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Eurozone set for volatile 2014 as it tackles banks

After beating back market panic that the eurozone was set to break up, eurozone nations moved in 2012 and 2013 to put their finances on a stable footing and strengthen the banking sector.

A new pact puts their finances under stricter control, with an obligation to cut the high debt levels seen as one of the reasons behind the crisis.

Eurozone leaders also moved to create a banking union, to reinforce lenders and reduce the likelihood wobbly banks would force countries into bailouts.

However the introduction of the banking union in 2014 risks doing the opposite as lenders are given a thorough check-up but individual eurozone countries are left on the hook for the costs of treatment.

In the hot seat will be the European Central Bank, which is conducting the in-depth reviews of the top 130 or so top eurozone banks before taking over as their supervisor at the end of 2014.

Lax supervision by national regulators has long been a concern of the market, and the ECB could well find that numerous banks are undercapitalised or even insolvent.

Top euro area banks are to generate twice as many loan losses on average in the years to come than their non-euro counterparts in places like Britain and Switzerland, according to a recent study by the research arm of Moody’s ratings agency.

‘More market volatility’ in 2014

As each country will have to pick up the bill separately, the ECB may find itself come under intense pressure from member states to avoid sparking a banking crisis the likes of which have already forced Ireland, Spain and Cyprus to seek bailouts.

"The tension can be expected to generate more market volatility in Europe in 2014 than was seen in 2013," Nicolas Veron of the Bruegel Institute think tank said in a recent comment.

The ECB, which has been credited with rescuing the euro by calming markets, could ironically find itself unleashing the next panic if it conducts a rigorous review of banks that is widely seen as necessary for a sustainable recovery of the eurozone.

"The ECB will be in no position to demand that banks raise capital if there is no backstop," said Wolfgang Muenchau in a recent Financial Times commentary.

Eventually there will be a common 55-billion-euro ($75 billion) fund to help close down banks, but following opposition from Germany, the eurozone didn’t create a transitional joint mechanism, or "backstop", to help recapitalise or wind down lenders.

But if the ECB finds banks are in bad shape in 2014 then eurozone states could find themselves with the same choice of ruining their finances or seeing banks collapse.

"It would risk financial instability if it exposed a bank as undercapitalised that has no access to outside capital," added Muenchau.

Eurozone states could try to tap the bloc’s ESM bailout fund, as Spain did for its banks, but the money would come with tough conditions.

However Veron believes that the ECB cannot afford to fudge the review of the banks.

"The risk is that, if the assessment fails to be consistent and rigorous, the ECB may find its reputation so damaged that the credibility of its monetary policy — and the perception of Europe’s ability to get anything done — could be affected," he said.

Bank resolution deal ‘biggest mistake yet’

The agreement reached by eurozone leaders in December 2013 on banking resolution has been widely criticised as being a too complicated collection of half measures.

Not only will it take a decade for the joint resolution fund to fill up, at 55 billion euros it "looks too small to deal with major systemic crises", said economist Christian Schulz at Berenberg Bank.

Germany also refused to hand over decisions on closing down banks to the European Commission.

Instead, when the ECB recommends a bank should be closed, a mixed committee of EU and national officials will make the decision, but the Commission and the Council (EU member states) can overrule the decision.

The European Parliament must also approve the resolution mechanism, and its president Martin Schulz has warned the system is too complex to close failing lenders quickly.

"If a bank cannot be wound up within a weekend in order to prevent a run on the banks, the system is too complicated," he told EU leaders at their December summit.

A banking union built on this basis "would be the biggest mistake yet in the resolution of the crisis" and could even "jeopardise financial stability", said the parliament leader.

However Berenberg’s Schulz said there may be methods behind the imperfections.

"Tough bail-in rules and a shaky backstop should incentivise the ECB as a supervisor as well as national governments and the banks themselves to do everything to avoid a new crisis in the first place."

The agreed bail-in rules regulate how losses will eventually be shared in bank failures, with investors and big depositors on the hook before public money is to be injected.

But analysts have also worried that banks may prepare for the ECB review by selling off commercial assets and government bonds, and scale back on granting loans, which would only worsen the prospects for recovery.

The ECB at the beginning of December revised up its forecast for 2014 eurozone growth to 1.1 percent, with the region’s economy expected to contract by 0.4 percent this year.

Richard Lein / AFP / Expatica