The banking union that wasn't

If the German position prevails, we'll see something called a European banking union announced and celebrated. But it won't be the real deal, and it won't be enough to make Europe's financial system work.

It has been the eurozone’s misfortune that governments become complacent the very minute the European Central Bank starts to act. We saw it last year when the ECB injected €1 trillion into the banking system, and when the crisis resolution process immediately stalled. You see it now in Spain, where Mariano Rajoy is refusing to make a formal application for a full rescue program. The fall in bond spreads has taken the pressure away.

But nowhere is the onset of complacency more evident than in the ongoing discussion about a banking union. I always suspected that Germany would turn out to be the stumbling block. And I was not surprised to read Wolfgang Schuble in the Financial Times on Friday arguing that the ECB cannot conceivably supervise 6,000 banks – which the European Commission will propose next week. Michel Barnier, finance commissioner, says it makes no sense to limit a system of bank supervision to the largest banks. Northern Rock, Dexia and Bankia would all have fallen outside the remit of a central European regulator. The largest eurozone banks are much less of a problem than the countless undercapitalised regional banks run by people with no understanding of the risks they are taking.

Germany’s public banks, savings banks and mutual banks are lobbying hard not to fall under a European system. Their business models rely on a friendly neighbourhood regulator looking the other way. If you imposed stringent controls on the German banking systems, the cosy relationship between industry and banks would be disturbed. The Germans see Barnier’s proposal as an attack on their economic model.

If the German position prevails – and it may well do – the project of a banking union will have irrevocably failed. There will be something called a banking union, announced and celebrated. The EU will congratulate itself, but it will be largely irrelevant to the workings of the financial sector. The eurozone will remain a monetary union with nationally supervised and crisis-prone banks for the foreseeable future.
Germany’s expressed preference to restrict centralised supervision to 25 banks reminds me of the debate about the EU mergers and acquisitions regime in the late 1980s. The disagreement between member states was solved through a size threshold. The European Commission would deal with large cross-border mergers, member states with the rest. Germany now applies the same thinking to the question of banking supervision. Schuble and his colleagues are looking at this from the perspective of competition policy, not financial stability, which is absurd. They fear an erosion of their own competitiveness. Once again, national interests take priority over the eurozone-wide common good.

A robust system must give a clear and positive answer to this question: who takes the final decision over whether to force a bank to raise capital, or whether to close down a bank? If it is the ECB, then we are at the right side of a compromise. If not, for example if the ECB has to consult with local regulators, nothing much will change, except to involve more people in a convoluted process. A proper banking union is the bare minimum for the eurozone to function, because the banking sector intermediates the imbalances that have arisen in the real economy. In the absence of a fiscal union, this is where transfers can take place – through deposit insurance and bank recapitalisations. Ideally, you would have both. But without either, the system cannot function.

Mario Draghi reminded us in an essay in Germany’s Die Zeit that the US Federal Deposit Insurance Corporation has been closing down an average of 90 banks per year. The EU has a lot further to go in deleveraging and recapitalising. And yet, the Spanish government continues to insist that there should not be a single bank closure. The purpose of a banking union is not symbolism, it is to restructure and recapitalise the banking system, and to share financial risk. The eurozone is not sustainable without it.

Even Barnier’s proposal, far-reaching as it may be, will not be sufficient. A banking union requires more than just an agreement on a central regulator. It would have huge implications for national law. For as long as national insolvency and labour laws diverge, the central regulator cannot just walk in and fire directors, or close down a bank. The banking union needs to be backed by a harmonisation of commercial and labour laws as they apply to banks – or better still, it should take the banks completely out of national jurisdiction.

If I had one piece of advice for Draghi, it would be this: do not accept an unlimited bond purchasing program without an agreement on a credible banking union. The issues are not directly linked, but without a stabilisation of the financial sector, no ECB bond purchasing program can succeed in the long run.

Copyright The Financial Times Limited 2012.