Saving Europe's banks: EU gets landmark deal

frankfurt european banks
The European Central Bank in Frankfurt will be at the heart of Europe's banking union.

Europe has agreed the core elements of a banking union that mark the most significant pooling of national power since the birth of the euro.

European Union leaders meeting in Brussels Thursday will sign off a compromise deal hammered out overnight by their finance ministers after months of difficult negotiations. It will then go to European lawmakers for final approval before May 2014.

The banking union is central to the eurozone's response to future financial crises.

The aim is to stop bank collapses from trashing national economies -- a fate Ireland suffered in 2010 -- and destabilizing the euro. By establishing a common set of rules for managing failing financial institutions, the EU hopes to avoid the kind of chaos seen in Cyprus this year.

So what exactly does it mean, and how will it work?

The first step, agreed a year ago, was to set up a common regulator for the eurozone's biggest banks.

A Single Supervisor: The EU agreed in December 2012 to give the European Central Bank responsibility for supervising the eurozone's biggest lenders. It will oversee some 85% of eurozone bank assets. Smaller banks will continue to be regulated by national authorities.

As supervisor, the ECB will able to force banks to raise more capital if needed. But before the central bank takes up its new role in November 2014, it wants a clearer picture of the risks the banks are carrying and their resilience to economic shocks.

Related: EU fines banks record $2.3 billion over Libor

To that end, it began reviewing the quality of the assets held by 128 banks across 18 countries, including major players such as Deutsche Bank (DB), Santander (SAN) and Unicredit (UNCFF)in October. The review will culminate in a series of stress tests next year.

ECB President Mario Draghi hopes the tests will lift a cloud of suspicion hanging over European banks and encourage more lending to businesses and households.

Europe poised for rebound in 2014
Europe poised for rebound in 2014

A Single Resolution Mechanism: More robust supervision is supposed to make Europe's banks stronger, but future crises can't be ruled out.

Eurozone policymakers struggled to agree the details of a mechanism for winding down failing banks, while minimizing the cost to taxpayers (in the form of government bailouts) and the impact on the economy and euro.

Related: U.S. regulators approve Volcker Rule

The European Commission had wanted the power to decide when to begin closing a bank, but Thursday's compromise means the decision will be taken by a Single Resolution Board, including national authorities. The commission and finance ministers can still object, or call for changes to the winding up plan.

A Single Resolution Fund: Unsurprisingly, perhaps, the hardest discussions were over who pays for shutting down a failing bank. Eurozone states have made a commitment to finalize the small print by March next year.

Starting in January 2016, bank shareholders and creditors would bear the losses first. If that is insufficient for a given bank, authorities would draw on resolution funds sourced from the banking sector, not the taxpayer. All deposits under 100,000 euros would be protected.

Levies from eurozone banks will be used to build up a single fund of 55 billion euros over 10 years. That looks like a drop in the ocean when compared with the 500 billion euros investors and governments have pumped into banks over the past five years.

In the meantime, national resolution funds will be gradually pooled. If they are exhausted, governments may be able to tap the ESM -- the euro zone's bailout fund -- as Spain did in 2012.

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