Political Economy: Don’t Rely on Banking Union to Solve Euro Zone Crisis

Conventional wisdom has it that the euro zone needs a banking union to solve its crisis. This is wrong. Not only are there alternatives to an integrated regulatory structure for the zone’s 6,000 banks, but centralization will undermine national sovereignty.

The rallying cry for a banking union sounded this year when it seemed that the euro zone might break apart. Advocates of such a union said that it would break the “doom loop” connecting troubled banks and troubled governments. This week, E.U. countries will meet to discuss the terms for a single supervisor for banks, the first stage of a banking union.

There are two parts to the doom loop: when banks go bust, their governments bail them out, adding to their own debts; and when governments become over-indebted, their lenders get sucked into a vortex, as their balance sheets are full of sovereign debt.

In its fullest incarnation, a European banking union would break the first part of this loop. There would be a central mechanism to recapitalize troubled banks or close them down. There would also be a single deposit guarantee scheme. The cost of dealing with banking crises would, therefore, be borne by the whole euro zone rather than by national governments.

The other half of the loop — the way ailing governments infect banks — would be left intact. This is worrisome given that banks in peripheral countries have doubled lending to their own governments to €700 billion, or more than $900 billion, in the past five years, according to the research organization Bruegel.

The current proposal does not even address the first part of the loop, as politicians are focusing on supervision. Although leaders did agree in June to let the euro zone directly recapitalize banks, Germany subsequently insisted that this would not apply to “legacy” assets, meaning that the promise was of no help to countries already hit by a banking crisis, like Greece, Ireland or Spain.

Moreover, E.U. countries are finding it hard to agree on how a single supervisor should work. Germany does not want its savings banks covered, for instance, an exemption that other countries think would be unfair. Germany is also worried that the European Central Bank, which will take over the supervision, could be diverted from its main role of fighting inflation if it felt the best way to prevent a banking blowup was to keep interest rates artificially low.

There are also difficulties that come with trying to satisfy the interests of countries that are part of the European Union but that are not in the euro zone. Some, like Poland, might want to join the banking union but complain that they do not have a say at the E.C.B.

Meanwhile, Britain does not want to join the banking union but is worried that the E.C.B. will make decisions that will be detrimental to London. Last week, Christian Noyer, governor of the Banque de France, fanned those fears when he told The Financial Times that there was “no rationale” for letting the euro zone’s financial hub be “offshore,” a reference to the fact London is not in the euro zone.

There is an alternative way of breaking the doom loop. First, banks should be required to hold a large chunk of capital that can be used to absorb losses if they go into a tailspin. This cushion, which could be in equity or in bonds, should amount to 15 percent to 20 percent of their “risk-weighted” assets, roughly double the equity-only cushion that new regulations demand. With such a big buffer, there would be less risk that governments would need to bail out their banks. Although the European Commission has bought into this concept, it has not quantified the buffer. It should do so.

Second, banks should be required to diversify their holdings of government debt. Greek banks would not hold little other than Greek bonds and Spanish lenders would not own almost only Spanish debt. Instead, all banks would have a mixture of bonds from across the euro zone, making them less vulnerable to over-indebted national governments.

With these two mechanisms in place, supervision, deposit insurance and “resolution” — the orderly wind-down of ailing banks — could be left to the national authorities. Governments would be free to devise their own policies for dealing with future bubbles, by jacking up the minimum capital ratios for banks or capping the size of mortgages, for instance.

There would still need to be coordination across the euro zone. The E.C.B. would also need to have the fortitude to refuse to act as a lender of last resort to inadequately capitalized banks. But, at the very least, even more powers would not be transferred to an unelected central bank in Frankfurt.

If the euro zone is determined to create a single banking supervisor, it should at least do so properly. That means giving the E.C.B. authority over all banks, not just the big ones. After all, the problems of recent years have been concentrated in fairly small lenders, as seen with Spanish savings banks. If the taxpayers of the euro zone have to cover failing banks, then the E.C.B. needs the authority to clean up national banking systems from top to bottom. It also needs to be more accountable.

The worst outcome would be for no institution to be in charge. Banking supervision is only the first step of a banking union, which is only the initial stage of a planned political union. If leaders of the euro zone cannot stomach the necessary transfer of sovereignty in this case, they should devise a more decentralized model for banks and for their overarching project.

Hugo Dixon is the founder and editor of Reuters Breakingviews.

Article source: http://www.nytimes.com/2012/12/10/business/global/10iht-dixon10.html?partner=rss&emc=rss