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Improving banking union

10 March 2014 By Hugo Dixon

The European Union’s half-baked banking union could be made to work – even though it wasn’t strictly needed to solve the euro zone’s problems and what has been agreed isn’t what the designers wanted.

The original advocates of banking union saw it as a way to prevent the euro collapsing during the dark days of early 2012. The idea was that a well-funded, euro-wide deposit insurance scheme would stop savers panicking. Meanwhile, if banks got into trouble, a strong euro-wide safety net would be able to bail them out.

During the crisis, savers and investors lost faith in the ability of weak governments to rescue their banks. That’s why banking union enthusiasts wanted euro-wide support systems.

In the end, what has emerged from the European policy factory is completely different. Germany latched onto a part of banking union that hadn’t previously got much attention, centralised supervision of banks, and nixed the idea of common deposit insurance. It didn’t want to be on the hook for bailing out other countries’ banks. Berlin also diluted the plan for a euro-wide safety net for bust banks – though the European Parliament is still trying to beef it up.

Despite all this, banking union doesn’t have to be a disaster. To see this, it is important to understand why the euro zone doesn’t actually need one.

In 2012 much was made of the “doom loop” that connected weak banks and weak governments. This had two elements: bust banks dragged down their governments if the latter had to bail them out; and bust states dragged down their banks if the latter had bought too many of their bonds.

This doom loop was, and remains, a serious flaw. But it is a mistake to think the only way to cut the loop is by euro-wide bailouts. There are better alternatives.

Look, first, at the problem of bust banks infecting their governments. This is only a problem if taxpayers have to rescue them. But who said governments should be in the business of bailing out banks? It is much better to make banks safe enough so that they don’t get in trouble in the first place; and, if they do, to require their investors to foot the bill.

That, indeed, is the broad programme that governments around the globe have been pursuing for the past five years. It involves preventing credit bubbles, forcing banks to hold more capital, “bailing in” bondholders if they run out of equity and restructuring lenders so it is easy to close them down if necessary.

The EU is doing all this too. But it didn’t require banking union to push it forward.

That said, the ECB could speed up some of these initiatives.

First, the central bank needs to work out how it is going to stop bubbles. In its new supervisory role, it will have what are known as “macroprudential” powers. This will allow it to tell national authorities to do things like jack up banks’ capital ratios if it fears credit is growing too strongly.

The snag is too many cooks may spoil the broth, as there are multiple bodies with macroprudential responsibility for all or parts of the euro zone. Even the ECB will have two units – the new bank supervisor and its financial stability directorate. It needs to provide clarity over who is going to do what.

Second, many banks don’t have enough debt that could be easily bailed in if they run out of equity. The solution is to require all banks to hold a minimum amount of bail-in debt, so that taxpayers don’t have to ride to the rescue.

This can be done without banking union. Indeed, the Group of 20 nations has asked for a global proposal later this year. The ECB should use its influence to produce a robust proposal.

Then there’s the matter of avoiding situations where banks are deemed too important to fail because their bankruptcy would cause havoc for the whole system – and so again have to be rescued. Part of the solution is to require lenders to draw up “resolution plans” that spell out exactly how they can be packed off to the knacker’s yard without too much contagion.

Again, banking union is not required. But, as a result of it, the ECB will be responsible for vetting euro zone banks’ resolution plans. With luck, the central bank will be less susceptible than national supervisors to lobbying by national champions – and so force banks to restructure themselves if that is needed to stop the too big to fail phenomenon.

Now look at the other half of the doom loop: how weak sovereigns infect their banks. Yet again, banking union per se does nothing to address that problem. It can only be dealt with if lenders are told they can’t hold more than a certain amount of their own governments’ bonds.

The ECB would prefer to impose such limits as part of a global regime. The snag is that countries with their own currencies and central banks don’t have such a need to follow suit. So the ECB may, at some point, have to face going it alone.

It won’t be easy for the ECB to bite these bullets. But it will need to, if the euro zone’s half-baked banking union is to be turned into something that is fit for purpose.


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