The heads of state and government also agreed that the ESM should backstop the Single Resolution Fund (SRF) in a step towards completing the banking union. If, in the event of a bank resolution, SRF funds proved insufficient, the ESM would then provide a loan to be repaid by the banking sector at a later date.
In principle, this common backstop is appropriate because euro area's significantly important banks are already subject to joint supervision. But before it comes into force, banks' balance sheets need to be free of legacy assets. If not, risks that arose under national responsibility would subsequently be communitised.
The same questions arise, and are even more pressing, in connection with a different topic - namely the proposed single deposit guarantee scheme. It could well increase the credibility of depositor protection in Europe and thus reduce the risk of a bank run. However, several conditions need to be met in order to align action and liability and to avoid moral hazard.
First and foremost, the legacy risks lurking on European banks' balance sheets need to be eliminated. For example, many banks are still sitting on a huge mountain of non-performing loans.
While it is true that the average non-performing loans ratio has fallen considerably in Europe since 2014, the problem largely concerns individual, hard-hit countries. In more than one-third of EU countries, the non-performing loans ratio is still above 5% - in some cases, well above it. Just for comparison purposes, the figure in the United States and Japan is around 1%. What's more, banks' risk provisioning to date is nowhere near enough to cover all losses that could result from non-performing loans.
Looking at government bonds, the situation isn't much better. Many banks hold large stocks of domestic sovereign bonds that are backed by little to no capital, thereby chaining themselves, as it were, to the solvency of their national governments. For instance, holdings of domestic government bonds currently account for around 10% of Italian banks' total assets, which is actually in excess of their capital levels.
There is a risk of unsound public finances taking their toll on banks, ultimately resulting in the deposit guarantee scheme having to come to the rescue. For that reason, it is not just about cleaning up banks' balance sheets to get rid of legacy assets in the here and now. There is also need to prevent an excessive amount of risk from ever building up again in future - risk that would then be transferred to other countries through a single deposit guarantee scheme.
The sovereign-bank nexus thus needs to be severed once and for all in order to pave the way for a single deposit guarantee scheme. Banking regulation lies at the heart of the problem. Up to now, government bonds have been given preferential treatment over loans to the private sector and households.
On the grounds of prudence, this special treatment is not warranted and needs to be stopped. After all, the debt crisis clearly refuted the notion that government bonds are risk-free. It would therefore be a mistake to create a single deposit guarantee scheme without first ensuring that all the conditions are met.
When it comes to reforming monetary union, thoroughness should be put before speed. Mr Weidmann would prefer to take small steps in the right direction than large strides in the wrong one.
Full speech
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