Blog Post

A banking union is no panacea

The claim that the eurozone needs a banking union is by now almost universal (see here by Martin Wolf, here by Wolfgang Munchau, here by the European commission, and here by the ECB, see here for an overview of the recent debate). In addition, there seems to be more and more political support. Such a […]

By: Date: June 9, 2012 Topic: Banking and capital markets

The claim that the eurozone needs a banking union is by now almost universal (see here by Martin Wolf, here by Wolfgang Munchau, here by the European commission, and here by the ECB, see here for an overview of the recent debate). In addition, there seems to be more and more political support. Such a banking union first and foremost refers to a eurozone safety net and restructuring mechanism for banks. In addition it will inevitably imply regulation and supervision at a European level. A banking union is necessary for two reasons. First, bad regulation or inadequate recapitalisation in one country is potentially harmful to other countries, especially inside a monetary union. Second, as the example of Spain and Ireland show the burden of saving its own banks can prove excessive much for a sovereign and its tax payers.

But will a banking union be sufficient; in other words, will a banking union create a stable monetary union? There are at least three reasons to worry.

First, a banking union solves only part of the pernicious feedback-loop between countries and banks when these keep a large amount of their sovereign’s debt on their balance sheets. The figure below illustrates the feedback mechanism that connects sovereign debt and banking crises. A banking union will reduce the burden for sovereigns of bailing out banks while at the same time freeing banks of the effect of lower value of implicit guarantees. This cuts the outer loop. If, however, banks persist in keeping disproportional amount of their sovereigns’ debt on their balance sheets, the inner loop remains. This will be more likely if banks remain national. Consequently, a banking union may not prevent the destabilizing sudden stops that are quickly becoming the main force destabilizing the monetary union. Different versions of eurobond proposals will help in this respect as banks will then prefer eurobonds over national sovereign debt also cutting the inner feedback loop.

Second, in a monetary union with national banking systems, the funding of country deficits due to public or private spending will largely occur through loans provided by banks in a surplus country to banks in a deficit country. Even when two countries are in balance, there may be large bilateral exposures. The funding of investments in one country through short-term loans by banks in other countries exposes the former country to destabilizing runs reminiscent of sudden stops. This is not an imaginary possibility. If a bank in a particular country fails and the reason of failure is unclear, this may negatively affect other banks from that country. Investors may put some nonnegative probability on the possibility that the origin of the bank’s problems is national. This will then raise the funding costs for other banks from that country as well. In extreme cases, this may trigger an outflow of funds from a country.

In contrast, if banks are truly European, funds can flow from one country to another country without leaving a bank. No contracts are necessary. And when contracts are necessary, the context of such contracts is very different, if only because withdrawing funding from a subsidiary is most likely harmful for the parent bank as well due to reputation effects. This significantly reduces the probability of a run on the financial system in a particular country. An additional advantage is that European banks with significant presence in multiple countries can lend money directly to Spanish firms with profitable investment opportunities. This makes a credit crunch less likely and less severe reducing the feedback loop even further.

Third, in the absence of European banks, money fleeing Spain can flow back only indirectly through the build up of imbalances in the Target 2 payment system. National central banks then acts as a lender of last resort to ‘their’ banks, by providing funding in return for collateral. The burden if losses are incurred, however, is shared EMU-wide. This requires intensive monitoring of the quality of collateral by national banks that act as agents on behalf of the European central bank. In economic terms, the agents have to exert costly effort (monitoring) to contribute to a common good (the quality of collateral). This raises an important governance issue: how does the European central bank incentivise national banks to act on its behalf? The same issue arises with ex ante regulation of regional banks, which requires detailed knowledge of national market conditions and will most probably be left to the current national regulators. Because in a banking union the bank resolution framework and deposit insurance are European, individual countries no longer bear the full cost of lenient regulation. Again this raises the governance issues described above.

A banking union is undoubtedly a step towards stability. But if banks stay regional and hold disproportional amounts of national debt on their balance sheets, stability is not guaranteed, while at the same time a banking union calls for an overhaul of governance of national central banks.


Republishing and referencing

Bruegel considers itself a public good and takes no institutional standpoint. Anyone is free to republish and/or quote this post without prior consent. Please provide a full reference, clearly stating Bruegel and the relevant author as the source, and include a prominent hyperlink to the original post.

Read article
 

Blog Post

European governanceInclusive growth

12 Charts for 21

A selection of charts from Bruegel’s weekly newsletter, analysis of the year and what it meant for the economy in Europe and the world.

By: Hèctor Badenes, Henry Naylor, Giuseppe Porcaro and Yuyun Zhan Topic: Banking and capital markets, Digital economy and innovation, European governance, Global economy and trade, Green economy, Inclusive growth, Macroeconomic policy Date: December 21, 2021
Read article
 

External Publication

European Parliament

Don't let up - The EU needs to maintain high standards for its banking sector as the European economy emerges from the COVID-19 pandemic

In-depth analysis prepared for the European Parliament's Committee on Economic and Monetary Affairs (ECON).

By: Rebecca Christie and Monika Grzegorczyk Topic: Banking and capital markets, European Parliament Date: October 21, 2021
Read article Download PDF More by this author
 

External Publication

European Parliament

What Are the Effects of the ECB’s Negative Interest Rate Policy?

This paper explores the potential effects (and side effects) of negative rates in theory and examines the evidence to determine what these effects have been in practice in the euro area.

By: Grégory Claeys Topic: Banking and capital markets, European Parliament, Testimonies Date: June 9, 2021
Read article
 

Blog Post

European governance

Urgent reform of the EU resolution framework is needed

In this blog, the authors argue that two aspects of the European resolution framework are particularly in need of reform – the bail-in regime and the resolution mechanism for cross-border banks – and propose a reform of both.

By: Mathias Dewatripont, Lucrezia Reichlin and André Sapir Topic: Banking and capital markets, European governance, Macroeconomic policy Date: April 16, 2021
Read article More on this topic
 

Blog Post

The impact of COVID-19 on artificial intelligence in banking

COVID-19 has not dampened the appetite of European banks for machine learning and data science, but may in the short term have limited their artificial-intelligence investment capacity.

By: Julia Anderson, David Bholat, Mohammed Gharbawi and Oliver Thew Topic: Banking and capital markets Date: April 15, 2021
Read about event More on this topic
 

Past Event

Past Event

Presentation of the Euro Yearbook 2021

Join us for the launch of the eighth edition of the 'Euro Yearbook'

Speakers: Maria Demertzis, Fernando Fernández, Fiona Maharg-Bravo, Antonio Roldán and Jorge Yzaguirre Topic: Macroeconomic policy Date: March 12, 2021
Read about event More on this topic
 

Past Event

Past Event

How could regulators address financial firms’ dependency on cloud and other critical IT services providers?

At this closed-door event Dirk Clausmeier, Head of IT security at the German Ministry of Finance will discuss financial institutions use of cloud service providers.

Speakers: Dirk Clausmeier and Nicolas Véron Topic: Banking and capital markets Location: Bruegel, Rue de la Charité 33, 1210 Brussels Date: January 28, 2021
Read article More on this topic More by this author
 

Blog Post

Memo to the European Commissioner for Financial Services Policy

The Commissioner for Financial Services Policy should define and promote a vision for a sustainable global financial regulatory and supervisory order, based on the lessons from the previous major international financial crisis in 2007-09 and its aftermath. As a member of President Ursula von der Leyen’s “geopolitical Commission,” the Commissioner should lead in setting the international agenda and build global credibility by driving the corresponding “domestic” (ie EU) reforms at home. This memo focuses on the international aspects.

By: Nicolas Véron Topic: Global economy and trade Date: January 20, 2021
Read article More on this topic
 

Blog Post

Economic recovery after COVID-19 requires a clear vision for a healthy banking sector

The EU framework for crisis management and state aid in the banking sector urgently needs updating.

By: Alexander Lehmann and Reiner Martin Topic: Banking and capital markets Date: December 16, 2020
Read article
 

Blog Post

Europe’s banking union should learn the right lessons from the US

In revived discussions on European banking union, some have suggested a new regime to deal with failing banks, alongside existing ones, drawn from parts of the United States’ bank resolution framework. This fragmented approach could be counterproductive. Europe should adopt a unitary regime, like the US, that applies to all banks irrespective of size.

By: Anna Gelpern and Nicolas Véron Topic: Banking and capital markets, Macroeconomic policy Date: October 29, 2020
Read about event More on this topic
 

Past Event

Past Event

Completing the banking union in the age of Next Generation EU

Invitation only event to discuss the banking union.

Speakers: Tuomas Saarenheimo and Nicolas Véron Topic: Banking and capital markets Location: Bruegel, Rue de la Charité 33, 1210 Brussels Date: October 27, 2020
Read about event More on this topic
 

Past Event

Past Event

Evaluating the European Commission’s control of state aid in the banking sector

Evaluating European Commission’s control of state aid to banks in the period 2013-2018.

Speakers: Mihails Kozlovs and Nicolas Véron Topic: Macroeconomic policy Location: Bruegel, Rue de la Charité 33, 1210 Brussels Date: October 8, 2020
Load more posts