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Europe must change course on banks

Thursday 22 December 2011 - by Nicolas Véron

A banking union within the EU is necessary to ensure the survival of the euro and would not threaten member states' national sovereignty, says Nicolas Véron, senior fellow at the Brussels-based think tank Bruegel.

The eurozone crisis keeps evolving along multiple dimensions. On the sovereign debt front, no deal is yet in sight on Greece's debt restructuring, and Italy and Spain face major refinancing needs in early 2012.

On the institutional reform front, the summit on 9 December fell short of delivering a true fiscal union, and tensions between the eurozone and the UK have been brought to boiling point. On the growth front, a possible deep and prolonged recession looms.

As during previous episodes, however, the banking system is a crucial piece of the puzzle and epitomises many of the contradictions of Europe's experiment in monetary union.

Almost continuously since 2007 that system has exhibited worrying gaps in risk management, compounded by massive supervisory failures in some countries.

In the past two years, deteriorating sovereign creditworthiness has increased the system's fragility. The combination of member states' guarantees on domestic banks, and those banks' outsized holdings of home-country sovereign debt in periphery countries, has accelerated the feedback loop between sovereign credit and bank funding conditions.

The result is fragmentation: whether a euro held in a Greek bank is equivalent to a euro in a German bank is ever more in doubt. This could produce a slow-moving death spiral for a currency union.

Instead of fighting this trend, the recapitalisation plan agreed on October 27 has reinforced it. More guarantees on banks are introduced at the national level, none at the European one.

Moreover, when raising the minimum capital ratio to 9 per cent, leaders decided that its assessment would rest on fair value (or mark-to-market) measurement of each bank's portfolio of sovereign debt.

The fair value principle is sound for financial disclosure purposes. But it is dangerously pro-cyclical when applied to regulatory capital calculations, especially when extended to debt that is held to maturity - a radical move towards "full fair value" that accounting standard-setters have never dared to embrace. This is a recipe for massive credit rationing and misallocation, for which there is more and more anecdotal evidence.

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