European Banking Union Step Toward “Transfer Union”

The interconnectedness of European banks and states necessitates closer union.

In many European countries, two important but ailing institutions are currently interlinked: sovereign states and national banks. The interdependency between them explains in large measure why the continent’s leaders are contemplating a banking union.

A national bank tends to unofficially support its sovereign by buying government debt. An ailing financial system can by itself generate a large negative shock to the economy due to its function in allocating resources. This is especially true in Europe as it depends greatly on its banks for this function. Large, systematically important banks tend to be implicitly backed by their sovereigns. When either experiences considerable stress, the other suffers similarly.

The direction of causality is not always the same. In Ireland, a dysfunctional financial sector added too much debt to the sovereign when Dublin pledged to prop up its banks. In Greece, the amount of government debt generated a crisis which spread to its, and neighboring, financial systems.

When Mario Draghi decided in December of last year to provide an unlimited credit window to banks, it proved not enough to permanently instil confidence. Banks that have amassed assets on their balance sheet that may not look attractive remain fundamentally unstable. Indeed, given that the European Central Bank doesn’t necessarily operate as a “lender of last resort,” it has only put more strain on the balance sheets of sovereign states that are expected to save private banks from collapse. With this in mind, it was not a surprise that investors considered the €100 billion recently requested by Spain in support of its ailing banks as an addition to sovereign debt.

A banking union is seen as the next and a necessary step in “ever-closer union.” In view of all the other options that have been debated, most prominently eurobonds, the fact that a banking union is seen as the least worst compromise is telling.

The nature of eurobonds is comparatively simple and it is difficult to mask the fact that some countries would benefit from the fiscal discipline of others. A banking union is indirect and adds layers of complexity to the bailout process. Like the covered bond purchases of the European Central Bank during the worst of the crisis or more recent interventions, the direction of funds and who provides them is not obvious.

A European banking union, governed by the European Central Bank, would seek to correct two pressing issues. First, as deliberated above, it would decouple sovereign and banks’ balance sheets. It would give power to the European Central Bank and the European Stability Mechanism to directly support banks without having to go through the sovereign of that country. A common framework for member states should be more than able to cover the balance sheets of banks that are deemed systematically important.

Second, one prominent issue and fear has been bank withdrawals in the countries that have come under the greatest pressure. A pan-European deposit insurance would reduce the outflow for banks where there is fear of a banking collapse.

In a more general sense it would also coordinate banking supervision and regulation. As the Bank for International Settlements states in its annual report (PDF):

The conclusion is hard to escape that a pan-European financial market and a pan-European central bank require a pan-European banking system. Put slightly differently, a currency union that centralizes the lender of last resort for banks must unify its banking system. Banks in Europe must become European banks.

With negotiations regarding the new framework beginning in September and the European Central Bank’s new powers coming to force beginning in 2013, there are a number of interesting aspects to pay attention to.

These changes will need to be defined and communicated for what they are — the reality of a “transfer union” will remain. In no way does a banking union and powers to directly recapitalize banks avoid this. Rather, as some banks are effectively shielded from the possibility of default, they may be induced to buy ever greater quantities of sovereign bonds.