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Gemma Godfrey

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What They Aren't Telling Us About European Unity

Posted: 01/21/2013 11:10 am

Huge strides forward in Europe and subsequent market rallies have raised hopes for the region. So is the road to recovery now clear or are significant risks still present? Crucially, what are the key areas of conflict we should be watching closely and which are 'red herrings'?

A greater degree of oversight of the banking sector is needed for stability. Issues of experience and breadth of oversight to include smaller banks are somewhat misnomers but issues of authority, conflicts of interest, and deposit guarantees are not. Nevertheless, turmoil creates opportunities and the road will remain rocky for the shorter-term at least.

Resolution Remains Just Out of Reach

'Tail risk' in Europe has dramatically reduced over the past few months. This refers to the risk of a dramatic event which could drive an extreme change in portfolio values, i.e., a Greek exit from the euro, having fallen substantially. Prompted by Draghi's statement that he will do "whatever it takes" to save the euro, and solidified with his launch of an 'Outright Monetary Transaction,' buying the bonds of countries that request help, markets have moved to reflect this reduction in perceived risk.

But does this mean the road to recovery is now clear? Unfortunately not. The risk of an immediate euro breakup may have eased but Europe still needs to integrate further before we can say unity has been strengthened sufficiently.

With the region rocked every time there is turmoil in one country's banking sector, providing a level of oversight to spread, offset and protect from risk is a desperately needed move forwards. Agreement has been reached to progress this course of action, and the European Central Bank put in charge. So what are the key areas of conflict we should be watching closely to decipher how far risk has truly abated? What issues matter and which are 'red herrings'?

Ready, Steady, Go... ?

The ECB may have been the natural choice of supervisor but it has neither experience of direct supervision, nor dedicated staff. However, this is probably the most easily remedied concern, with recruitment of a team with appropriate experience.

Of greater concern is the lack of authority with which the central bank would begin its 'reign'. A 'Banking Resolution Mechanism,' i.e. a process for the enforcement of support, rules and regulation, will only come into place at a later date. Threats without force are just words and the sustained support that could bring is doubtful.

Furthermore, the central bank's original mandate of price stability could be compromised. It is unclear how a conflict of interest can be avoided when knowledge of bank positioning may affect its resolve to implement monetary policy. Knowing an interest rate move, for example, could destabilize a large bank and create a level of turmoil, may muddy the waters.

One for All and All for One

Germany has voiced its opposition to a broad-based level of oversight, focused not just on the largest banks but any that could pose a risk to the stability of the banking sector. As the country within the region with the largest number of 'small' banks as well as almost a third of the regions total number of banks, this has been a focal point in the press. The claim is that the administration costs to comply would be enormous, passed on customers and hit the local economy.

However, for two main reasons this again is more of a distraction than a nail in the coffin. Firstly, as in Spain, for example, it was issues in smaller banks which brought chaos to the country. Bankia, the 'bailed-out' bank, was constructed from several smaller struggling banks. Germany's smaller banks together have total assets than exceed Deutsche Bank and are responsible for around 38 percent of both bank lending and deposits. Therefore, oversight should indeed include these banks.

Secondly, on a day-to-day basis, smaller banks may continue to receive oversight similar to national arrangements, minimizing the feared disruption and cost. Rules were 'softened' when the European Parliament expressed the desire for the ECB to have the choice of delegating its supervision of smaller relevant lenders to national authorities. A feeling of loss of sovereignty is still tough to challenge but may be eased and outweighed by necessity.

Nevertheless, hostility from Germany continues in the form of opposition towards a single deposit guarantee scheme. A 'run on banks' was touted as a key risk as capital outflows from the periphery European countries gathered momentum last year. A lack of confidence in the safety of customer deposits drove exits and challenged the liquidity levels and stability of the targeted banks. A region-wide scheme to guarantee these deposits is hoped to bring some calm and reduce these fears.

This is a crucial part of the longer-term plan for a return of confidence to the region but has seemingly 'dropped off the agenda' according to Germany, resisting further discussion. The fear is the relative strength of one country will be used to offset weaknesses in another. Taxpayers from one country could end up having to pay for the mistakes of a bank in another. Nevertheless, behind the headlines, it is understood that some form of transfer from Germany to the periphery is necessary for stability and this is certainly an issue to watch closely going forward.

A Rocky Road

Therefore, Europe has some crucial challenges to tackle over the next few months. Longer-term strategies must be embedded to protect the region. To complicate matters, politicians will continue to be distracted by 'putting out fires.' For example, a request for help by Spain remains hotly debated and there is the potential for further civil unrest in reaction to growing opposition to austerity. The risk of further turmoil in Greece is high as it is tasked with completing bank recapitalization and paying public sector debts, but a long-term solution to alleviate reliance on financial support remains illusive.

Turmoil creates opportunities and the road will remain rocky for the shorter-term at least. International firms that are merely headquartered in an area of weakness can provide an interesting opportunity as price moves, volatile in the shorter-term, more accurately reflect underlying value over the longer-term.

 

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