Q&A: The eurozone's banking union

Frankfurt skyline The ECB will oversee the eurozone's banks from its headquarters in Frankfurt

The 17-nation eurozone is moving to strengthen its banking sector by introducing common rules and protections. The idea is to make huge taxpayer-funded bank bailouts a thing of the past.

What is the "banking union"?

It consists of three parts, or "pillars":

  1. A common banking supervisor (or "Single Supervisory Mechanism"): This job goes to the European Central Bank (ECB), which will be given the power to monitor the health of and the risks taken by all the major banks within the eurozone, and intervene if any gets into trouble
  2. A Single Resolution Mechanism: If a bank anywhere in the eurozone gets into trouble, the process of bailing it out - or even letting it go bust - would be managed by a common "resolution authority", funded by a regular levy collected from eurozone banks
  3. A common deposit guarantee: Anyone with an ordinary bank account anywhere in the eurozone would have their money - up to a limit of 100,000 euros (£84,000; $138,000) - guaranteed by a common eurozone fund

What powers will the supervisor have?

According to an EU proposal, the ECB will "have direct oversight of eurozone banks, although in a differentiated way and in close co-operation with national supervisory authorities".

The ECB, in its new role as supervisor, will monitor the health of all 6,000 banks within the eurozone (but not the UK), and be able to intervene when a bank is in trouble.

Countries such as the UK and Sweden, outside the euro area, can enter into "close co-operation arrangements" with the ECB if they choose to.

In contrast to the European Banking Authority, which sets the rules under which all banks in the EU (including the UK) must work, the ECB would be able to impose its will on the national banking regulators.

The plan is for the ECB to have direct oversight over 130 eurozone banks, from November 2014. Each of those "systemically important" banks has assets greater than 30bn euros. National supervisors will remain in charge of the smaller banks, but the ECB can intervene if necessary.

The European Commission has argued that, during the financial crisis, even relatively small banks such as Dexia and Northern Rock got into trouble and threatened the entire financial system.

The German government wants the ECB to have a more limited role. German Finance Minister Wolfgang Schaeuble does not want the ECB to have powers over his country's savings banks (Sparkassen) or the regional Landesbanken.

German Chancellor Angela Merkel is also concerned not to overburden the ECB with too many responsibilities too quickly.

Another concern for Germany is that the ECB's new supervisory powers should be strictly separate from its existing monetary policy powers - so that, for example, the ECB will not be tempted in future to set interest rates too low in order to help out banks that are in trouble.

How will the Single Resolution Mechanism work?

If a eurozone bank got into trouble, the process of rescuing it - or, in the worst case, putting it through a kind of bankruptcy procedure - would be carried out by a pan-European "resolution authority".

As part of any rescue, the eurozone governments would require the bank's existing shareholders and lenders to take a lot of the losses - that was the case with the bank bailouts in Spain in 2012 and Cyprus in 2013.

But earlier eurozone bank bailouts - notably those in the Republic of Ireland and Greece - had come at great cost to ordinary taxpayers.

All eurozone banks will be required to contribute annually to national resolution funds that could be used to absorb the cost of a bailout - and therefore reduce the cost to taxpayers. In 10 years' time, it is expected that those funds will be merged into a common resolution fund, worth about 55bn euros.

To the extent that taxpayer money is also needed to absorb losses, or has to be put at risk by buying new shares in a troubled bank, in order to provide it with more capital, then this would be provided by the eurozone governments collectively.

ECB President Mario Draghi has warned there is a danger that decision-making in the new authority could become too complex. That would be a big handicap if, as is often the case, a bank has to be wound up in a matter of a few days, to prevent bigger losses.

The ECB, European Commission, member states' governments and European Parliament all want to have influence in the new resolution authority, and it is not yet clear how many votes would be required to wind up a bank.

Germany is already the biggest contributor to the EU's new bailout fund - the 500bn-euro European Stability Mechanism (ESM) - and is especially anxious not to make its own taxpayers liable for a foreign bank's debts. So Germany and some other countries are reluctant to relinquish sovereignty over bank bailouts.

Germany's new coalition agreement says ESM money should not be directly available for winding up banks. There is also German opposition to using ESM funds directly to recapitalise banks.

What is bank capital?

When banks make losses on their loans and investments (their "assets"), it means that they have less money to repay their investors.

These "investors" include ordinary people who have put their savings in a deposit account at the bank, other financial institutions who have lent the bank money, and the bank's shareholders.

The bank's capital is the value of its shareholders' investments, based on the bank's financial accounts.

It is calculated by taking the value of all the bank's assets, and subtracting from it the value of everything the bank owes to its depositors and lenders.

The shareholders are the first in line to take losses on their investments. Each time the bank makes a loss on a loan it has made, the shareholders suffer an equal loss on the value of the bank's capital.

If the losses are so big that they eat up all of the bank's capital, the bank is insolvent - its assets are no longer worth enough to repay all of the deposits and loans that the bank owes.

For this reason, the bank's capital is a measure of how much loss the bank can potentially absorb without going bust.

How will the common deposit guarantee fund work?

Currently each eurozone country operates its own national deposit guarantee scheme. During the 2008 financial crisis, all EU countries agreed to raise the amount of each deposit that they guarantee to 100,000 euros.

There is now a drive to "harmonise" these national schemes. But it is unclear if, and how much, these schemes will then be guaranteed by all of the eurozone's governments collectively.

A maximalist version might create a single deposit guarantee scheme with a blanket guarantee from the eurozone. A minimalist version may retain the existing national schemes, and give each one a limited guarantee from the ESM.

Whatever the case, the eurozone banks will also be required to make big regular contributions to the scheme (on top of their contributions to the Single Resolution Fund), in order to minimise the cost to taxpayers.

When will all this happen?

The ECB will spend most of next year putting the new Single Supervisory Mechanism into place, aiming to launch it in November 2014.

The results of new ECB stress tests on eurozone banks, scheduled for the coming months, will shape the new authority's operations.

The second pillar - the Single Resolution Mechanism - is likely to be launched in January 2016. But in the early years, the funding of it will remain under national, rather than central, control.

There is a general desire among EU politicians to avoid having to change European treaties. Treaty change is usually cumbersome and time-consuming, and would further delay the whole banking union project.

But in the long run, a treaty change may be unavoidable if the ECB is to be given adequate authority, and if the new resolution framework and deposit guarantee scheme are to be strong enough to avert a future financial crisis.

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