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What made the crisis so costly in terms of output and employment was not the higher risk premia on government debt per se, but the tight link between governments and bank finances, combined with the predominance of bank financing throughout Europe. The ‘doom loop’ acted as a crisis amplifier whereby weak governments increased the cost of financing for banks and the difficulties of banks then depressed the economy, which then weakened both governments and banks even further.
Eurozone leaders finally recognised this problem when they decided in the summer of 2013 to create a system of banking supervision and a common institution to restructure banks in difficulties. This combination has been dubbed Banking Union, but, while important and helpful, what has been done so far is not sufficient to prevent the recurrence of crisis. The Banking Union should be completed and complemented with other measures to weaken the link between national governments and national banking systems.
Two issues in particular need to be tackled:
The two issues need to be tackled in tandem for economic and political reasons, but the required solutions are quite different in nature – diversification of sovereign debt holdings can be enforced by a low-level change in some obscure details of banking regulation (and maybe even by the ECB on its own). A common deposit insurance requires the creation of a new institution. [...]
Conclusions
Nation states are usually able to deal with small shocks themselves, but they need support when the shock is so large that access to the capital market is impaired (Gros 2014). In completing the Banking Union, one should heed the lessons from the economics of insurance and provide protection against large, systemic shocks. Nation states could remain responsible for deposit insurance for the occasional individual bank failure. But a common fund is needed to provide re-insurance when the shock is so large that it would overwhelm national resources.
A similar principle should be applied to banks – they should be able to survive the failure of any one of their debtors, including the failure of their own government. But this means that banks should not be allowed to lend more than a fraction of their capital to their own government.
Peripheral governments still resist mandatory diversification of sovereign risk for banks, but would like more risk-sharing through a common deposit insurance. Germany has taken the opposite position. The package of sovereign-risk diversification by banks and risk-sharing through re-insurance of deposit insurance could represent a political compromise that makes economic sense as sovereign risk diversification by banks would lower the danger of systemic crisis caused by imprudent fiscal policy.