Another Eventful Week in the Euro Area

In the first week of September, the European Central Bank (ECB) introduced yet another new acronym into the mix of solutions in the euro area crisis — Outright Monetary Transactions (OMT), the name for the bank’s plan to buy up debt of troubled European countries. Now three other players in the euro area crisis must step up to the plate. First, the European Commission will publish its proposals for a European Banking Union. Second, the German Constitutional Court will rule on the constitutionality in Germany of the new European Stability Mechanism (ESM), which is to serve as another lending backstop. Third, the Dutch voters go to the polls. All three of these developments will likely contribute constructively to the longer-term solution of the euro area crisis.

Progress Toward a Banking Union

True to form for Brussels, something close to the final version of the banking union proposals — concerning the ECB’s new role as the main euro area banking regulator — was leaked last week to an Italian newspaper. Thus we know some of what the Commission plans to unveil Wednesday. There is much to inspire confidence.

First, the ECB will become the main decision-maker in the new euro area “single supervisory mechanism” that includes both the ECB and national competent authorities. The ECB will get a lot of new legal authority. It will gain the power to grant and withdraw the banking authorization for credit institutions in the euro area, the power to scrutinize acquisitions and disposals of holdings in these institutions, and the ability to wield a big sanctions hammer similar to that held by EU competition authorities. If a euro area bank breaks EU rules, the ECB will be able to fine it up to 10 percent of its total annual turnover in the preceding business year.1 There should be very little confusion about who is going to call the regulatory shots in the euro area. 

The concept of a “single supervisory mechanism” is wonderfully flexible. It grants flexibility to national supervisory authorities in line with the European Union’s general principle of subsidiarity (e.g., regulation that is as decentralized as feasible), leaving ample room to address German concerns about the scope of a new supranational euro area banking regulator. Germany has the largest number of euro area banks and credit institutions, and many of them like the Landesbanken and Sparkassen are idiosyncratic to Germany, so it is unsurprising that its concerns have been the most vocal. Most German banks and credit institutions will evidently remain supervised day to day by German national authorities, but the ECB will have ultimate responsibility for their soundness. It will also have authority to investigate and carry out on-site inspections at any euro area bank and credit institution. The European Union’s institutional capacity to overcome concerns over overlapping national and supranational responsibilities thus looks likely to accommodate German and other member states’ concerns in banking regulation.

Institutionally, the ECB would set up a new supervisory board consisting of a chair and vice chair selected from the ECB governing council. (The first chair will probably be the ECB vice president Vitor Constancio; the position would never be held by the ECB president because of the need to separate monetary policy and banking regulation.) Four other ECB representatives and one member from each of the EU member states participating in the banking union would also sit on the governing council. In other words, the Board could include officials from non-euro area members. This new ECB supervisory board would be accountable to the European Parliament and the EU Council of Ministers via annual reports, appearances before the Parliament and Council, and the obligation to answer questions submitted by the two.

In many ways, this proposed euro area institutional setup looks like the new-look Bank of England as the main UK banking regulator. For macro-prudential regulation, the Bank of England will put its new Financial Policy Committee (made up of both the top Bank of England leadership and outsiders) in charge of identifying, monitoring, and taking action to remove or reduce systemic risks. Its goal will be to protect and enhance the resilience of the UK financial system. And for microprudential regulation of individual firms, the Bank of England will establish a Prudential Regulation Authority (PRA) within the organization.

For those always impatient with the speed of euro area crisis resolution, it is worth recalling that this national overhaul of the UK institutional framework for financial regulation was initiated by the Chancellor as far back as June 2010,2 after the fiascos of Northern Rock and RBS (Royal Bank of Scotland). It is still a work in progress, with the PRA launch expected in early 2013. Similarly, the Dodd-Frank bank overhaul of the US financial regulatory system, enacted in 2010, remains to be fully implemented.

The European Commission’s plans to transfer regulatory responsibilities to the ECB by January 2014 suggests that creation of a European Banking Union is on an unusually fast track by the standards of comprehensive financial regulatory overhauls in advanced economies.

The transition period will begin next July, when at least half of the euro area banking sector will be transferred to the ECB’s regulatory responsibility. (The ECB must make the initial list of banks public by next May). Non-euro area members can presumably choose to join at the same time. The ECB may begin regulating financial institutions that have received or requested public assistance before these dates, however — an important possibility for Spain and Ireland that might speed their bank recapitalizations by the European Stabilization Mechanism as early as January. So far so good on banking regulation. But some elements still need to be worked out. Little is known, for example, about the European Commission’s intentions concerning the other important outstanding elements of the European Banking Union. Most important is the establishment of a European deposit insurance scheme and a common European resolution system. The political sequencing of the banking union has been clear since the June 2012 EU Council. Joint supervision is to take place first, followed by common resolution and deposit insurance schemes. The latter two parts are likely to be adopted well into the future. The delay means that uncertainty about the euro area banking system will persist. The direction of the Commission’s likely proposals was indicated in a speech by ECB vice-president Vitor Constancio on September 7. In it, he discussed how a “euro area wide resolution authority would be very beneficial” and how it “would be merged in the future with deposit insurance into an European Deposit Insurance and Resolution Authority (EDIRA) similar to the FDIC [Federal Deposit Insurance Corporation] in the US.” Even if still some time away, an FDIC-like EDIRA organization for the euro (plus) area would be a big step towards the institutional solidification of the euro area.

The German Constitutional Court

Then there is the issue of the German Constitutional Court’s ruling on the ESM. It is often implied that the Karlsruhe Court’s lengthy review of this case and its earlier rulings limiting the room for maneuver of the German government in relation to the European Union are signs of rising euro skepticism within the Court and in Germany more broadly. That, however, is probably a mistaken interpretation.

It is entirely appropriate for the German Constitutional Court to take its time to investigate this critically important issue. It should also be noted that the ruling this week is merely on whether to uphold an injunction against the ESM and not its final ruling on the constitutionality of the ESM. The court’s legal investigation should be viewed as merely another chapter in a very long historical friction between the governments of individual member states and their national parliaments in the European Union. Most of the economically meaningful legislation passed by any national parliament in the European Union is merely the conversion into natural law of already agreed EU legislation negotiated by the national government (and in some cases the European parliament) ahead of time in Brussels. It is thus easy to see how this type of clash emerges, when parliament (as is the case in Germany) is the constitutionally sovereign representative of the democratically determined public will of the nation. This has more to do with the clash of jurisdictions of the executive and legislative branches of government in Germany than with the scale of Germany’s potential financial liabilities to the ESM. The principal legal concern here stems from the German Bundestag’s ability to continue to exercise its budgetary sovereignty, when it is the German government that is represented in the ESM leadership.

There are several reasons to believe that the German Constitutional Court will rule in favor of the ESM. First, there is no historical precedent for the German Constitutional Court to block actions supported by an overwhelming majority of the Bundestag. Second, the ESM is capped at €500 billion and the German government has enough voting weight in the ESM (27 percent) to block any action by the ESM. Germany thus retains sufficient veto power for the German Constitutional Court to find that its authority is not compromised. There is thus no real risk, given the way the ESM treaty has been written, that Germany’s financial exposures could suddenly be raised against the will of the German government. The court is likely to concentrate on ensuring that the Bundestag, rather than the government, retains this ultimate authority. It will most likely call for the German Bundestag to have a direct say through, for example, a straight vote or parliamentary committee oversight.

Recall the composition of the German Bundestag [PDF] and the fact that the ESM’s purpose is to “mobilize funding and provide stability support under strict conditionality, appropriate to the financial assistance instrument chosen, to the benefit of ESM Members which are experiencing, or are threatened by, severe financing problems, if indispensable to safeguard the financial stability of the euro area as a whole and of its Member States.” In reality, the Bundestag is unlikely to cause more than a temporary delay of any of its future actions.

No Stumbling Block in Dutch Elections

The Dutch will elect a new national parliament this week amid the usual concern about radical or extremist elements. Most likely, however, there will be the usual euro area split between the traditional center-right/center-left parties that have little actual policy difference — representing 70 to 75 percent of the vote — and a minority populist fringe on the far left and right representing the remaining 25 or 30 percent.

The Dutch electoral system has no threshold for gaining House of Representatives seats. If a candidate gets 1/150th of the votes, he or she gains one of the 150 seats. This guarantees that the next Dutch government will be a coalition of several parties. The latest polls suggest that this coalition will be formed without the participation of the euro-skeptic Dutch Freedom Party of Geert Wilders. Irrespective of whether the incumbent Prime Minister Marc Rutte of the center-right Liberals or the center-left Labor leader Diederik Samsom wins, continuity will remain. This is another example of how the “center” of euro area politics is stable and capable of dealing with the electoral challenges presented by populism and an ongoing economic crisis.


1. If a banking subsidiary does so, the relevant total annual turnover is that of the ultimate parent undertaking.

2. See George Osborne’s Mansion House speech from June 16, 2010.

Copyright © 2012 the Peterson Institute.

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