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Retail banks from any country in the European Union, and indeed in the wider European Economic Area, are entitled to operate in other countries as branches, supervised by their home country, with the host country having minimal influence over the quality of that supervision or the adequacy of capital solvency. Icelandic banks were therefore able to raise deposits in Britain, not subject to FSA supervision. But when they went bankrupt, Iceland could not afford to bail them out or to compensate depositors – the banks were simply too large relative to Icelandic GDP, ‘too big to save’.
Should we head towards more European integration to enforce a common prudential regime which would guard against such failures; or towards less Europe, with banks from other countries having to operate as subsidiaries, and subject to the capital and liquidity requirements of each country?
The regulatory answer has been largely ‘more Europe’ – the establishment of the European Banking Authority and the European Systemic Risk Board, rather than a removal of cross-border branching rights. But on the ground, in terms of what banks actually do, the trend has been rather the other way – the role of cross-border retail branches is less important than before, in part probably because depositors have become more aware that if a bank branch fails they cannot rely on bailout being repeated, and will be dependent on the deposit insurance scheme of the home country. But the issue of ‘more Europe or less Europe’ certainly has not gone away – indeed, it has become more complex and pressing as the financial crisis of 2007-08 has morphed into the eurozone travails of 2010-12.
In a barrier-less single market, credit can in fact flow in a perverse fashion, misallocating resources: and the consequence of a regional bust may be increased by the economic inter-relationship between local companies, households, banks and the state. These factors apply within the eurozone, but to a far greater extent, making current account imbalances more relevant than between US states, for three reasons:
As a result, the economic prospects and creditworthiness of the households, companies and the banks within one country, and of the national government, are more closely correlated within eurozone countries than within US states. A correlation made worse if, as was the case in Ireland, the government’s tax base was heavily skewed toward precisely those sectors, in particular property, most likely to be subject to boom and bust effects. Patrick Honohan’s report of May 2010 showing how ‘cyclical taxes’ which vary strongly with the domestic economic cycle, increased from 8 per cent of Irish government revenues in 1987 to 30 per cent in 2006.
The eurozone is therefore inherently more susceptible than the US to developments which would contradict the conventional wisdom that current account imbalances do not matter within a single currency zone.
At the core of the imbalances within the eurozone was therefore the very ease of credit flows, and the very completion and deepening of the internal financial market, which were seen as overt and positive objectives both of single market completion and of the single currency itself.
Such a conclusion would of course be impossible if we could assume that credit only ever flows to finance long-term viable investment projects. But if it can flow to support unsustainable real estate booms, greater freedom of credit flow and greater freedom to create additional credit can be harmful not beneficial.
Yes it is clear that current account balances within the eurozone can matter: and that several countries now face important competitiveness as well as fiscal challenges. But we should also recognise that in some eurozone countries – and in particular in Ireland and Spain - the underlying problems were those created by private capital flows and private credit creation, interfacing with fiscal and banking systems whose structural characteristics increased the correlation between corporate, household, banking system and sovereign risk.
Because of these structural vulnerabilities, any micro-level benefits of deeper single market completion arising from the move to a single currency have been overwhelmed by adverse macro-economic consequences. And as a result we are left now with the fundamental problem of a toxic inter-relationship between bank and sovereign credit risk.
One crucial lesson we have learned in the wake of the crisis is that the harm produced by macro-instability – the losses to wealth and employment induced by financial crises and subsequent recessions – massively outweighs any micro-efficiency benefits available from making financial markets marginally more complete and efficient. That lesson should inform our redesign efforts at both European and global level.