Blog Post

Continued financial fragmentation will put ECB on the hook

Failure to agree on a strong banking union will push more responsibilities onto the ECB. The introduction of tough bail-in rules, higher capital levels and a common insurance fund backed by an ESM credit line within a shorter time period would make the job of the ECB easier and could save tax payers’ money. It would also facilitate the recovery in Europe’s South. The ECOFIN should be bold.

By: Date: January 8, 2014 Topic: European Macroeconomics & Governance

Europe is coming closer to a deal on banking union. The creation of the single resolution mechanism and the single resolution fund is its most important element and the hope is to conclude discussion next week. Well designed, it would end financial fragmentation and lead to a desirable and needed convergence in funding conditions throughout the single currency area. An insufficient agreement next week at the ECOFIN and the European Council would put the ECB in an awkward situation and may force the ECB to engage in non-standard monetary policy measures to fulfil its mandate.

The ECOFIN next week intends to finalise the work on the single resolution mechanism and the fiscal back-stop. Some of the elements of the deal that have leaked from the ECOFIN meeting this week are encouraging. The bail-in instrument will be advanced to 2016 helping to reduce the bill for tax payers. Yet, depending on the final agreement, the deal could be insufficient to end financial fragmentation and fix Europe’s banking problems. For a very long period, national bank insurance funds will have to shoulder the largest part of the costs. With only a few large banks per country, national funds will be insufficient in case of one of them facing a problem. Indeed, an insurance requires many banks to participate. Put differently, if a large national bank was to face trouble, the national insurance fund would be insufficient and national tax payers would have to foot the bill. A common insurance fund paid by bank levies from the banks supervised by the ECB would make sense for the German tax payer also, as the risk would be spread over a larger geographic area.

But the basic elements of the deal also suggest that banks will face different funding conditions for an extended period. Banks in countries with weaker public finances will have to pay a risk premium because of their location. Banks in countries with larger banking systems compared to GDP will be put at a structural disadvantage. Banks in Germany will benefit from the value of the best state guarantee that the German state provides. As a result, interest rates on credit will be different for a long time. A good company in Europe’s South will not be able to access affordable credit. Yet, without credit, the recovery will not come and the downward dynamics observed in Europe’s South will continue.

Confronted with this situation, the ECB will be faced with increasing pressure to act and the case for more action is actually compelling. Inflation rates have been falling throughout the euro area also because the ECB’s monetary policy signals do not reach the households and corporations in Europe’s South. The different levels of state guarantees and the unfinished cleaning-up of balance sheets is impairing the monetary transmission channel. The best way to fix it would have been to clean the balance sheets and afterwards put in place a common backstop. Now the ECB may have to rely on non-standard policies or changes in the collateral framework.

Having to work with different levels of government guarantees for banks can also lead to conflicts of interest for the ECB. What if, in 5 years, a major bank faces massive capital shortfalls but the national fund and the government behind it would not have the resources to stem the problem? Should the ECB really risk another crisis and an ESM financial assistance programme or rather keep the bank alive with liquidity?

Failure to agree on a strong banking union will push more responsibilities onto the ECB. The introduction of tough bail-in rules, higher capital levels and a common insurance fund backed by an ESM credit line within a shorter time period would make the job of the ECB easier and could save tax payers’ money. It would also facilitate the recovery in Europe’s South. The ECOFIN should be bold.


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