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Will banking union reduce default risk for banks in the eurozone ?

European investors do not believe banking union will reduce default risk for banks in the eurozone, according to a Fitch Ratings quarterly investor survey conducted in July. 

Over a third (39%) believe this is because not all three pillars - common supervision, resolution mechanism and centralised deposit insurance - will be fully implemented. Twenty-seven percent expect independent resolution to mean that banks are less likely to be supported. A small number of investors (6%) consider that even assuming full implementation the proposed measures are insufficient. This leaves just 28% of survey respondents who are optimistic that the regulation shift will reduce default risk.

The publication of the European Commission's proposal for a single resolution mechanism (SRM) on July 10 had a positive impact on the survey responses. Belief that the union would reduce default risk rose from 20% before this date to 35% afterwards.

In Fitch's view, the different pillars of the banking union have different impacts on the risks for European bank creditors, which may have conflicting implications for default risk. We expect the first pillar, the single supervisory mechanism (SSM) centred on the European Central Bank, to be in place by end-2014. The SRM is the second and probably final pillar now that some form of depositor preference will be built into the final bank recovery and resolution directive.

A single supervisor should bring consistency and comparability of risk measurement and reporting. Many national regulators have already reviewed asset valuations and required banks to strengthen capital ahead of the SSM's balance-sheet assessment, which may be combined with the European Banking Authority's EU-wide stress test. This should help reduce bank failure risk.

However, the SRM could make sovereign support for banks less likely, or at least make it more likely that senior creditors would have to share the burden. A single resolution board making objective and balanced decisions could reduce hesitation in the intervention and resolution of a weak bank, reducing total costs so the burden for the sovereign can be limited. If the final proposals mean sovereign support is weakening, investors are likely to differentiate more between weak and strong banks.

The survey also shows more positive investor sentiment towards banks generally. The sector is the most represented of all corporate sectors in investor portfolios and the second most favoured marginal investment choice (behind high yield). Survey respondents were most bullish on the outlook for fundamental credit conditions in the financial segment, and expected spreads to remain at current ranges or tighten, while they forecast issuance to reduce in absolute terms as well as relative all other sectors.


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