7 Jun 2012

Spain’s cajas, Banking Union and British EU exit

In Frankfurt, late last year, the high priests of the Eurozone had a fundamental change of view.

For years the presumption had been that a flawed and incomplete Eurozone would work, if only fiscal policy – tax, spend, and government borrowing – were also coordinated and eventually controlled at the European level.
Such disciplines would help the coordination of macroeconomic policy, and provide cover for transfer payments from rich to poor countries, such as occurs in the US and UK.

A splenetic attempt at that (the Stability and Growth Pact) was made and then ignored in the first decade of the single currency. It is being reheated now as the “Fiscal Compact”.

The theological foundation of the Eurozone is “the Theory of Optimal Currency Areas” advanced in the 1960s by Nobel prize-winning economist Robert Mundell. Over fifty years, the theory made clear that a geographical area needed to fulfil four characteristics to be suitable for a common currency: labour mobility, capital mobility, a synchronised economic cycle, and the ability to share fiscal risks.

Well the good burghers of Frankfurt have decided this is no longer enough (even as it is debatable that these four characteristics have been achieved). The experience of the past decade has led them to conclude that a further factor: financial union is required.

As it has been put to me – by very senior officials – Spain and Ireland were not the Euro’s fiscal criminals. They adhered to the strictures of the ignored Stability Pact. It did not prevent disaster and the need for bailout. In both these countries, it was a poorly regulated financial sector (in Spain’s case, a specific part of the financial sector, the building societies or cajas) that led to both economies’ troubles. So the lesson being taken from the Spanish crisis is that financial regulation matters as much as fiscal sobriety.

Immediately that manifests itself in the Eurozone-wide deposit guarantee system that will be required to innoculate against contagious bank runs. After all would you trust a 2008 Northern Rock-style government deposit guarantee, if it came from a newly-elected Greek government? But then if it becomes an EU-wide guarantee, there are huge implications for German and French banks who would eventually pay for any pan-eurozone deposit insurance scheme.

As Britain learned with Iceland, cross border deposit insurance only works if you assume that foreign bank regulators are competent.

In the case of the Spanish cajas, they were part-regulated by regional government, not solely the Bank of Spain and the Economy ministry. Their massive disastrous real estate investments were often driven by boards full of regional political appointees.

If German of Finnish banks, are in the future, to be liable to pay fees into deposit protection funds that might pay out for a Spanish Caja, then a more thorough supranational bank regulation regime is necessary.

So in the medium term, the Eurozone will be rebuilt on three, not two pillars. Monetary union, fiscal union, and banking union.

And this is where Britain comes in.

The mood music that I detect, is that Eurozone banking union will not function properly without some oversight of the wilder activities of the City of London casino. The shadow banking system in particular is disproportionately run from the Thames.

But the conventional commercial bank lending of HBoS and RBS also had a large impact on Ireland. The ECB might also want to impose counter cyclical limitations on mortgage lending, for example.

The degree of this oversight or control will be the fundamental sticking point for Britain’s relationship within the European Union. For those that see Britain’s interest as synonymous with that of the City, it begins to mark a passage out of a new Eurocentric EU for Britain.

It might begin to explain what happened with David Cameron’s intriguing veto of the fiscal compact treaty last December, despite that treaty having no mention of banking or finance.

The attempt by the European Central Bank to limit the activity of London based clearing houses in euro derivatives, and the Treasury’s court case against this, are a taste of things to come. Expect more treaty changes and referenda.

Clearly the immediate eurozone issue is its very integrity.

Spain seems to have played hardball and won some concessions. This will only encourage Greece’s bailout rejectionists in next Sunday’s election re-run. But the medium term changes to strategic thinking are happening right now. And they will have a profound impact here.

Follow @faisalislam on Twitter.

9 reader comments

  1. JonTarg says:

    This is a very intriguing piece with many disturbing implications. For example your comments about Ireland support the view that the Irish banking system would not be in the hands of the IMF now(with all the punishing fiscal repurcussions this usually entails) had Ireland not joined the Eurozone or if the Eurozone had been better constructed in the first place.

    The UK’s position in the EU has surely been strengthened by the impression that, notwithstanding the failure of RBS/ABN and of Lloyds/HBOS, Eurozone banking supervision was poorly designed from the outset and has been shown to be unfit for purpose as presently implemented; a conclusion you also draw.

    Moving from that conclusion to say that this places UK closer to exit from the EU altogether seems illogical.

    Noone in the Eurozone can seriously be expecting Eurozone hold-outs such as Britain and Sweden to join the Eurozone anytime soon. But if the UK acts without schadenfreude couldn’t it be an important voice in shaping a currency union that is workable, and in which we may possibly want to take part; e.g. one with a sensible harmonized deposit insurance scheme to protect against contagion?

  2. Paul says:

    A good piece, but I query this:

    ‘A splenetic attempt at that (the Stability and Growth Pact) was made and then ignored in the first decade of the single currency. It is being reheated now as the “Fiscal Compact”.’

    In fact the legislation around the enforcement of the Stability and Growth Pact was significantlyc enhanced when the ‘six-pack’ regulations (actually 5 Regs, 1 Directive) became law on 12th December 2011, and a further ‘two-pack’ around monitoring measures is currently being negotiated via the usual Council-Parliament co-decision making process (called the ‘ordinary legislative process’ under the Lisbon Treaty).

    The Fiscal Compact (actually part III of the Treaty on Stability, Coordination and Governance)announced in late 2011 to much fanfare by Merkel and Sarkozy does not add much to what already is law (though the requirement to include its provisions in national law IS new) and was not much more than political cover for Sarkozy, who needed to be seen to be doing something/anything. Of course it did become more draconian when Merkel insisted on a ‘sign up to it or you can’t be considered for bail-outs’ clause to scare Ireland into submission).

  3. Patrick says:

    “Spain seems to have played hardball and won some concessions” Not from Fitch Faisal who have downgraded it to BBB this evening!

  4. Muggwhump says:

    I wonder if this explains the politics behind government’s ‘referendum lock’…

    They know that the public are mainly anti EU and will vote NO in any euro referendum almost regardless of the thing being voted on.
    But by not making it an ‘in out’ vote, rather one that kicks in if more powers are handed over, and having a fair idea that any powers that are to be handed over in the years ahead will be concerned mainly with regulating banking, they are using the public’s euro skepticism as a shield to protect the city.

    My guess is they’ll use the threat of a referendum defeat to win opt outs from the new rules thereby getting exactly what they want without asking anyone anyway.

  5. Dave B says:

    “It might begin to explain what happened with David Cameron’s intriguing veto of the fiscal compact treaty last December, despite that treaty having no mention of banking or finance.”

    Cameron was just trying to use the opportunity to get something HMG wanted.


  6. Andrew Dundas says:

    During the 2010 election campaign St. Vincent Cable was flattered by UK media for his observation that Spain had superior Bank Regulation because Spain had ‘counter cyclical limitations on lending’.
    We know NOW that counter-cyclical limitations are no defence against excessive borrowing. And Cable is no longer regarded as an economic sage. So why are we applauding plans to adopt counter-cyclical limitations?
    What we also know – but have done nothing about – is that the Credit Rating Agencies had powerful incentives to provide unjustified AAA ratings on CDOs. Those subsequent CDO defaults are what destroyed Lehman & US Banks, that then toppled the worldwide financial system. Why aren’t we supervising those Ratings Agencies?

  7. EarlyDoors says:

    When I insure my house or anything of value to me I do it as an individual. My building or contents insurance is paid out by an individual provider not directly from an industry pool.
    If I am lucky enough to have a positive bank balance that amount should be insured under an explicit scheme I have negotiated with my bank or a third party provider. After all how many current account holders actually require a £50000 guarantee?
    Such an approach would be good for the financial system but bad for banks as they would have to cover that insurance as millions of individual contracts with the Central Bank. Consequently no bank would ever be too big to fail as all deposits would have been insured at the expense of the margins of the banks.
    This crisis has not been a failure of the market. On the contrary it is human distortions in the market that cause the problems. We need more market and less regulation, and most importantly political strength to allow failing enterprises to be destroyed.

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