OpinionJul 16 2014

The eurozone long-term view

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He does not much look like a celebrity, but in terms of headlines and column inches, I reckon Mario Draghi, president of the European Central Bank, might have given George Clooney and Kanye West a run for their money this year.

For the last few months nearly every investor in Europe has been obsessed with whether “Super Mario” will break out the defibrillator to shock the flat-lining eurozone economy back to life. The ECB’s targeted lending and further preparatory work for the purchase of asset backed securities will take time to work.

In the meantime, investors should not forget that behind the scenes slow and steady progress is being made on consolidating the long-term future of the single currency bloc, namely the European Banking Union. Last week, the German Cabinet approved a package of draft laws which effectively gave proposals the green light.

The last ECB meeting gave up a few more details on how it plans to run the targeted long- term refinancing operations and how banks will be able to access this source of cheap funding in the future.

On the whole, the details were more lenient than first thought with a lower than expected hurdle for gaining access to the cheap funding. The first round of TLTROs begins in September and until the ECB can assess the impact on lending and influence on economic growth, monetary policy is likely to remain in a holding pattern. That is, unless the economy takes a severe downturn or inflation starts heading to zero.

While these issues are the focus of attention, there is gradual process being undertaken to address some of the reasons why we had a eurozone crisis in the first place. Top of the list is the loss of faith suffered by what we now know was a highly unstable financial system.

It was almost two years ago that European leaders pledged to restore confidence and shore up the banks by creating a banking union. The idea being that a union would break the vicious cycle that had been perpetuated by individual governments and banks through a series of government bailouts and increasingly punitive debt burdens.

It was almost two years ago that European leaders pledged to restore confidence

The ECB will take on its new role as the single supervisor of the largest banks in November. This should lead to at least some sort of harmonisation of the oversight of banks inside the eurozone.

While it may be quieter on the monetary policy front for the next few months, as the ECB tries to gauge banks’ reaction to the TLTROs, Mr Draghi and his colleagues have enough to do to keep themselves busy. Next up in October will be the conclusion of the comprehensive assessment programme the ECB wants to undertake before it begins its supervision. This will comprise the stress tests necessary to gauge the resilience of bank balance sheets.

Next year, a new institution will be charged with either restructuring or winding down the most troubled banks. This will be the second pillar of the banking union, the “Single Resolution Mechanism”.

This newly minted pan-European agency will be able to draw on a fund of approximately €55bn (£44bn) to inject fresh capital into banks. However, there will be a greater role for bail-ins rather than bail-outs to prevent governments from being left to foot the bill. Shareholders, creditors and the very largest depositors will lose money first should a bank fail.

The creation of a banking union is a clear step towards greater financial integration in Europe and will ensure the eurozone project is based not just on monetary union but also financial union. The process to ratification could, however, be very long and drawn out.

Current banking union proposals still need strengthening and this will involve negotiating an uneasy compromise between member countries, many of which have divergent interests. But the need to establish an entente cordiale will be vital: if another financial crisis presented itself then a flawed banking union would prove just as ineffective as not having one at all.

Investors can take some solace from the fact that this will lead to a stronger Europe in the long run. And, for a regional economy that is larger than the US but has a reputation for being weighed down by self-interest and squabbling, a stronger, more unified economy can only be of long-term benefit for markets.

Kerry Craig is global market strategist of JP Morgan Asset Management