POLITICO Nagel/Veron: Breaking the vicious circle between banks and sovereigns for good

23 October 2024

Twelve years after its initiation, it is time to complete the banking union.

Joachim Nagel is president of the Deutsche Bundesbank. Nicolas Véron is a senior fellow at The Peterson Institute for International Economics in Washington, DC, and at Bruegel in Brussels.

In the early hours of June 29, 2012, boldness and clarity came together. After a long night of negotiations, European leaders laid the foundations for the banking union project. They found strong and clear words on its purpose, stating “it is imperative to break the vicious circle between banks and sovereigns.”

The decision was taken in the aftermath of a twin crisis that had shaken the euro area — a sovereign debt crisis coupled with a banking crisis. The close links between sovereigns and banks had created a “doom loop”: sovereigns bailed out teetering banks, straining public finances, and rising sovereign bond yields put pressure on banks’ home-biased sovereign exposures. 

Such loops emerged as a particular vulnerability of the euro area, with its unique institutional setup as a monetary union of otherwise sovereign states, increasing the pressure on the eurosystem to save the day. The banking union was conceived as the sword that would sever the doom loop.

Today’s banking union is primarily the result of intensive legislative efforts between 2012 and 2014. They established a complete framework for supervising European banks, and an incomplete one for dealing with banking crises. This helped to mitigate the vicious circle, in particular by creating a Single Supervisory Mechanism under the European Central Bank and national supervisory authorities. That has proven its effectiveness, but the vicious circle has not yet been broken.

Before the lessons of 2012 are forgotten, the new EU term offers an opportunity to finish the task and break the vicious circle between banks and sovereigns for good. Action must go both ways. First, block the direct contagion channel from banks to sovereigns. Taxpayers should not have to suffer when banks run into problems. Second, close the contagion channel from sovereigns to banks. A sovereign credit event cannot and should not be ruled out in a monetary union with sovereign fiscal policies at the national level. At the same time, it must not be permitted to drag down banks with it and thus further jeopardize financial stability.

The first aim calls for strengthening the crisis intervention framework. Valuable progress has been made with the establishment of the Single Resolution Board and the Single Resolution Fund. 

The latter has reached its target level, currently at €78 billion, after a decade of build-up. However, a more streamlined and predictable framework is needed. Specifically, resolution should be a credible and feasible option to manage more, if not all, failing banks under EU law, instead of the current confusing mix of European and national procedures that leaves too much scope for national state aid and moral hazard....

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