MILAN, June 19 (Reuters) -

EU policymakers have renewed calls for cross-border bank

mergers as they look to address the multi-trillion euro

investments needed to finance the bloc's green and digital

transformation.

A plan for a fully-fledged banking union has stalled and

bankers and supervisors point to the absence of a joint

guarantee system for euro zone depositors as the biggest

impediment to its progress.

Below is an explanation of why little-understood banking

rules and the lack of a European deposit insurance scheme (EDIS)

make cross-border takeovers a tall order for European bankers,

who routinely complain of excessive hurdles.

WHERE WE STAND

The euro zone has taken significant steps towards a banking

union, by establishing a single oversight system under the

European Central Bank a decade ago and adopting a single

resolution mechanism to deal with failing banks.

But current rules, forged after the global financial crisis

and a string of bank bailouts, reflect expectations countries

would need to deal with any banking crisis at a national level.

This is a particular problem for so-called host countries,

several regulatory and banking sources told Reuters, such as

Belgium, Croatia and Portugal, where a significant portion of

their banking sector is made up of local units of foreign banks.

In some cases, these units account for a small fraction of

the parent company's assets, making them relevant in the host

country but of little importance for the bank's home country.

Under current rules, liquidity and capital is ring-fenced at

the national level, depriving cross-border banking groups of

what could be a competitive advantage.

Without a single deposit scheme, it has so far proven

impossible to overcome rules designed to keep bank capital and

liquidity within the borders of the subsidiary's host country.

This so-called 'solo' regime is reassuring for countries

such as Belgium that banks operating in their markets will not

need to depend on their parent entities for support in a crisis.

But it discourages banking takeovers in another jurisdiction

because it makes it impossible for groups to efficiently manage

liquidity and capital.

HOW BANK ASSETS GET 'TRAPPED'

Banks with a cross-border presence must meet requirements on

capital, liquidity and loss-absorbing debt both at a group and

subsidiary level, restricting intra-group flows.

Any excess cash generated in a country gets 'trapped' and

cannot be freely shifted across national borders to support the

banking group's operations elsewhere.

In 2021, calculations by ECB supervisors showed that there

were around 250 billion euros of high-quality liquid assets that

could not be moved freely within the banking union because of

provisions at the European Union and national level.

WHO SETS THE RULES?

Trapped assets are created by multiple sets of rules at both

the national and European level.

National laws apply because member states have adopted EU

rules on bank capital requirements, which in turn contain the

internationally agreed Basel framework.

Being based on national laws, capital requirements cannot be

waived by European supervisors, so banks must keep capital

ring-fenced in each jurisdiction.

European supervisors can, however, waive bank liquidity

requirements at the subsidiary level - allowing banks to create

cross-border liquidity sub-groups.

But banks have so far shown little interest in such waivers,

several sources said. That is partly because member states can

render them ineffective by applying another set of rules, the

sources added.

The so-called large exposure rule caps at 25% the amount of

a bank's capital that can be exposed to any counterparty.

Such a rule could be waived intra-group, but some countries

have opted to still apply it, effectively limiting how much

liquidity a subsidiary can move to its parent, even in the

presence of waivers.

In other cases, countries require lenders to post collateral

to exempt international groups from applying the large exposure

rule cross-border.

Such a regulatory backdrop makes liquidity management a

costly headache for cross-border groups, lessening the appeal of

international expansion given that it becomes impossible to

shift resources where they could be best employed.