A banking union – it is necessary, but is it likely?

Written by Philip Whyte [1], 27 July 2012

Could the EU's summit of June 29 come to be regarded as a watershed? Following umpteen crisis summits that have failed to tackle the root causes of the eurozone crisis, EU leaders finally got to the heart of the matter: the need to break the vicious interaction between weak banks and fiscally weakened states.

They committed themselves, "as a matter of urgency", to consider Commission proposals for the establishment of a 'banking union'. They were right to do so. Such a union is key to the eurozone's survival. But the obstacles to its adoption are still huge.

To understand why a banking union is essential to the eurozone's survival, consider how the US and the eurozone responded to the 2008 crisis. Both sides faced the same problem: over-leveraged banks that had insufficient capital to absorb losses on bad loans, particularly to the housing and construction sectors. The policy challenge was to wind down (where possible) or recapitalise (where necessary) insolvent banks, and reassure depositors that their money was safe. Where the US and the eurozone differed was the level at which the problem was tackled.

In the US, the crucial action took place at federal level. The Federal Deposit Insurance Corporation (FDIC) wound up insolvent banks when it could (450 have been liquidated since 2008, including large-ish entities like Washington Mutual). Institutions considered too systemic to fail were recapitalised by a federal instrument, the Troubled Asset Relief Programme (TARP). And depositors were backed by a US-wide protection scheme administered by the FDIC. The use of US-wide instruments was and is a symbol and guarantee of states' commitment to the union.

In the eurozone, by contrast, almost all the action took place at national level. Several consequences followed. Governments were slower to recognise (and spent a lot of time trying to conceal) the weakness of 'their' national banks. Fewer of these were wound up (a reflection of their crucial importance in local politics). When banks were recapitalised, individual states (like Ireland) were pushed into a sovereign debt crisis. And national deposit protection schemes could not prevent depositor flight from countries with weak sovereigns such as Greece.

The point is not that the US's response to the financial crisis was perfect (it was not). It is that the eurozone's structure gave rise to problems that did not arise in the US – because banks and states interact very differently when certain key functions are performed at state rather than federal level. Unlike Ireland, the US state of Delaware was not plunged into a sovereign debt crisis when the insurance giant AIG was bailed out. Unlike in Greece, fears of a default by the US state of California have not provoked runs (or 'jogs') on banks incorporated in that state.

European policy-makers have been reluctant to accept that the eurozone's decentralised nature makes it an inherently unstable currency union that forces its constituent states and 'their' banks into a pernicious and deadly embrace. On the face of it, all that changed at the June 29 summit, when member-states agreed to consider establishing a banking union. Among the features of such a union would be: a shared supervisory authority; a collective deposit protection scheme for the currency union; and a common resolution framework for dealing with weak banks.

What, then, are the prospects of European leaders agreeing to establish a banking union along these lines? The idea of a banking union is sometimes spoken of as an easier route to 'mutualisation' (or federalisation) than issuing common debt – partly, the reasoning goes, because citizens do not understand what a banking union entails. But this is only true as far as it goes. Member-states have not committed themselves to establishing a banking union – merely to consider doing so. And the national obstacles to forming such a union remain formidable.

Some countries may balk at the prospect of the ECB supervising certain types of bank (which are often vehicles for patronage and politically-directed credit). They may resist giving a supranational body the power to liquidate national banks. A common deposit protection scheme may raise similar objections as those to a eurobond. And the European Stability Mechanism will not necessarily evolve into a European TARP, because politicians may struggle to accept that the national taxpayers to whom they are responsible should stand behind banks in other countries.

Moreover, even if governments could agree to a full banking union, this would still not be enough to fully stabilise the relationship between states and banks in the eurozone. One of the peculiarities of the eurozone is that sound banks within it can still be vulnerable to runs. The reason is that Greece is not California. Since the weakness of its public finance raises doubts about its continued membership of the currency, depositors face incentives to take money out of Greece to protect their savings from being redenominated into a currency that loses its value against the euro.

It is no mystery why the eurozone is arranged as it is, nor why there is such resistance to reorganising it. Its configuration simply matches political realities at national level. If the existence of federal institutions and functions reflects the commitment of individual states to the union in the US, their absence reflects the limits of individual states' commitment to the eurozone. Because Germany does not stand in relation to Spain the way Texas does to Florida (and is disinclined to do so), the eurozone is prone to strains that do not arise in the US and that threaten its survival.

The question now is whether the currency union's member-states can finally accept the logic of what they have created. It has become increasingly hard to see how they can will the survival of the eurozone and simultaneously oppose the very features that are critical to making it work. One such feature is a proper banking union. In June, European leaders gave themselves until the end of 2012 to consider setting up such a union. They may not have that time, and they cannot afford to fail.