ECB Hits Small Banks, Makes City of London, Wall Street Salivate

By Don Quijones: Thanks to Europe’s Banking Union, consummated to minimal fanfare on Nov. 4, 2014, supervision of Europe’s 130 biggest banks, representing 80% of total financial assets, was passed from national authorities into the welcoming hands of the ECB, an institution that is frighteningly opaque, unaccountable and undemocratic – even by modern European standards.
The ECB is now the single supervisor of the most important banks, not only of the euro zone, but of the entire 28-member European Union. This new setup grants Europe’s central bank a huge amount of power — power it is not afraid to wield, as 11 million Greeks have just learnt.
As I warned in July last year, in a Europe-wide banking union, pretty much everything that is wrong with Europe’s financial system (i.e. excessive concentration, over-complexity, moral hazard, excessive risk-taking, capital shortfalls) would almost certainly get a whole lot worse. So the big banks were happy with the new banking union.
If the last seven years have taught us anything, it is that when the big banks win, the smaller banks lose. When they go down, the bigger banks are always on hand to help out and take them over for cents on the euro. This process of consolidation will form an essential part of Europe’s banking union.

A Harmonization Frenzy
But murmurs of disquiet are already being heard from the banks of some of the continent’s smaller nations. As Euractiv reports, the Czech Banking Association (ČBA) has warned that if the ECB continues to push regulations that ignore the specific, on-the-ground realities of each national banking sector, market stability in the country could be hit.

“If [the standard] is approved in the form in which it was initially drafted, we will see convergence of business models across the EU,” Monika Laušmanová, chairwoman of the committee for banking regulation of ČBA, said.

“But while it makes western European banks more stable, Czech banks will go in the opposite direction. The market will get riskier,” she added.

The problem derives from the ECB’s ambition to harmonize and standardize banking regulations across markedly different markets. At the behest of the European Banking Authority, national regulators are expected to tell banks in all 28 European Union Member States what the minimum requirements are on “eligible liabilities” (MREL) they are supposed to have, so that they are ready for any future failure. In other words, each bank is supposed to have a certain minimum level of eligible liabilities (equity and bonds) in the event of a bail-in.
The problem is that some banks in some EU countries operate in a much more risk-averse fashion than big banks in core EU countries like Germany, France and the UK, in whose interests the regulations are primarily designed. For example, as Laušmanová explains, the Czech banking sector has a very conservative business model:

Banks concentrate on the local market and at the same time, satisfy most of its financial needs. Banks are predominantly financed by equity and primary deposits and have high levels of liquidity.

One direct result of this prudential approach is that unlike most other European banking systems, the Czech bank sector sailed through the financial crisis virtually unscathed. While banks in the Eurozone sought public help to avoid default and their returns have been lackluster (at best) during the post-crisis years, Czech banks have experienced rates of return on equity (ROE) ranging from 16.2% to 26.4% between 2008 and 2014.
Perverse Incentives
But that system is now under threat. According to the minimum requirement of eligible liabilities (MREL), bigger banks in Europe will have to raise total volume of eligible liabilities to a level that equals double the amount of all capital requirements, reserves, and buffers that are currently prescribed by the national regulator.
“Czech banks simply do not have the kind of liabilities that could be qualified as eligible,” Laušmanová said.
If Czech banking authorities are obliged to count all capital requirements in the MREL, Czech banks would need to raise their debt considerably:

ČBA estimates that an average bank would need to raise the debt by 4.9 % of total assets. Czech banks would need to go international in terms of their investments. With a new debt comes a new liquidity and that will need to be invested somewhere. The problem is that there are almost no opportunities on the local market, bankers claim. Since banks will need to recover higher costs related to the new debt, they will need to invest in riskier assets, ČBA said.

In other words, to comply with the ECB’s new regulations – regulations supposedly designed to make Europe’s banking system safer – Czech banks will have to take on considerably more risk by issuing a lot of debt and then using the proceeds to buy huge quantities of complex debt instruments from the international markets. You can almost imagine the salivating smiles spreading on Wall Street and in the City of London. 

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