​Europe’s Banking System: Still Waiting For Decisive Action

Guild Investment Management  |

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Last week, Europe’s leaders convened for a summit of the European Commission, to lay out their plans for addressing a variety of issues that are troubling the European Union and the Eurozone.

Item one was Brexit: without a sign-off on “phase one” of Brexit negotiations, there would have been a political and financial storm. That sign-off was duly given, with much goodwill in evidence for the UK’s prime minister from European officials. The Brexit process continues to look difficult, but not at all disastrous for either side.

Item two was the issue of migrants. The wind-down of the Syrian civil war has led to a sharp decline in migrant flows to Europe, and a corresponding sharp decline of angry political rhetoric on both sides of the issue. But there is still a divide between those who want mandatory quotas for accepting migrants, and those who think such quotas do not respect the independence of Europe’s nation-states. In short, stay tuned for more contentious debate on this subject. This is a worthy example of the standard operating procedure of European bureaucrats -- kick the can whenever possible, especially if the immediate threat of crisis has receded. It is important to remember that this is how the Eurozone bureaucracy functions -- do not expect decisive action outside a full-blown crisis.

Item three was the most interesting one to us -- further discussion about the regulation of the European banking system.

Why Europe Matters

Our regular readers know that for several years, we have suggested that the next trouble spot for the global economy could be a European banking crisis. U.S. regulators acted decisively, and for the most part effectively, to counter the weaknesses that led to the crash of 2008. We have our quibbles with the effectiveness and fairness of some elements of the financial reform legislation that gradually came into effect after the crisis, but by and large, the U.S. did a good job of strengthening its banking system.

Europe, though, has not done the same. The Eurocrats have done what they do best. They have proposed an expansive regulatory structure while not explicitly acknowledging the real-world problems and constraints that will render its implementation impossible unless they are addressed. Is it progress that grand-sounding regulatory structures and bodies are proposed, while their implementation remains stymied by intractable rivalries and disparate economic and political cultures? Maybe it is progress. But it is not much progress, and when and if another crisis comes, the half-built regulatory structures and bodies will probably not have the power needed to stem the tide.

During Europe’s 2012 crisis, the stability of the whole Eurozone was threatened by the near-insolvency of the “peripheral” countries then called the “PIIGS” -- Portugal, Italy, Ireland, Greece, and Spain. That near-disaster prompted the first big plans to centralize the oversight and regulation of the European banking system through the creation of a genuine banking union. The union would have two pillars -- a “Single Supervisory Mechanism” (SSM), in which the European Central Bank would take on the role of Europe’s supreme financial supervisory body, and a “Single Resolution Mechanism” (SRM), which would grant that regulatory structure the authority to wind down failing banks in an orderly way. The SRM would be able to access a “Single Resolution Fund” (SRF), a pool of money contributed by European banks to assist in recapitalizing institutions falling under its mandate.

Halting steps have been made towards giving these institutions real power. However, underneath, the same problem remains.

The European Union’s Simple, Unspoken Problem

In essence, the problem is that the European Union is still divided into two “zones,” which could roughly be called “north” and “south.” The northern countries, which include Germany, the Netherlands, and the Scandinavian countries (and many of the newer Eurozone members in eastern Europe), have higher productivity, a more welcoming business climate, and more sober public finances. Culturally, they also tend to have a greater emphasis on work and frugality. The southern countries, which include France, Italy, Spain, Portugal, and Greece, have lower productivity, higher regulatory burdens, a greater emphasis on the welfare state, and a tendency to spend beyond their means. The stereotype of the flâneur -- a loafer who sits in the café all day -- is not entirely without foundation.

These political, economic, and cultural differences are sand in the gears of the European Union. This is why it has remained a union that’s only half complete. It has a common currency -- but still, no empowered common financial regulators, common fiscal framework, or common tax structure. It used to be that these differences were resolved by different prices for national currencies and sovereign debt. But the Euro has eliminated the mechanism of currency pricing, and the European Central Bank has suppressed the mechanism of interest-rate differentiation.

The pressures created by this half-union have continued to build. There are two possible responses: to undo the half-union, or to proceed to full union. Ultimately, these are the only choices. The UK opted out of “team union” when it voted for Brexit. Now the remaining members of the Eurozone have to decide what to do.

Germany and France: Coming Closer Together?

Advocates for deepening and completing the union got a big boost with France’s election of Emmanuel Macron. With France moving more towards the center from the left, and Germany’s Angela Merkel softening and moving more towards the center from the right, it seemed that finally, the European Union’s two halves might meet in the middle and “get the job done” in terms of creating real banking reform with teeth. (Merkel’s domestic political woes have somewhat cooled optimism about the new cooperative spirit, however.)

Last Week’s Summit

So what happened at the summit that ended last week?

Essentially, the participants laid out a roadmap to express their determination to work towards completing the Eurozone’s financial and fiscal regulatory structures:

• First, the creation of a Euro budget and a Eurozone finance minister. This would build a fund -- a so-called European Monetary Fund -- which governments could access for stimulus, for example, during an economic downturn. France and Germany both agree on the basic proposal, but differ on the details, and the same worry as ever is there for Germany -- that Germans would end up on the hook for the profligacy of the continent’s café-dwellers.

• Second, giving the Single Resolution Method some teeth by funding the Single Resolution Fund, to cover the costs of the resolution process -- and compensate depositors. Repeat what was said above: while there is general agreement, the “northern bloc” remains skeptical and worried that its members will find themselves on the hook for profligate southern banks. Given the state of Italy’s banks, for example, this fear seems not unjustified.

So where do things stand? EU President Donald Tusk aims to reach agreement on the proposals “by June” -- a deadline that would complete discussions ahead of the start of campaigning for the 2019 elections for the European parliament. In short, the Eurocrats talked, and agreed to come together to talk some more, and signaled their intention to make a deal at some point in the future. The rapprochement of France and Germany makes that future deal look a little more possible -- but still, we are not holding our breath.

Investment implications: The European economy has been in the doldrums for a long time, and as part of the current coordinated global growth acceleration, has been performing more strongly. (It also continues to benefit from ongoing QE.) While Europe is not our primary focus, we believe European stocks will have the ability to perform well in 2018, buoyed by the global economy and by global investors in search of markets which have not appreciated as much in price as the U.S. Within Europe, we would favor Germany, Austria, the Netherlands, Scandinavia, and eastern Europe, particularly Poland and the Czech Republic. If the dollar shows signs of strengthening against the euro, we would hedge our exposure to the currency. While we are generally encouraged by the recent European summit and the discussion of Eurozone fiscal and financial reform and integration, we’re skeptical that rapid change is on the horizon. Such change would be necessary for us to become more long-term bulls on Europe. Without it, we restrict our positive view to the duration of the current global expansion.

To learn more about Guild Investment Management, please go to www.guildinvestment.com.

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