EU fudge fails to dent bank rally

EU leaders failed to reach agreement on a banking union, but this didn't stop bank CDS spreads rallying on Wednesday.

A draft document was released in the early hours, and it showed that a broad framework had been agreed in principle by eurozone countries. But it was also clear that the difficult details had been deferred, a familiar scenario to seasoned analysts of Ecofin summits. Eurozone finance ministers will reconvene next week, and there is still a possibility that a deal will be struck before year-end.

However, even if it is agreed, it is becoming apparent that a banking union is not on the immediate horizon. The Single Resolution Mechanism will not come into effect until 2016, so won't be able to recapitalise banks soon after the ECB's stress tests are completed towards the end of next year. And the Single Resolution Fund, which will be funded by bank levies, will have a sum of just €55bn by 2023. In the meantime, a network of national resolution funds will step into fill the breach.

An amount of €55bn is small compared with recent bailouts in the periphery, and the leading role for national resolution funds means that the damaging link between banks and sovereigns will still exist over the next 10 years. The bail-in mechanism for senior creditors was brought forward to 2016 from 2018, and it seems that this is the preferred method of the EU to break the negative feedback loop. Eurozone finance ministers were unable to agree on a backstop for the SRF, and the obvious solution of using the European Stability Mechanism (ESM), is anathema to Germany.

Overall, it wasn't an encouraging outcome. But the markets have become accustomed to the EU's dysfunctional decision making, and there was little impact on spreads. Indeed, the Markit iTraxx Senior Financials index, trading at 78bps, is now just 16bps wider than the Markit iTraxx Europe. This is the smallest differential since August 2010.

Despite the lack of an imminent banking union, the uncertainty surrounding the ECB's Comprehensive Assessment next year and the question of how peripheral countries will recapitalise banks, many institutions have seen their spreads rally this year. Credit investors are focused on the balance sheet, and capital positions have improved this year. This trend is expected to continue into 2014.

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