Newsletter | Volume 1

The building blocks of the banking union consist of the Eurozone Stability Fund (ESM) to provide security, stability and support to its member countries in financial difficulty. Single Supervisory Mechanism (SSM), the Single Resolution Mechanism (SRM) can offer the option for the ESM to recapitalise banks directly.

The system for financial assistance to ailing banks is based on the broader foundation of the principles that have been agreed upon for the resolution of ailing banks within the member states of the Union and that, once adopted as a directive, will guide national legislation in this matter. A separate Commission proposal, to be published shortly, will cover the creation of the SRM, as mandated by the December 2012 European Council.

Under its founding treaty, the Eurozone Stability Fund (ESM) may provide stability support to its member countries in financial difficulty in the form of loans, by purchasing their bonds in primary and secondary debt markets, by providing precautionary financial assistance in the form of credit lines, and by financing the recapitalisation of financial institutions through loans.

In June 2012, the eurozone summit decided that the ESM should also be able to recapitalise banks directly, in order "to break the vicious circle between banks and sovereigns". In December 2012, the European Council also agreed that the building blocks of the banking union would consist of the Single Supervisory Mechanism (SSM), the Single Resolution Mechanism (SRM) and the possibility for the ESM to recapitalise banks directly.

Reduction in market fragmentation
The ministers of finance and the economy of the eurozone have now agreed on the main features of a new ESM instrument for the direct recapitalisation of the euro area banks (Eurogroup, 2013) and on a framework for the recovery and resolution of credit institutions (Council of the European Union, 2013).

The new ESM instrument will enter into force only after the SSM is effectively in place and the legislative proposals for the SRM and Deposit Insurance directives are finalised by Council and Parliament; in all likelihood, therefore, well into 2014. This accommodates widespread demands for a delay – not only by Germany – and is somehow also at variance with the urgency of the eurozone summit decision last year. The truth is that, once again, as soon as financial markets tensions begin to ease, institution-building also slows down, and with it the reduction in market fragmentation.

Due diligence of the balance sheet
Utilisation of the new ESM instrument will be subject to strict conditions, in line with the instructions of the eurozone summit. Accordingly, it will only be made available when the requesting member state cannot help its banks on its own without endangering the sustainability of its sovereign debt, aid is indispensable to the eurozone's financial stability, and the financial institution concerned is undercapitalised (in breach of CRD IV prudential requirements) and unable to attract sufficient capital from private sources. In order to preserve the top credit rating of the ESM, it has also been decided that the available funds under the new instrument must not exceed euro €60 billion – not an insignificant sum, but hardly sufficient when there is a need to intervene for several banks and across several member states. It may be recalled that market participants apparently consider a ceiling that is double the amount consistent with the ESM's top rating.

Aid is indispensable for financial stability
The decision to grant the capital injection will be subject to thorough due diligence of the institution's balance sheet quality and loss-absorption capacity, in order to assess its continuing viability and need for restructuring. It will only proceed after an adequate capital contribution by shareholders (capital write-down) and creditors (debt conversion into equity or write-offs) of the beneficiary institution, in line with the proposed directive on resolution.

In addition, the requesting member state will be required to inject capital into the distressed institution as required to bring its common equity (CE Tier 1) up to its legal minimum (4.5% of risk weighted assets under the CRD IV rules), as well as more broadly to participate in the capital injection, alongside the ESM, for an amount equivalent to at least 20% of the total public contribution in the first two years, and 10% thereafter. These provisions entail that the ESM assistance does not cover 'legacy' debts – one of the 'red lines' drawn on the negotiating table by (potentially) creditor countries.

It is envisaged that the ESM will intervene by purchasing common equity (CET 1 capital) and will acquire strong rights of involvement in the institution's business decisions and even choice of management – while ensuring as the text goes, "a careful balancing between influence by the ESM and maintenance of independent commercial business practices", so as to leave open the possibility of a return of the institution to "market functioning".

(To be continued in the next newsletter)
Source: http://www.ceps.eu

References
Benink H. and H. Huizinga (2013) "The urgent need to recapitalize Europe's banks", VOX-EU, 5 June.
Council of the European Union – Economic and Financial Affairs (2013) "Council agrees position on bank resolution", 11228/13 PRESSE 270, Brussels, 27 June
(http://consilium.europa.eu/uedocs/cms_data/docs/pressdata/en/ecofin/137627.pdf).
European Commission (2013), "European Financial Stability and Integration" Report 2012, Brussels, April.
Eurogroup (2013), "ESM direct bank recapitalization instrument – Main features of the operational framework and way forward", Luxembourg, 20 June
(http://www.eurozone.europa.eu/media/436873/20130621-ESM-direct-recaps-main-features.pdf).
IMF (2013), "Global Financial Stability Report: Old Risks, New Challenges", Washington, DC, April.