For the time being, we propose that banks in need of recapitalisation from the ESM be turned over to the ESM directly – instead of having the national government borrow on the bank’s behalf. Banks from Cyprus, Greece and Spain would likely fall under this proposal. The ESM, and not the national government, would then restructure, recapitalize and resolve the failing banks dedicating the bulk of its funding capacity to this purpose.

The Eurozone must eventually become a single banking area with a single banking authority. But this final goal has become the enemy of good current policy. At the June 2012 European Summit direct bank recapitalisation was agreed upon in principle, but was made conditional on the formation of a Banking Union. Since then, the difficulties of legislating, designing and implementing a Banking Union have meant delay and dithering. A year after that sensible decision, the deadly embrace between insolvent national banking systems and insolvent member-states continues.[i]

Today the dominant EU view remains that banking union must be completed before the ESM directly recapitalises banks. And that when it is complete, the ESM’s contribution will be partial and come only after a bail in of depositors in the fiscally stressed countries of the periphery. That way, the banking crisis will either never be resolved or its resolution be delayed for years, risking a new financial implosion.

Our proposal is that a national government should have the option of waiving its right to supervise and resolve a failing bank. Shares equivalent to the needed capital injection will then pass to the ESM, and the ECB and ESM will appoint a new Board of Directors. The new board will conduct a full review of the bank’s position and will recommend to the ECB-ESM a course for reform of the bank.

Reform may entail a merger, downsizing, even a full resolution of the bank, with the understanding that steps will be taken to avoid, above all, a haircut of deposits. Once the bank has been restructured and recapitalised, the ESM will sell its shares and recoup its costs.

The above proposal can be implemented today, without a Banking Union or any treaty changes. The experience that the ECB and the ESM will acquire from this case-by-case process will help hone the formation of a proper banking union once the present crisis recedes.

NOTES: [i] Indeed, recent decisions have made this embrace permanent.

Now read Policy 2: Limited Debt Conversion Programme