Europe’s Banking Union

Breaking Out of the Doom Loop

By | Updated July 7, 2016 10:10 AM UTC

European leaders emerged from an all-night summit in June 2012 resolved to "break the vicious circle" between national governments and the banks that held their bonds — the so-called doom loop. With the debt crisis raging for a third year and Spain's banks on the ropes, they emerged with a plan for a banking union, focused on the euro currency bloc, that would keep taxpayers off the hook when lenders collapse. The plan has three parts: putting the European Central Bank in charge of bank supervision; setting up a single resolution authority to handle failing lenders; and creating a common system of deposit insurance. Four years on, the first part's up and running and the second just got started. Work on the third is mired in a political standoff. Meanwhile, the banks are still awash in sovereign debt.

The Situation

The Brussels-based Single Resolution Board, responsible for handling euro-area bank failures, has been open for business since Jan. 1. New European Union rules that can force creditors to share losses have yet to be tested. The agency is determining the level of capital EU banks must have available to be wiped out or converted into equity if they get into trouble. Elke Koenig, head of the SRB, says a minimum level of 8 percent will be set for the ``big banks'' of global or national significance, though policy makers are already considering easing the requirements. The Frankfurt-based central bank is developing a track record as banking supervisor, after kicking off its oversight in November 2014 with a stress test that failed 25 lenders. There are mounting concerns that the profitability of banks is being weakened by the ECB's push into negative interest rates, which could drive them into riskier assets. Meanwhile, there's no evidence the doom loop has been broken. In fact, banks in the euro area hold more bonds issued by their home governments than they did in June 2012 — 4.2 percent of total assets versus 3.5 percent. Until that risk is defused, Germany opposes reviving proposals for a deposit insurance system. 

Source: European Central Bank 

 

The Background

The banking union was born in the heat of Europe's financial meltdown, part of a policy push that included more than 40 laws to curb banks’ risk-taking and enforce market discipline. Unlike the U.S., with its single central bank and strong national regulators, the EU had to build institutions from scratch at the same time it was putting out fires with bailouts for Greece, Ireland, Portugal, Spain and Cyprus. The sovereign-bank links worked in both directions in the crisis: Greece’s budget blowout crippled its lenders through their holdings of the government’s debt, while weak banks forced Ireland into a bailout and threatened the finances of Spain. The EU put up more than 4.5 trillion euros ($5 trillion) — 37 percent of the bloc's economic output — in rescue aid for banks in the three years to October 2011.


The Argument

The bloc is deeply divided over the remaining roadblocks to completing the banking union. Some of the issues reach into questions of national sovereignty that have dogged the common currency since its inception. At the heart of the problem is the treatment of sovereign debt as a risk-free asset on the balance sheet of banks, which helps them meet the capital requirements imposed by regulators. It's tricky to unwind the links between national governments and their banks, both because of the sheer amount of state debt on banks’ books, and because of the role the bonds play in financial plumbing, such as repurchase agreements. Germany, whose taxpayers shouldered the biggest share of the bailouts, is leading the charge to impose restrictions on banks' holdings of state debt. Global regulators are also working on the issue. Many policy makers agree that the EU should wait for guidance from the Basel Committee on Banking Supervision.

The Reference Shelf

First published Dec. 20, 2013

To contact the writer of this QuickTake:
Patrick Henry in London at phenry8@bloomberg.net

To contact the editor responsible for this QuickTake:
Leah Harrison at lharrison@bloomberg.net