The EU Summit Scenario Matrix
With any and every European leader talking unilaterally (and only one worth listening to, given the market's reactions), we ask and answer what should investors expect from the forthcoming EU Summit and what are the investment implications? Morgan Stanley's Arnaud Mares offers a succinct analysis of the three key axes being debated around the 'banking union' premise: a European Deposit Guarantee Scheme (DGS); a Common rule book and European level bank supervisor; and a federal resolution regime (and, in some proposals, a federal recapitalisation vehicle). The base-case view is that the current set of EU banking union proposals, whilst directionally helpful, are too long-term or too timid to address the 'crisis' with supervision stratified and insufficiently federal leading investment implications of little meaningful relief in Eurozone banking and sovereign credit markets. Recent comments from European ministers suggest that the path to federalized Banking Union will be far from an easy one, given the tightly interconnected federal debate.
Scorecard on European initiatives to be discussed at the June 29 summit
The current proposals revolve around three poles:
1) Deposit Guarantee Scheme:
The current deposit insurance proposal is essentially a patchwork quilt of national schemes with a European backstop rather than a truly federal scheme so pressure on the weakest sovereigns (and banking systems) would persist. We believe a truly federal scheme would be a far better outcome.
2) Common rule book and single European level bank supervisor
A consequence of federalisation of banking is a common rule book and European level supervisor; again, there are competing proposals. We believe that investors should also not underestimate the need for federal level supervision of the banking systems hould a federal guarantee be put in place. Given the very natural domestic vested interests in banking systems (domestic lending, buying sovereign debt and so on), we should not underestimate the potential opposition.
3) Common resolution regime and potential for crisis recapitalization vehicle
We critically need to see a way to resolve – and support – institutions. The current proposals have much to commend them over a 10 year point of view. But our discussions with regulators underscore that the tools and ability to address the resolution of a large institution in today’s stress environment feels highly unlikely.
And the various scenarios play out as follows:
- Our base case view is that the current set of EU banking union proposals, whilst directionally helpful, are too long-term or too timid to address the 'crisis'. In our base case, national deposit guarantee schemes are likely to remain national but with European-level bridge loans. No provision is likely to be made for the ESM to recap banks directly (which the ECB and we think advisable to reduce the sovereign-bank doom loop). Supervision would be stratified and insufficiently federal. Clearly the investment implications need to be dovetailed with other fiscal measures, but we think there will be little meaningful relief in markets from this base case and we would continue to be cautious on Eurozone banks and sovereigns.
- Our bull case revolves around the ESM being able to intervene directly in banks, ECB being the lead supervisor for all Eurozone banks and Euro-outs having some safeguards. This, alongside other proposals, could be a game changer and lead us to be far more constructive on sovereigns and banks.
- Our bear case revolves around little progress being made on the three key axes. We think the risks of even greater bail-outs being needed and the 35% chance of Eurozone divorce that we laid out in a prior note would be most heightened in this scenario. Investment implications would be most negative in this scenario.
Recent comments from European ministers suggest that the path to federalized Banking Union will be far from an easy one, given the tightly interconnected federal debate.
- “The question of a banking union is very tightly connected to the question of the other themes we are considering, for example a fiscal union,” “It makes little sense to single out the banking sector when talking about mutualization of debt, without taking the rest into account.” “It’s important that a banking union doesn’t lead to euro bonds by the back door, for example when a bank is active in financing the government and then that bank enjoys a common debt guarantee,” Jens Weidmann, Bundesbank, Bloomberg, June 25, 2012
- "Whoever is footing the bill must also have a right of control, particularly when it comes to the large sums that are seen in banking crises", Sabine Lautenschlaeger, Vice President of Bundesbank, (June 12, 2012).
- “We cannot push through a banking union when the French have just cut their retirement age to 60 and we have raised ours to 67.” Senior Dutch politician cited in FT (June 11, 2012).
- "It seems to me absurd that our deposit protection schemes, which were built over many years, should be used for insuring savings deposits in euro-zone crisis countries," Christian Brand, President of Germany's Federal Association of Public Banks (June 11th 2012).
- “It is important to develop EU banking regulations and supervision and to safeguard depositors. However Finland cannot accept a banking union based on shared responsibility.”, Jutta Urpilainen, Finnish Finance Minister (13th June, 2012).