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Doubts Plague Europe's Pledge For Banking Union

Concerns are growing among European investors and lawmakers that plans for a eurozone banking union will end up half-baked, with the financial backstops required to underpin the ambitious scheme unlikely to be in place for years.

Concerns are growing among European investors and lawmakers that plans for a eurozone banking union will end up half-baked, with the financial backstops required to underpin the ambitious scheme unlikely to be in place for years.

Differences of opinion over what precisely is needed to create a banking union among the eurozone's 17 countries and other EU states that decide to join were on display at a finance ministers' meeting in Cyprus last weekend.

As well as questions about how quickly the European Central Bank can be put in charge of overseeing banks, the agreed first step towards a banking union, there are divisions over how to set up a single bank-resolution fund and whether it is feasible to have a unified deposit-guarantee scheme any time soon.

The last objective, in particular, looks likely to prove a major stumbling block, with Germany regarding a single guarantee as akin to the mutualisation of eurozone debt -- something it firmly opposes and has said cannot be discussed until the end of the process of deeper EU integration.

"Originally the idea of a banking union was to have deposit guarantees to stop the outflow of money from Spain," said Sharon Bowles, who chairs the European Parliament's influential economic and monetary affairs committee.

"But they are shying away from mutualisation and all you are left with is supervision, which if left on its own would have more drawbacks than benefits. It could split the (EU) single market."

There are three major steps in a banking union: the ECB being given responsibility for monitoring all eurozone banks and others that sign up; a fund to close down and settle the debts of distressed banks; and a fully fledged scheme to protect citizens' deposits.

While ECB supervision is expected to be in place from early next year and the framework for a resolution fund is under discussion, Germany and others are concerned deposit guarantees will put them on the hook for banks in Greece or Spain.

"People have been living under the illusion that banking union is a substitute for fiscal union," said Paul De Grauwe, an economist at the London School of Economics whose analysis has frequently informed policymaking in Brussels.

"It's about money and having access to taxpayers' resources. There is a risk it will be half-baked if it does not have a fiscal backstop."

And even when it comes to the first step in the process - ECB supervision, which policymakers regard as a pre-requisite for the direct recapitalisation of struggling banks - there are differences over what steps need to be in place first.

In Cyprus, German Finance Minister Wolfgang Schaeuble warned that handing oversight to the ECB was not in itself sufficient to allow for direct recapitalisation, casting doubt on how straightforward the process will be.

The remarks disappointed investors, who were expecting the oversight issue to be settled by the end of this year so that the ECB could start to take responsibility from Jan. 1, 2013.

That in turn has heightened the edginess surrounding Spain, many of whose banks are in need of recapitalisation and are expected to get funds from the eurozone's permanent bailout fund, the ESM, in the coming weeks or months.

BIG RISKS

Germany's reticence is understandable. Banks in the eurozone's weakest countries have made trillions of euros of loans to consumers, business, governments, banks and other institutions that may not be able to repay.

Banks in Spain have lent 2.2 trillion euros ($2.86 trillion), including money lodged with other banks and the eurosystem, according to ECB statistics. Banks in Italy have loans of 2.5 trillion euros. In Greece, the stockpile is 270 billion euros, and more than 430 billion euros in Ireland.

"People are worried from a systemic point of view about Spain and Italy being dragged further into the crisis," said Tony Stringer, a sovereign debt analyst with Fitch Ratings.

"From the point of breaking the link with sovereign creditworthiness, there has to be a way of dealing directly with the banks' liabilities, rather than simply having a pan-European regulator. By pooling the banking sector risks through the ESM, you are getting away from the pernicious link."

Eric Stein, a fund manager with Eaton Vance Investment Managers, a U.S. investor that buys European government debt, is watching the debate closely.

"As the sugar high wears off after the action of the ECB and the Federal Reserve, markets are going to focus on problems such as those in the Spanish banking sector. Up to now, there was a consensus the ESM was going to take care of that."

The debate about the different aspects of banking union, which is as complex as it is divisive, has already become bogged down in discussion about how wide the ECB's new remit should be.

The European Commission has proposed that it be responsible for the oversight of all 6,000 banks in the eurozone in order to give it the legal clout to overrule a national regulator and deal with a smaller bank in crisis. In practice, day-to-day supervision would stay with the national regulator.

Yet Germany, which wants to keep oversight of its regional savings and cooperative banks and has long had doubts about the wisdom of direct bank recapitalisation, has questioned whether the ECB should spread itself so thinly. It wants the ECB to take charge of major systemic banks, not all 6,000.

"You don't know where the problems will manifest themselves," said Fitch's Stringer, questioning Germany's line. "If there is a systemic problem across a number of smaller entities, that can add up to a big liability.

"Any supervisory system that didn't embrace the whole banking sector would be less supportive to sovereign ratings."

The debate worries policymakers.

"If the idea is to do some sort of lax supervision in a way to meet the conditions for the ESM to directly recapitalise banks, I would not do this," said one central banker.

The depth of division, as well as the prospect of a drawn-out battle with the European Parliament for approval of the changes to how banks are monitored, means reaching the deadline set by euro zone leaders of starting the new regime from the start of next year is all but impossible.

"It's going to take time to assess where all the member states stand on all of this," said one EU diplomat. "In terms of getting decisions in place by January next year, that's going to be hard."

Copyright 2012 by Reuters. All rights reserved.

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