand of high unemployment, excessive debt and insufficient capital formation.

There’s a point to this and it’s not just schadenfreude. This continued muddle has real consequences for US and global capital markets. Some good, some bad. The bad’s sorta obvious. To the good, it once again, re-confirms that there will be opportunities for non-European depository institutions to find market share in Europe, not just next year but for years to come. It means the capital markets must be resuscitated in Europe to meet the capital needs of the commercial real estate market. I know it’s hard for non-EU lenders to lend in Europe. I know the CRE capital markets have struggled and struggled and struggled to reignite as a viable business model; yet I’m convinced, in the reasonable near term, US banks will lend in Europe with material scale and the EU commercial real estate capital markets will re-emerge as a viable and material part of the capital formation process in Europe. It’s essentially syllogistic: credit markets need capital. The existing brick and mortar structure of capital formation in Europe is impaired. Something will fill the gap. Keep an eye on this unfolding mess.

While it’s intellectually frustrating to watch our European friends tie themselves into knots and work so hard to avoid encountering real solutions, willful escapism provides opportunities for others and some of us should at least enjoy it.


DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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