Does Europe need a banking union?

April 30, 2012

Does Europe need a “banking union” to shore up its struggling monetary union? And is it going to get one?

These questions are raised by the increasingly lively debate over how to break the link between troubled states in the euro zone periphery and their equally troubled banks. In some countries, such as Ireland, the lenders have made so many bad loans that they have had to be bailed out – in turn, dragging down their governments. In Greece and Italy, the banks have gorged on so many government bonds that they have been damaged by their state’s deteriorating creditworthiness. And, in Spain, the current focus of the euro crisis, a bit of both has been happening: banks made too many bad loans – and then bought too many government bonds.

One proposed solution to this incestuous relationship, advocated among others by the International Monetary Fund, involves creating a centralised Europe-wide system for regulating banks and, if necessary, closing them down and paying off their depositors. The idea is that the region’s lenders would be viewed as European banks rather than Spanish, Greek or Italian ones. If they got into trouble, they wouldn’t infect their governments; and vice versa. That would make the whole euro crisis easier to manage.

While the idea carries much theoretical appeal, such a fully-fledged banking union isn’t realistic. The incestuous embrace between governments and banks may be unhealthy, but that doesn’t mean politicians entirely dislike it. National oversight of lenders gives politicians all sorts of ways of meddling in their economies. And this is not just in the troubled countries. Relatively healthy states such as Germany and France would be loath to surrender the power to boss around banks to some supra-national authority.

Citizens in rich states wouldn’t like the idea of having to bail out banks that had gone on a binge in a completely different part of Europe either. What’s more, even if a centralised banking body was created, would it really have the clout to tell the big boys what to do?

A further difficulty concerns whether such a banking union should stretch across the euro zone or the entire European Union, which includes the United Kingdom, home to the region’s largest financial centre. Britain would argue that it shouldn’t be roped into a system that is designed to shore up the single currency it is not a part of. On the other hand, if the euro countries went ahead on their own, the single market in financial services would fragment.

Quite apart from the politics, a banking union wouldn’t actually solve all the problems. In particular, it would do nothing to stop banks owning too much government debt. Indeed, in the last few months, Spanish and Italian lenders have bought even more of this debt – using cheap money from the European Central Bank. This has helped finance their governments through a rough patch but at the cost of tying the banks’ fate even more closely to that of their countries. Over time, governments ought to be weaned off reliance on their local banks. But, realistically, this isn’t going to happen fast.

Does this mean that a European banking union is a totally dead idea? Not quite. It may be possible to cherry-pick bits of it. The most important part would be to create a Europe-wide “resolution” regime. The basic idea is that such a regime would allow insolvent banks to go bust in a controlled fashion. If shareholders haven’t put in enough capital, bondholders have to be “bailed in”. Only if bondholders also haven’t put in enough capital do deposit guarantee schemes – and possibly taxpayers – have to be activated to make sure savers are repaid. With such a framework, governments such as Ireland’s wouldn’t in future be infected by their lenders’ problems.

At present, many European countries lack such a resolution regime and those that do exist don’t collaborate effectively with one another. What’s more, until recently the European Central Bank has been hostile to the idea that bank bondholders should suffer any losses. It prevented Dublin from bailing in bondholders, fearing that this would trigger contagion.

The mood, though, is changing. The European Commission is planning to publish plans for an EU-wide resolution regime in June. Even the ECB has started lending its support to such a scheme. The devil, of course, will be in the detail. But there finally seems to be momentum behind this proposal.

A second idea that could be cherry-picked is to reinforce Europe’s deposit guarantee schemes. At the moment, every country has its own. The problem is that depositors in weak countries, especially Greece, don’t have confidence that their national schemes have enough money to pay out. So savers have been taking their cash abroad.

It is too much to expect that Germany, Europe’s paymaster, would agree to a euro-wide deposit insurance scheme. But what about some sort of reinsurance scheme? Nicolas Veron from the Bruegel think tank argues that the European Stability Mechanism, the euro zone’s soon-to-be-created bailout fund, could provide national schemes with a backstop.

Europe is not ready for banking union any more than it is ready for political union. But such ideas show there are practical ways of limiting the unhealthy nexus between lenders and their governments. Europe should grasp them.


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A half solution, the problem is that the basic levers of economic control are not contrlled by a single entity. Taxing and spending and state investment are controlled by individual countries but the European Union imposes requirements for the Euro, thereby controlling individual economic in a Fed-like manner, and by a policy without the representative concern for an individual economy (which should be the job of their individual governments).
The current system is dysfunctional, one goes they all go. The system needs to be tweaked, bring back national currencies and keep the Euro for its advantages, twin currencies, where each country can set its policies with respect to its economy but not drag down their neighbors if they make bad policy. Instead the value of their currency vs. the Euro would go down.

Agree that such basic banking rules should be imposed system-wide as a condition of continued membership of the Euro states, for the reassurance of all investing in other states.

Posted by George286 | Report as abusive

Two comments: 1) I think you are too negative on whether European Banking Union could help wean banks off their own government’s debt. It is clear that European governments have insisted on banks and insurers continuing to rate their debt as riskless. (This is why the US government insisted on imposing an otherwise illogical leverage ratio.) If instead the Eurozone were represented on the Basel committee, it might change this. A Eurozone regulator might also impose concentration limits on individual government’s debt.

2) I think you are two positive on the chances for a common resolution regime without a banking union. No country will agree to rules that force it to contribute its taxpayers money to bail out banks, so a common regime will only work with either a central bailout fund (which would effectively require a banking union) or with someone else to pay for the bailout. Europe’s hope has been to bail in bondholders to remove the risk to taxpayers, but the IMF points out in its recent paper on the subject points to the difficulties of introducing such a regime in the current circumstances: ‘For
instance, at the end of 2010, 10 out of 33 of the largest international bankswere refinancing themselves as if they were rated at speculative levels. Higher cost of funding over a long period of time could prompt bank managers to seek riskier assets or simply deleverage. A system-wide bank deleverage could hinder economic recovery.’ In other words, Europe needs to overcome its sovereign/banking crisis before implementing a bail-in regime.

Alan Watson

Posted by AlanWatson | Report as abusive

I agree with the article’s conclusion, but I must take issue with one of its premises:

“In some countries, such as Ireland, the lenders have made so many bad loans that they have had to be bailed out – in turn, dragging down their governments.”

The lenders did not have to be bailed out. Iceland declined to bail out their reckless lenders and their economy is now doing quite well.

I would even go so far as to assert that reckless lenders should never be bailed out. It’s ethically wrong and as southern Europe demonstrates, ineffective.

Instead, they should be punished in every conceivable way by their investors, the government and any other party who suffers financial harm. That would, of course, be very painful for the countries in which those banks are located, but so is the effect of the bail out.

The consequences of the American bank bail out and the more recent Eurozone bail out are still fermenting.

Posted by breezinthru | Report as abusive

breezinthru –

Iceland is doing so well that it’s on the verge of becoming a semi-autonomous territory of Canada (  /1140013–iceland-s-loonie-idea-adopting -canadian-currency):

Canada’s dollar and stable banking system look pretty good to some Icelanders these days.

With an election planned in Iceland for the spring of 2013, the future of Iceland’s currency is expected to be an issue, Gunnlaugsson said.

Any move to adopt the loonie would mean giving up control over Iceland’s monetary policy. In effect, it would make Mark Carney governor of both the Bank of Canada and Iceland, with the power to set interest rates and other monetary policies for both countries.

But some Icelanders say the trade off would be worth it if it helped stabilize the economy and attract foreign investment.

“No-one wants our currency. It’s as if you were forced to do business in Disney dollars,” Arsaell Valfells, a professor with the University of Iceland, told The Star in a telephone interview Friday.

Canada’s loonie is a good fit for Iceland because both countries are resource based, so the currency goes up and down with the value of commodities.

For Canada, closer ties with Iceland would increase its influence in the Arctic region, the last frontier for mining, oil and gas exploration, areas where Canada is a global leader.

The impact on Canada’s currency of selling sufficient loonies to Iceland to make the switch would be small, said Doug Porter, deputy chief economist with BMO Capital Markets.

Iceland’s population is just over 300,000 and its economy is less than one per cent of Canada’s.

Posted by TobyONottoby | Report as abusive

Walt Disney World still outperforming Iceland –

“Smile! . . . With millions of visitors annually, it’s no wonder the Disney parks are among the most photographed places in the United States. On any given day, Disney’s PhotoPass photographers take between 100,000 and 200,000 photos of guests at Walt Disney World Resort. The PhotoPass service allows guests to view, share and order their Disney photos online and create Disney products such as PhotoBooks and mugs.”

From “Walt Disney World Fun Facts”

Iceland tourism booms as currency plummets

“More than 10,500 Canadians visited the country last year, a rise of 68 per cent from 2007, contributing to an overall total of 502,000 tourists in the nation of just 320,000, according to Iceland’s tourism board.”
April 23, 2009

Posted by TobyONottoby | Report as abusive