14 May 2018

PIIE: Completing Europe’s Banking Union means breaking the bank-sovereign vicious circle

A narrow interpretation, based on euro area leaders’ past commitments, equates it with breaking the bank-sovereign vicious circle; a more ambitious long-term vision for complete banking union implies the removal of all cross-border distortions within the euro area banking market. Even the minimalist version, however, entails more reforms than those publicly under current consideration.

 “Banking union” has become a widely used expression to refer to the project of shifting banking-sector policy instruments from the national to the European level, but there is no official or legal definition of what it is or should be.

Euro area leaders, however, associated banking union from the start with a clearly stated objective, namely that “it is imperative to break the vicious circle between banks and sovereigns.” It refers to the mechanism by which sovereign risk and bank risk are highly correlated with each other in Europe’s monetary union. Thus, a major banking-sector problem will cause fiscal, and conversely, reckless fiscal management will result in a credit squeeze; the ensuing financial fragmentation across country borders impairs the operation of area-wide monetary policy and ultimately risks a break-up of the monetary union, giving rise to redenomination risk. This vicious circle, also referred to as the euro area’s “doom loop,” is best understood as a combination of direct and indirect financial linkages.

A “complete” banking union, then, must include a policy framework in which the bank-sovereign vicious circle is broken. This is evidently not yet the case, as many of the linkages have remained essentially intact since the start of banking union almost six years ago.

A maximalist version of “completing the banking union” would remove all national determinants of banks’ activity and business models, thus fulfilling the promise of a perfect internal market in which all cross-border competitive distortions have been eliminated. This maximalist agenda, which may be labeled a “single-market banking union,” has many things in common with the European Commission’s ongoing effort towards a capital markets union. Like the latter, it is a worthwhile long-term project that cannot realistically be completed any time soon.

The bank-sovereign vicious circle can arguably be broken with a much more limited package of policies that would address the critical linkages. This comparatively more modest approach may be called a “no-doom-loop banking union:” falling far short of the fully-fledged single-market banking union, but good enough to declare mission accomplished with a straight face. A recent Franco-German euro report outlines one possible way to do that. It suggests:

• a European deposit insurance scheme that guarantees all covered deposits in the euro area identically and unconditionally (banks’ contributing fees would remain differentiated on a national basis, to account for the differences that will persist as long as a single-market banking union is not achieved);
• sovereign concentration charges, i.e. a regulatory incentive for euro area banks to diversify their sovereign exposures within the area but away from their home country; and
• phasing out restrictions on cross-border pooling of capital and liquidity by multinational banks within the euro area, thus encouraging cross-border integration that will mitigate the indirect linkages.

Implementing such an agenda would inevitably entail a long transition period, but the corresponding policy choices are sufficiently straightforward and commonly understood for policymakers to make binding decisions shortly.

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© Peter G Peterson Institute for International Economics