A clearer sky for the euro


Several hurdles were removed on 12 September 2012

  • The German Constitutional Courtruling cleared the way for the launch of the European Stability Mechanism (ESM).
  • Dutch parliamentary elections did away with the risk of a eurosceptic government in a core country.
  • The European Commission ambitious proposal for bank regulation provides a road map towards a banking union. 

The Constitutional Court clears the way for the ESM
On Wednesday, the German Constitutional Court dismissed six complaints against the ratification of the ESM and the fiscal compact, although it issued a small number of provisos. The main constraints imposed by the Court are already included in the ESM Treaty. The key points are:
1. The Court stated that German liabilities under the ESM must be capped at €190 billion. Any increase would require parliamentary approval.
2. The Court ruled that direct ESM access to ECB refinancing operations would be in violation of the law.
3. The Court considered that the ESM Treaty is permissible only if the articles protecting the inviolability of the ESM documents did not prevent full parliamentary oversight. 

1. €190 billion cap already included in the ESM Treaty
In the short term, this is not a significant constraint. Germany capital subscription foreseen in the ESM Treaty is currently €190,024,700,000. This amount represents Germany’s maximum obligation and is guaranteed under Article 8(5) of the ESM Treaty.

An increase of the ESM capital is possible, but only by mutual agreement of the Board of Governors. That means that the German representative could block the decision, and the German parliament would therefore have its say. The Court appears to be concerned about the possibility that the €190 billion cap may be overridden if a payment shortfall by an ESM member triggers a call for capital increase from the Board of Directors. There is very little risk of this happening but the Court recommended that clear and specific limitations on German obligations when the ESM Treaty is ratified.

2. ECB refinancing of the ESM is not an option
The second point is straightforward. Since the ESM has been granted the possibility of buying sovereign debt on issuance (primary market), it is clear that ECB refinancing would violate Article 123 of the Lisbon Treaty. This is therefore not an option, and we have already commented this point previously.

3. The German parliament will be kept informed
The third point highlights the Court’s apparent concern about the provisions of the ESM Treaty covering the professional secrecy of the persons working for the ESM. While considering that these articles are intended to prevent sensitive information from being leaked to the capital market, the Court wants to ensure that the ESM Treaty is interpreted in a way that guarantees that “the Bundestag and Bundesrat will receive the comprehensive information which they need to be able to develop an informed opinion”. Provisions in this respect do not appear out of reach.

Threat of a eurosceptic government in Netherlands averted
The Dutch political crisis had increased the threat of a eurosceptic government being voted into power in a core country or at least of the political decision process being blocked by political instability. Preliminary results suggest a win for the conservative VVD party, closely followed by the social-democratic PvdA party. Both are pro-European parties and appear to have won significantly more seats than suggested by the results of most recent surveys. The parties are expected be able to form a ruling coalition that is likely to adopt measures needed to make progress towards resolving the crisis in the euro area.

A first step towards a banking union
The European Commission’s proposal for a thorough reshuffle of financial supervision framework, as outlined by Internal Market and Services Commissioner Michel Barnier, is quite ambitious. The proposal is a set of legislative articles which establishes a single supervisory mechanism for banks led by the ECB. This first step is part of a roadmap that would lead to banking union over the coming years. Once completed the whole framework will include:

  • A centralised supervisory authority;
  • A single rulebook;
  • A common deposit protection;
  • A single bank resolution mechanism.

The central role of the ECB
The proposals to reform the supervisory framework give the ECB ultimate responsibility for the financial stability of banks, while national supervisors would implement decisions and be responsible for day-to-day monitoring. Accordingly, the ECB will become responsible for:

  • Authorising credit institutions;
  • Compliance with capital;
  • Leverage and liquidity requirements;
  • Conducting supervision of financial conglomerates.

A very ambitious timetable
The Commission proposes to have the new Single Supervisory Mechanism (SSM) in place by 1 January 2013, but a phasing-in period is envisaged:

  • As from 1 January 2013, the ECB will be able to decide to assume full supervisory responsibility over any credit institution, particularly ones that have received or requested public funding.
  • As from 1 July 2013 all banks of major systemic importance will be put under the supervision of the ECB.
  • As from 1 January 2014 the SSM will cover all banks.

As the proposal has to be approved by the European Parliament (EP) and the Heads of State, the whole project seems very ambitious, not to say utopian.

As a result, the time available to achieve a consensus among the 27 member states (the reforms have to be adopted at the European Union level) and to hire the specialised staff at the ECB seems very short. There is therefore every likelihood that the timetable will not be met. In any case is the proposals are a good basis for discussion and pave the way for an agreement on a banking union, which is a central piece of the puzzle of resolving the crisis.

The European Commission against Angela Merkel
In giving the priority to the endangered banks the Commission has firmly stuck to its initial position which is opposed to that of the German government, who wanted systemically important banks to be submitted to the single supervision first.

A possible obstacle to Spanish bank recapitalisation
Beyond timetabling issues, the most worrying point is that the German government wants to see an unified supervision before direct recapitalisation of banks by the ESM. If the German government stands by this position, it means that recapitalisation of the Spanish banking system may be far to be imminent.

A new watershed in the European crisis
To sum up, we undoubtedly believe that this week’s decisions have meet market expectations, therefore clearly mark a new watershed moment in the euro-area crisis.

The euro area is now equipped with a stability fund (ESM) which, according to its likely President Jean-Claude Junker, is expected to hold its first meeting on 8 October. So far in the euro-area crisis emergency funds have always suffered a lack of funds. In contrast, however, the ESM is now backed by the ECB acting as a lender of last resort, then the ammunition available is expected to suffice to remove much of the threat of an euro break-up.

The possibility of a… rosier scenario
At this point, we can outline what may be a rosier scenario:

  • The Spanish government will ask for the international aid.
  • In the light of previous measures implemented by the Spanish government, the Troika will request no significant additional fiscal rigour.
  • The ESM will recapitalise the Spanish banking system directly. The amount (approx. €60 billion) will be deducted from the Spanish public debt.
  • The ECB’s interventions, or even better, the threat of ECB interventions, will prevent sovereign periphery spread.
  • The Irish banking system will enjoy the same conditions than the Spanish system.
  • Credit conditions in the periphery will be relaxed giving the asphyxiated economies more breathing space. 

…but many potential setbacks lurk
The likelihood of seeing this rosier scenario materialise without setbacks remains small. Political procrastination or shortsightedness have the potential to wrong-foot markets owing to inadequate decisions. The most immediate potential sticking points are:

  • Mariano Rajoy wants to wait for elections inGaliciaand the Basque Country before asking for international aid.
  • Acrimony is likely to grow over the probable €20 billion shortfall in Greek finances.
  • Due to the peculiar political situation, Mario Monti will be unable to ask for an international aid.

Fixing the worst of the crisis does not imply economic recovery
Even in the event that the rosier scenario does materialise, it is worth underlining that a closing of peripheral sovereign spreads is merely expected to relieve credit conditions somewhat as a result of an improvement in bank balance sheet. This is likely to facilitate credit roll-over, notably for SME, and as such stem the flow bankruptcies.

At this point, an economic recovery in the periphery is another chapter. However, preventing public finances from deteriorating further and easing the strain on bank balance sheets will be a major turning point in the crisis.

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