Blueprint for Banking Union

Note: this essay draws heavily on “What kind of European banking union?” by Jean Pisani-Ferry, André Sapir, Nicolas Véron, and Guntram B. Wolff. However, the synthesis is my own and does not necessary reflect those authors’ research.

The rationale for a European banking union complementing monetary union is straightforward. To start, there is an inherent contradiction between pan-European banking and exclusive national responsibility for bank crisis resolution. Developments during the recent crisis have exposed further weaknesses: capital is seeking safety rather than moving freely; asset ring-fencing and risk-shifting may actually increase the overall public cost; and finally, the ECB simply cannot address solvency concerns while staying committed to its primary target of combatting inflation. A banking union can address these problems while not veering into the more dangerous fiscal union territory, as Stephen Castle argued in the New York Times.

Consensus on some elements

What would a banking union entail? First, a European banking charter to create a single rulebook for all bank entities. Second, a supervisory body that, unlike today’s EBA, has direct authority over banks. And lastly, European deposit insurance funded by contributions from participating banks. These elements are present in Brussels’ latest plan for a banking union that will take effect in 2013. 

While it is imperative that the banking union include the Eurozone countries, incorporating the entire EU-27 would harmonize the functioning of financial markets with the free movement of goods, capital, services, and people. However, an EU-27 banking union is probably too ambitious given the objections of the UK and other countries.

Decisions to be made

Many aspects of the banking union have yet to be determined. Chief among them are which banks will be involved, who will act as the supervisor and how to structure the deposit insurance. Pisany-Ferry and his co-authors offer the following thoughts on these issues:

Which banks: The union should cover the entire banking sector – if political consensus can be achieved for it – rather than only those banks considered systematically important at a European scale. This would avoid distortions between smaller and larger banks, while also removing the possibility of skirting rules through subsidiaries.

Which supervisor: The ECB is better suited than the EBA to act as the banking union supervisor, due to its greater resources and higher credibility. However, this could place new political pressure on the ECB, interfering with fiscal policy. Therefore, it will likely be necessary to create a new supervisory institution.

What deposit insurance: Deposit insurance will most likely occur through a re-insurance of the existing national deposit insurance schemes, potentially with additional contributions from member states’ governments. To create a fiscal “backstop” for the re-insurance, it is necessary to give the managing entity the ability to draw on additional resources in case of crisis – either through contingent taxation or borrowing. Again, these merely create an “intervention chest” for crisis resolution.

An uphill but important battle

Implementation of a banking union is far from simple. It requires, at the least, increased empowerment of the European Parliament, and at the most, the creation of a new European Ministry of Finance. Authorities must be vigilant so that banks do not hide their losses in the hope that they will eventually be mutualized.

Nonetheless, the failure to move forward on this issue could greatly endanger the viability of the monetary union. The proposed banking union would not only help address the negative feedback loop between sovereigns and banks; it would also demonstrate that the euro area has the political will to draw lessons from the crisis.