A eurozone banking union will fundamentally change the rules of the game for Britain in Europe: Is Cameron ready to pull another veto?

Over on the Telegraph blog, we argue:

Talk of a banking union for the eurozone has become fashionable. Many, including the British government, see the idea as a way to provide some sort of backstop for the eurozone, where shaky banks remain a huge threat not only to the single currency, but also to the British economy.

Banking union, as a concept, has merits – it tries to deal with the ever elusive question: what happens when cross-border banks fail? But, viewed from London, a banking union is also political dynamite. It cuts to the heart of both a key national industry and Britain's future place in the EU as the eurozone integrates further.

There are only embryonic proposals on the table at the moment, and a lot is unclear. A banking union could involve a wind-down mechanism, resolution fund and deposit guarantee scheme – all on a cross-border basis. It could also take various different institutional shapes, putting the Commission, the ECB or national capitals respectively at the centre (expect turf battles). All of these vital decisions will take a lot of negotiation and time to sort out and may involve EU treaty changes – while there’s huge resistance in some member states, not least Germany. It may not be politically possible to achieve.

Regardless, the UK cannot take part in the banking union itself: politically, it would involve a massive transfer of powers to the EU, which no British government will go anywhere near. Economically it would be virtually impossible too, given the disproportional risk accounted for by the City of London, which neither side would be willing to accept. Instead, in a scenario reminiscent of David Cameron’s December veto, the question is whether London will simply nod through the changes (whether a Treaty change or not, the UK will have veto over at least some elements) or whether it will name a price for its approval.

George Osborne and No 10 have said they will seek safeguards to ensure that “British interests are secured and the single market is protected… anything affecting the single market should be agreed by all 27.” But is Cameron really willing to veto the same union that he is calling for?

Because if, according to UK wishes, a fully-fledged banking union indeed materialises, it’s very difficult to see how it would not cut right across the single market. The most obvious risk is over ‘location policy’ – whether in future a certain firm or financial activity must be supervised by eurozone authorities in order to do business there. This would essentially serve as a massive barrier to UK firms doing business in Europe – in an extreme case, the City of London would effectively become ‘offshore’ for the purposes of trade with euro countries.

But more probably, for a banking union based on cross-border liabilities to really work, it would need to be backed by perfectly harmonised regulations, to avoid a bank in one country essentially free-riding off the back of guarantees by taxpayers in another country. This is precisely why the Germans are so sceptical – without a single set of rules the banking union would spill over to fiscal union but without the corresponding central controls. Not only because backstopping banks is a big part of state liabilities, but also because banks flush with new eurozone-wide guarantees could lend to their domestic sovereigns at incredibly low rates, essentially providing artificial subsidies to states and removing market pressure for reform (sound familiar?). That would give rise to moral hazard of ridiculous proportions.

Instead, the eurozone will need a ‘single rulebook’ for banks, which may or may not be compatible with the current rules governing the single market in financial services. For example, to counter free-riding risks, individual countries could have no discretion whatsoever on capital requirements for banks. It would be a single target for all euro countries, with zero flexibility. This may not be a disaster for the UK – it could even be a benefit. But it could also go the other way, ending with an in-built eurozone majority voting to apply the single eurozone capital target for the EU as a whole, which could be substantially different to the needs of the UK. A eurozone banking union would also alter the basic relationship between the home and host countries of cross-border banks (i.e. subsidiaries), shifting the previous fragmentation from national borders, to the euro/non-euro divide.

Again, this may or may not be a problem for the UK, but the point is that inherent in the creation of a full-scale banking union is the fragmentation of the EU single market – which means that, if you’re sat in London, you should tread extremely carefully around the issue. A compromise may be possible (though it won’t be pretty) which would allow for the gap between the eurozone and the single market to remain narrow (we’ve suggested some potential compromises here). But the political dilemma for the UK government is clear: is it prepared to use another veto to block a banking union absent UK-specific safeguards – risking being perceived as hampering efforts to save the euro? Or will it simply nod through potentially game-changing proposals, risking the wrath of its backbenchers?