A new concept has recently emerged in the policy discussion as a solution to the euro area’s woes: a banking union. It appears that discussions on a banking union will now be on top of the agenda of the next European summit. So are politicians now talking about how to rescue banks instead of how to generate growth and increase jobs as was initially planned? In fact, there is no contradiction here. One of the important reasons for low growth in Europe is the uncertainly about the euro’s future and that is intrinsically linked with the idea of a banking union. Here is why.
Let us start with the idea of a banking union. The rationale for a banking union is rather straightforward. EMU was constructed on the basis of two pillars: a monetary and a fiscal one. It has no financial component. Recent developments have exposed further weaknesses. First, the previously integrated euro-area financial market has entered a process of fragmentation. 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. Furthermore, they have been encouraged by national authorities to cut cross-border lending.
The absence of a banking union has thus created huge uncertainty and even a break-up of the euro area is now discussed. This uncertainty has severe negative consequences on growth, jobs and investment. In fact, international investors are increasingly starting to drop their European investments. Domestic investors reduce their investment in the fear of a fragmentation of the euro area and certainly reduce exposure to the South of Europe where investment is most urgently needed. Creating a European banking union is therefore one of the key factors for a successful overcoming of the crisis and for generating growth. So what would a banking union consist of and what would it imply?
A banking union would assign to the European level the responsibility for deposit insurance, bank supervision, and crisis resolution. This is not an easy move. Deposit insurances have been put in place to prevent a bank run on banks. By protecting depositors, depositors will keep their savings at the bank. This increases the stability of the banking system and thereby helps promoting growth. For a deposit insurance to be effective there needs to be a commitment by the governments to stand behind it. In Europe, this would imply a joint commitment by European governments to step in and protect depositors throughout the euro area. This is a major political step to take as it could result in large payments from some countries to others.
Second, a banking union would centralize the supervision of banks throughout Europe. This is the necessary counterpart to the creation of a common deposit insurance as well as to a common resolution system. In fact, mutualising risk also means that one has to centralise control over risk as otherwise every country would have a large incentive to supervise banks only lightly and impose the losses on tax payers of other countries. A creation of a common supervisory authority is thus needed.
Third, a common resolution authority needs to be created. When a bank becomes insolvent, an orderly process to manage this insolvency is needed. Ideally, this process should minimize the costs to the tax payer while at the same time ensuring the stability of the financial system and preserving the most important functions exercised by the bank. This requires strong political authority and technical expertise. The cross-border nature of banking in Europe also implies that a European authority can exercise this function in the most efficient way.
The path towards a common European banking union is certainly difficult. At the same time, it has become clear that a more centralized approach to banking is necessary if Europe wants to recover stability and resilience. In turn, this stability is one of the most important factors needed for more growth in Europe. Focussing on the banking problems is certainly the best thing European leaders can do for growth and jobs at their next summit.