The new concept of European banking union has emerged in the discussion of European leaders on the solutions to the euro crisis. This is not a good name from a communication viewpoint, as citizens are angry against banks for having created the crisis and against the European Union for having mismanaged it. But the idea makes considerable sense and here is why.
The European monetary union was constructed on the basis of two pillars: a monetary one, the independent and price-stability oriented ECB, and a budgetary one, fiscal discipline and a modicum of coordination. It had no financial component apart from the ban of capital controls and the promotion of a single market for financial services, both of which apply to the whole EU, and it had no banking component, apart from those arising from the operation of monetary policy. The ECB itself had few financial stability competences.
The crisis has exposed the limits of this bare-bones model. First, the previously integrated financial market has fragmented along national borders. Banks were European in quiet times, but have become national in crisis times as they depend on national governments for being bailed out, if needed. They have been encouraged by national authorities to cut cross-border lending and retreat within national borders. This is understandable from a national viewpoint, as taxpayers have little reason to pay for the consequences of imprudent lending to foreigners, but risks disintegrating the euro area. Already, capital that was supposed to move as freely across countries as across regions has stopped flowing from North to South, which has resulted in within-EMU surprise balance-of-payment crises.
Second, there is strong correlation between banking and sovereign solvency crises. Especially in Greece, Ireland, Spain and Italy sovereign solvency concerns affected banks and bank solvency concerns affected sovereigns because of strong “home bias” in banks sovereign bonds holdings and of sovereigns’ individual responsibility for bailing-out banks. The ECB cannot quell this vicious circle, because a federal central bank cannot be mandated to assist particular sovereigns.
Moving to a banking union with centralised responsibility for deposit insurance, bank supervision, and crisis resolution would contribute to the resilience of the EMU by strengthening financial integration and reducing the potential for sovereign-banking crises correlation.
However this is not an easy move and it cannot be done piece by piece. If not backed up by fiscal support, European deposit insurance would not help dealing with crisis overwhelming bank-financed deposit insurance. Also, if insurance is moved to the European level, supervision has to follow suit, or national supervisors would have a strong incentive to overlook banks’ excessive risk-taking in their jurisdiction.
Second, there are limits to what can be insured. European deposit insurance cannot cover the risk of euro exit. This would simply amount to subsidising it massively as bank accounts would keep their euro value even if corresponding bank credits were converted into a new currency.
Third, the euro area is a subset of the EU that does not include its main financial centre, London. So there would be a need for creative variable geometry combining the EU and the euro area dimensions. The UK, traditionally opposed to the initiatives he did not want to take part in, has changed attitude: PM David Cameron has decided that national interest was euro area “make-up” rather than “break-up”. But the devil is in the details and negotiations on the exact contours of the banking union and its interaction with the single market rules will be difficult.
Last but not least, any insurance mechanism involves distributional biases. Countries with stronger banking system are naturally reluctant to subsidise those whose banking systems are or are perceived to be weaker. True, it is hard to say ex ante who is stronger and even if in the end the survival of the euro may be worth a transfer, in the short term Northern European countries are reluctant to support Spain, where the legacy of the real estate crisis is severe.
Will Europe bite the bullet? Until recently it seemed it would not. Banking protectionism, fear of transfers and reluctance to European centralisation suggested that this sound idea had little chances to see the light. The risks of recent developments for the euro area and market perception that the very existence of the euro is at stake may lead the European leaders to change their mind. It would not be the first time they wait until they are on the edge of the cliff to take the decision they should have taken earlier. But it would not be the first time they end up taking the right decision.