A banking union baby step

July 03, 2012, Tuesday/ 11:53:00

BRUSSELS – At the beginning of the financial crisis, it was said that banks were, in Charles Goodhart's crisp phrase, “international in life, but national in death.” At the time (2008-2009), large international banks had to be rescued by their home countries' governments when they ran into trouble. But the problem now in Europe is the opposite: banks are “national in life, but European in death.”

In Spain, for example, local savings banks (cajas) financed an outsize real-estate boom. As the boom turned to bust, the losses threatened to overwhelm the capacity of the Spanish state, and the problem became European, because it threatened the very survival of the euro.

The Spanish case is symptomatic of a larger problem. National supervisors always tend to minimize problems at home. Their instinct (and their bureaucratic interest) is to defend their countries' “national champion” bank(s) abroad.

But their resistance to recognizing problems at home runs even deeper. Until recently, the Spanish authorities maintained that the problems in their country's real-estate sector were temporary. To acknowledge the truth would have meant admitting that for years they had overlooked the build-up of an unsustainable construction boom that now threatens to bankrupt the entire country.

In the case of Ireland, the situation was initially not much different. When problems started to surface, the finance minister at the time initially claimed that the country would carry out “the cheapest bank rescue ever.”

Given national supervisors' predictable tendency not to recognize problems at home, it seemed natural that the cost of cleaning up insolvent banks should also be borne at the national level. It thus seemed to make sense that even in the eurozone, banking supervision remained largely national. The recently created European Banking Authority has only limited powers over national supervisors, whose daily work is guided mainly by national considerations.

But reality has shown that this approach is not tenable. Problems might originate at the national level, but, owing to monetary union, they quickly threaten the stability of the entire eurozone banking system.

At their June summit, Europe's leaders finally recognized the need to rectify this situation, transferring responsibility for banking supervision in the eurozone to the European Central Bank. Given that financial integration is particularly strong within the monetary union, putting the ECB in charge was an obvious choice.

Moreover, the ECB already bears de facto responsibility for the stability of the eurozone's banking system. But, until now, it had to lend massive amounts to banks without being able to judge their soundness, because all of that information was in the hands of national authorities who guarded it jealously and typically denied problems until it was too late.

Putting the ECB in charge should also help to stop the creeping disintegration process, which is not publicly visible, but is very real nonetheless. Just ask any of the large international banking groups headquartered in financially stressed eurozone countries.

Consider the case of a bank headquartered in Italy, but with an important subsidiary in Germany. The German operations naturally generate a surplus of funds (given that savings in Germany far exceed investment on average). The parent bank would like to use these funds to reinforce the group's liquidity. But the German supervisory authorities consider Italy at risk and thus oppose any transfer of funds there.

The supervisor of the home country (Italy) has the opposite interest. It would like to see the “internal capital market” operate as much as possible. Here, too, it makes sense to have the ECB in charge as a neutral arbiter with respect to these opposing interests.

But, while putting the ECB in charge of banking supervision solves one problem, it creates another: can national authorities still be held responsible for saving banks that they no longer supervise?

Economic (and political) logic requires that the eurozone will soon also need a common bank rescue fund. Officially, this has not yet been acknowledged. But that is often the way that European integration proceeds: an incomplete step in one area later requires further steps in related areas.

This incremental approach has worked well in the past; indeed, today's European Union resulted from it. But a financial crisis does not give policymakers the time that they once had to explain to voters why one step required another. The will have to walk much more quickly to save the euro.

Daniel Gros is Director of the Center for European Policy Studies. Copyright: Project Syndicate, 2012.

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