The European banking union as a matter of equality

Tough times in the zone: the euro is holding out for a hero. Rock Cohen/Flickr

Academics, politicians, international economists and central bankers alike talk and talk about the theoretical benefits of a European banking union. But these reflections go far beyond the current, real political consensus within the eurozone.

Overall, the proposed banking union consists of a system of joint regulation, supervision, resolution and deposit guarantee schemes across the eurozone.

The issue was discussed at the most recent European Council, and it has proved to be a good demonstration of the mismatch between the goals that a union can potentially achieve and the complex political reality of the process.

Neither the progress made thus far nor the future timescale for the project are very promising. The main weakness now refers to the Single Resolution Mechanism (SRM) for failed banks throughout the proposed union, as the framework currently proposed is too decentralised.

Banking union discussions are dominated by the current lack of political equilibrium. Specifically, the main concern is over who pays for bank losses, and to what extent the euro members are willing to give some financial supervision and fiscal authority powers away to centralised bodies. The meeting made clear that the current plan points to an excessively decentralised system.

It is not only that the scope of the banks under the supervision of the European Central Bank (ECB) will be limited, it is also that national supervisors will set a complex and difficult to manage network that will serve as the Single Resolution Mechanism (SRM). Moreover, the agreements on the resources committed to the SRM are currently unreasonably low given the bank losses during the current financial crisis. And national supervision bodies will be able to set their own resolution mechanisms providing that they commit a similar amount of resources to other eurozone counterparts.

This is not looking like a banking union. Rather, it looks more like an inconsistent collage of measures with limited reach.

It is striking that many specific issues are on the table well before an agreement on the “big picture” issues like a consistent plan for what to do with failing banks is achieved. Specifics like bail-in measures, or the establishment of bridge institutions (the temporary transfer of good bank assets to a publicly controlled entity) shouldn’t be discussed without first resolving these big issues.

As designed, this model of banking union cannot be effective; it lacks structure and firepower. Continuing the project with these limitations will make it substantially more difficult to correct in future.

Debate on the banking union has been more focused on solidarity between members (ie transfers of funds supporting bailouts in troubled banking systems) than on the real benefits of the banking union for the eurozone as a whole. Admittedly, there is a trade-off between the quality and strength of the banking union and the time taken to reach it. However, the banking union is not being set up so that everyone benefits.

There are a number of political reasons for this, including the current tensions between the eurozone’s central and peripheral countries. Members should be aware that the project itself works as a signalling device - markets will not put faith in something which might easily fail under decentralisation. A project that puts the European Banking Authority (EBA) in London, the supervisory authority in Frankfurt and the resolution mechanism all over the place is, at the very least, confusing.

A number of duplicities should be amended. The current design suggests that, over time, many of the supervisory and regulatory mechanisms in the eurozone will fragment due to decentralisation and insufficient coordination across national boundaries. This implies considerable risks such as regulatory arbitrage (banks trying to benefit from better supervision conditions in certain areas) and financial instability (ie deposit flight) if the various decentralised deposit guarantee and resolution schemes remain.

The banking union should benefit the entire eurozone. However, conflicts of interests and perverse incentives make the picture look rather different. The attempts to make progress with the project have shown us that financial fragmentation in Europe is not simply a circumstantial trend. Rather, fragmentation is a structural consequence of a weak and overly decentralised financial structure, and a lack of solidarity between members.

All in all, a banking union is not a matter of benefits being transferred to peripheral countries. This is not simply about Spain, Greece and co asking for more. It is about creating a level playing field with correct incentives for a single banking market.