First Steps Toward A European Banking Union

Did Europe really take its first steps toward a banking union?

It appears that they did, in an all-night session of eurozone officials at the EU summit. An agreement was reached concerning the creation of a single bank supervisor, under the charter of the European Central Bank.

The “change in banking supervision could be the most far-reaching of all the decisions taken. Instead of the hotchpotch of 17 different bank supervisors, there will now only be one for all eurozone banks, a major step towards a so-called banking union banking union that is arguably the most significant change to the single currency area since it was created.”

This would be significant step. It would be significant because you now have 17 different sovereignties, 17 different banking regimes, and 17 different regulatory bodies.

Going to a single banking union would be very similar to going to a single currency ... with all the problems of managing a single currency.

Given the current system, many of the sovereign governments in the EU have used their banking to support their undisciplined fiscal policies. Up until recently, all sovereign debt was considered to be riskless, so the banks were able to buy up lots and lots of this sovereign debt and use it in a way that allowed them to meet regulatory capital requirements.

As a consequence, these unconstrained national governments could rely on the banks to buy their debt and the banks could rely on national regulatory bodies to uphold their capital positions because they held this “riskless” national debt. On and on it went in a vicious circle between the banks and the sovereigns. And the affected national governments “talked up” their banks as the banks drifted more and more into trouble with some becoming insolvent.

In order to get through the current banking crisis, eurozone officials agreed to “radically restructure” the €100 billion recapitalization plan requested by Spain. Under the new agreement the funds would go directly into Spanish financial institutions, removing the responsibility for administering the bailout from the Spanish government itself.

Also, in the agreement, Italy will get some concessions in how it is treated in the upcoming plans and further review will be given to Ireland, consistent with these efforts.

Bottom line, the eurozone nations will no longer have the responsibility for bailing out their own banks. The fund that will be used to provide the pool of funds for these bailouts will be the European Stability Mechanism (ESM). Currently, this fund has €500 billion in resources.

Timing becomes all-important in the creation of this central banking supervisory authority, because the situation, as it stands, is unsettled. The ECB is to have plans for this banking authority “before the end of the year” because the creation of this banking supervision is “a matter of urgency.” Spain’s bank bailout will take place immediately under the new guidelines and then could be switched to the new supervisory authority when it is in place.

The problem faced by those attempting to create the new eurozone banking union is that times have changed and the world is constantly moving into an electronic future. The eurozone cannot just set up a regulatory system to just deal with current problems!

This is a problem that has been highlighted in the United States by the recent JPMorgan Chase losses. Financial institutions have moved into a new world order, driven by the attributes of information technology. Financial institutions are scaling up to operate within this virtual world. The smaller banks will not be able to compete in this technology space and hence the average size of a financial institution is going to increase.

According to FDIC statistics, there are 525 banks in the United States that have assets in excess of $1.0 billion. The average size of these 525 banks is over $22.0 billion. According to Federal Reserve statistics, the 25 largest domestically chartered banks in the United States average $290.0 billion in total assets. Bank of America (BAC), Citigroup (C), JPMorgan Chase (JPM), and Wells Fargo (WFC) have $8.0 trillion in total assets divided among them - an average of $2.0 trillion each.

The largest 25 domestically chartered banks plus the offices of foreign-related banks control more than 70 percent of all commercial banking assets in the United States. It is these organizations that will be driving the introduction of the new technology. Folks, this is what the future is going to look like ... and the regulators, in my mind, cannot stop it from happening.

Technology is driving this scaling up. I call your attention to an edition of a journal published by the Institute of Electrical and Electronics Engineers called IEEE Spectrum. The cover story of the June issue is “The Beginning of the End of Cash”. Let me tell you, if the electrical and electronic engineers devote a full issue of their journal to this subject - you better watch out! How about this article: ”Quantum Cash and the End of Counterfeiting.”

This is why, to me, an article like the one written by Philip Augar in the Financial Times is scary. The title of the essay is “Too big to manage or regulate are what matter now.” His suggestions are: one, to break up the banks along Glass-Steagall lines; two, for banking supervisors “to leave as little as possible to management discretion and to go for bold, simple rules that are easy to understand and possible to enforce"; and three, to remove the grotesque incentives that encourage corrupt behavior.

What universe does Augar inhabit?

The problem is that many suggestions about the banking system are along these lines today. Yesterday, the officials of the eurozone took a bold, initial step in creating a new banking structure for Europe. We all hope that they will continue along this road, and will continue at a fairly rapid pace. However, it will not do anybody any good if those creating the new banking structure look solely at the past. Finance is just information and the use of information is going to adapt to the technology available to it.

Banks -- financial institutions --are getting better and better at using the new information technology.

Bank managements -- and the managements of financial institutions -- have not caught up with these new advances in information technology. Their ability to judge and control risk is just one place where these managements fall short of where they need to be.

Yet, I would suggest that these bank managements are light years ahead of where the regulators are in terms of understanding and managing the use of information in this modern era. Creating a banking union and a regulatory structure that does not accommodate this fact is either going to fail, or, and this I believe, is going to drive all the technologically savvy organizations out of their sphere. That is, the banks will find a way to leave the industry.

There is no question in my mind that these banks will do it -- and leave the new banking union with just the “dogs.” This possibility will become more of a reality if the European banking union is formed. But, I believe, the European banking union must be formed. (By the way, if you have not been reading my blog over time…I believe that the United States is leading this charge.)

Who needs a commercial bank? I don’t!