The European Banking Union: An Insufficient Compromise

by Koen Maaskant. Originally published on 2014/02/10

In a reaction to the previous article published on the European Banking Union, this article further elaborates on and criticises the working of this new EU mechanism.

“Today is a momentous day for the banking union. A memorable day for Europe’s financial sector. […] We are introducing revolutionary changes to Europe’s financial sector. Finally learning all the lessons of the crisis”. By using these words commissioner Michel Barnier framed the agreements made in December 2013 that aimed at establishing a strong banking union as a great achievement which will prevent the Eurozone from any disasters similar to the current Euro crisis.

However, are such words really labeling this agreement in the right way? This article aims at describing the main functions of the European Banking Union as proposed by this agreement and point at some possible flaws.

After the occurrence of problems in several countries that affected the Eurozone as a whole, policymakers and academia pointed at the need of breaking down the link between banks and sovereign states. Financial sectors had to be saved by governments, leading to sovereign debt crises. For example, Ireland eventually needed financial support from the EU and the IMF in order to stick to the guarantee of its major banks that were in trouble because of a property bubble.

The three pillars

Through a centralized banking union, this link between banks and sovereigns could be broken down. More specifically, the banking union should consist of three so-called “pillars” as explained in the former article on the banking union: (i) a single supervisory mechanism, (ii) a single deposit guarantee scheme, and (iii) a single resolution mechanism.

The least controversial issue has been the establishment of a single supervisory mechanism through transferring the supervision of the financial sector from national banks to the European Central Bank (ECB). The agreement made at the end of 2013 puts forward the ECB as the main supervisory body from November 2014 onwards. However, before the ECB can start supervising banks, all banks within Europe will have to pass a stress test that is said to be rigorous enough to reveal almost all potential problematic assets and liabilities. After this cleaning operation, supervision from Frankfurt will focus on the biggest 150 banks that represent roughly 80% of all bank assets.

The second pillar constitutes a single deposit guarantee scheme through which everyone is guaranteed € 100,000 in case of a bank failure. Through harmonizing the guarantee schemes in the Eurozone the banking union aims at strengthening confidence in the safety of the people’s deposits.

The most debated pillar has been the single resolution mechanism, which tries to create a common procedure for the resolution of failing banks through the establishment of a fund that can provide banks with financial assistance. As strongly advocated by Germany, this fund will be fully funded by the banks themselves through a levy. Eventually, the fund should hold 55 billion euros around 2025. As Germany and its allies are not willing anymore to pay for any other failing banks in the Eurozone, it has been decided that during the transition period until 2025 banks will have to be bailed out by national governments and can only depend on the current ESM fund in exceptional cases.

Flaws in the system

Even though these three pillars seem to be able to address the problems associated with the bank/sovereign link, several flaws of the current proposal should be considered and further investigated. Possibly the most important problem of the agreement has to do with the single resolution mechanism, which has been created in such a way that the process of bailing out or shutting down banks will have to go through several committees before a decision can be reached. Not only does the European Commission have a say, representatives from each member state will be able to contribute to the decision making process and a new agency will be established that will also have a vote. According to Annalisa Piazza of Newedge, “from the moment a bank is identified as being at risk, up to the moment it is closed, the new system might require approvals from as many as 100 people”. As the recent crisis has shown that this process normally requires the ability to make quick decisions, often in only the short period of a weekend, the current plan with the involvement of so many policy makers is likely to be too extensive and too slow.

Moreover, Germany has raised concerns that the ECB’s new supervision tasks might inflict their regular monetary policy. A compromise has already been reached by letting the ECB only supervise the major banks of the Eurozone, rather than all banks. However, the problem remains that the ECB might take into account the position of some of the banks that it will supervise when setting its interest rates.

Another detail that needs further investigation is how the Eurozone will deal with failing banks until the fund will be filled by 2025 with money from the banks. Even though Germany and other northern European countries are not willing to let their taxpayers pay anymore for these bailouts, it would strongly affect the confidence in the Eurozone as a whole and the home countries of these potentially failing banks in particular in case a single country is responsible for the resolution of its failing banks, as shown by the current crisis.

The Euro crisis taught us that reforms are needed and that a monetary union cannot exist without a banking union. Even though the changes proposed in December by the European leaders are promising, several issues need to be addressed before we can speak of revolutionary changes. Moreover, action is needed soon, as the political will within Europe to make these changes will soon fade away as a more sustainable economic recovery is on its way. The momentum currently created by the financial crisis should be used in order to counter a financial crisis to come.