10 September 2018

VOX: The transition to a banking union for the EMU

There is little agreement about the order and pace at which the elements of a banking union should be introduced. This is understandable, considering the current state of banks and governments finances within EMU. Authors outline three possible scenarios for the transition process. More scenarios are possible, but these three demonstrate the trade-offs between risk sharing and risk reduction (Bénassy-Quéré et al. 2018).

All scenarios require a reduction in the number of non-performing loans within the EMU. Although banks do hold reserves for the expected losses due to non-performing loans, it is unclear whether they would prove to be sufficient.

Under the first scenario, risk-reduction and risk-sharing measures are implemented simultaneously (Goyal et al. 2013). This may mean that countries and banks that are in relatively good shape will be unintentionally or willingly (moral hazard) burdened with the risks of others from the past. For this reason, opposition to this scenario exists particularly in the northern EMU countries.

Under the second scenario, the problems at weaker banks must be solved first, before the banking union could be completed. Under this scenario, the emphasis is on risk reduction and only at a later stage on risk sharing. Addressing the problem of non-performing loans would take time and/or additional capital. Italian banks would need a total of €37 billion in additional capital in order to be able to write off 20% of non-performing loans and implement risk weighting (Soederhuizen and Teulings 2018).

EMU remains vulnerable during this period of transition. In the short run, the bank–sovereign nexus would not be severed and there would still be conflicts of interest on both national and European levels. This would partly be due to the fact that a European Deposit Insurance Scheme would not yet be implemented, and, therefore, any bank insolvency could still have a national impact.

Adopting a middle course would make further risk sharing conditional on achieving risk reduction. In this scenario, the pace of implementing risk sharing depends on the progress made in risk reduction. Such progress could be assessed on an annual basis, and any subsequent steps would only be taken after a certain amount of progress had been established. Each year, the European Deposit Insurance Scheme could, for instance, cover a larger share of deposits, which could be made contingent on sufficient numbers of non-performing loans being resolved (Gros and Schoenmaker 2014). This would provide the incentive to reduce the existing risks as well as allowing for more risk sharing. A complicating factor here would be the annual assessments and/or negotiations about the progress made on risk reduction.

None of the scenarios is optimal for all countries. Under the first scenario, in which both risk reduction and risk sharing are implemented relatively rapidly, there is the chance of the northern countries being presented with part of the bill. Under the scenario in which first all problems must be addressed and solved, EMU would remain vulnerable to shocks for a longer period of time. The scenario in which risk sharing is made contingent on risk reduction would require making complex, annual political choices. Waiting too long to implement measures may lead to a situation in which solutions need to be found under the pressure of a new crisis. Although the pressure of a crisis might conceivably force decisive action, it most likely would not result in the most efficient outcome. Any repercussions would then also be felt all over Europe.

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