European banking union isn’t the solution to the immediate crisis facing the eurozone

In City AM today we lay out our thoughts on the latest plan to save the eurozone - a 'banking union'. Although the plan has some merit and may be needed in the long term it just doesn't look suitable for solving the short term crisis facing the eurozone right now. See below for full piece:

WHATEVER new twist the Eurozone crisis takes, the answers always seem to be another union: economic, fiscal, political, federal – you name it. The latest in this long and somewhat misguided list is a banking union. The idea is simple: a deposit guarantee scheme and a bank resolution fund would be created at the Eurozone level to backstop any systemically important bank which finds itself in a solvency crisis.

It sounds promising and it is a worthwhile idea. In particular, if Europe is ever going to get its act together, there has to be a way for bust banks to fail. Additionally, no-one can dispute that, if the Eurozone is to ever become workable in the long term, ensuring it has efficient and effective cross-border financial markets – most importantly interbank lending – will be vital. In the past few months, we have seen an increasing re-nationalisation of Europe’s banking sector, as domestic banks increasingly buy up their respective countries’ sovereign debt, tightening the link between banks and sovereigns with huge systemic implications.
Unfortunately, there are three key reasons why a banking union – as with any other union – does not present an answer to the immediate crisis.

Firstly, any banking union would need to be backed up by strong Eurozone-wide financial regulation. All regulation would need to be harmonised to limit any moral hazard from the new guarantees underpinning financial institutions. This would also require very strong central enforcement mechanisms, to counter the temptation among national regulators to fudge the rules.

This raises a second point. For a banking union to work, the Eurozone would need a whole new set of institutions, equipped with powers cutting deep into the economic sovereignty of its member states. Such powers would include ordering wind downs of banks, forcing bail-ins on bondholders and even taking shares in tightly held flagship national banks. Even if this was possible – it’s not at the moment as Germany remains strongly opposed – it would be a time consuming exercise, even with crisis serving as a whip on Eurozone leaders’ backs.

Thirdly, though a banking union would address instability stemming from solvency issues, it would not deal with the redenomination risk. Consider the state of banks and the economy in Spain and Greece. The flight of deposits in Spain is at best based on a single institution’s insolvency (Bankia), but also possible concerns over the cash-strapped state’s ability to provide a backstop. The banking union would assuage these fears, although it is not a necessity to do so in the short term, a thorough recapitalisation of the banks with external assistance would have the same effect. However, in Greece the concerns stem from the country’s potential exit from the euro – an increased backstop would not stop this unless deposits were underwritten and banks guaranteed in euro terms indefinitely (even if Greece were to exit the euro). This would be impossibly complicated and would provide a huge burden on the other Eurozone states while making an exit far easier and more attractive for Greece – creating further moral hazard concerns.

On top of all this, there is the thorny issue of the UK. The Eurozone would not want to exclude the UK, as it would be perceived as giving the City of London a competitive advantage. But including the UK would be politically impossible given the need for regulation and institutional control at the EU level, and economically impossible given the size of resolution fund needed to backstop a financial sector as large as the UK’s. Though a compromise may be possible eventually, for now it would simply throw up another impasse in UK-EU relations and attempts to tackle the crisis.

A banking union can’t solve the situation in Greece and may not be needed for Spain, but movements towards a cross border resolution scheme should continue. This can be combined with a recapitalisation of Spanish banks with Eurozone funds – albeit with strong conditions, including winding down banks – as well as moves to encourage the pre-funding of national deposit guarantee schemes to help tackle the solvency risk in countries such as Spain.

Outlining a long-term vision for the euro is important but outlining policies to tackle the immediate crisis must be the priority.

 For an(other) excellent round up of the problems facing the creation of a European banking union we suggest checking out Alex Barker's ten points over on the FT Brussels Blog.