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European banking union done properly

A manifesto by economists in Germany, Austria and Switzerland

Michael Burda, Hans Peter Grüner, Frank Heinemann, Martin Hellwig, Mathias Hoffmann, Gerhard Illing, Hans‐Helmut Kotz, Tom Krebs, Jan Pieter Krahnen, Gernot Müller, Isabel Schnabel, Andreas Schabert, Moritz Schularick, Dennis J Snower, Uwe Sunde, Beatrice Weder di Mauro, 9 Jul 2012

As originally written at VoxEU.org

The EU Summit decision on banking union is being questioned by some economists in Germany. This column argues that a banking union is a critical step in ending the EZ crisis and building a more stable EZ financial architecture. It is a translation by Michael Burda of the German-language manifesto drafted by the First Signatories listed below and signed by over 100 economists.

The financial crisis has exposed a fatal flaw in the design of European monetary union which can be removed only by decisive policy action. Policymakers in Europe now have an opportunity to change the game. A central aspect of this problem is the conflation between debt of the private sector and that of European national governments.

In the course of the crisis, fiscal budgets are being tapped to refinance systemically relevant financial institutions. At the same time, financial institutions continue to play a central role in financing national governments, lending money to them and holding their debt. An unavoidable consequence is that bank failures have led to sovereign debt crises and sovereign debt crises have led to banking crises, leading to growing mistrust of both national banking systems and government finance. The situation is aggravated by the fact that international investors, driven by fear of total collapse, have withdrawn funding to struggling countries, both for governments and for banks. This has in turn led to a balkanisation of national financial markets and threatens not only the European monetary union but the European integration project as a whole.

Only by breaking the link between the refinancing of banks and the solvency of national governments will it be possible to stabilise the supply of credit in crisis countries. If the refinancing of banks – and the insurance of bank deposits – can be made independent of the financial state of the respective domiciling country, national sovereign crises can be decoupled from the private sector financing. In this way, contractionary demand shocks induced by corrective national fiscal policy can be softened by a broadening of the supply of credit. A European backbone to the refinancing of banks will dampen the impact of the coming fiscal consolidation. An indispensable requirement for this is a set of uniform regulatory banking standards which are implemented by a single European authority.

Deeper financial integration and a de-coupling of government and banking finance are essential elements for a more stable financial architecture in Europe. These steps are important for breaking the vicious circle between sovereign debt and banking crises. A monetary union with free capital flows cannot work reasonably without a unified banking framework. For this reason, the decisions of the last EU summit represent a move in the right direction. Now it is crucial to implement these decisions, in order to create a durable solution with uniform European structures.

In no way does this endorse a collectivisation of bank liabilities. Rather it is essential to cede key powers of regulatory intervention in member countries to a banking supervision authority at the European level. This European banking supervision authority should have the ability to authorise rapid recapitalisation of troubled banks. In extreme cases, this may mean the expropriation of previous equity holders and the partial conversion of bank debt into equity. A unified resolution procedure must be capable of recapitalising, unwinding, or liquidating insolvent financial institutions in an impartial manner.

At the same time, creditors must be made liable for risky investments, so that the resolution of troubled financial institutions can be executed without taxpayer money. In order to secure the financial stability of a banking union, a common restructuring fund that can intervene and impose binding conditionality on reorganisation plans is needed. The ESM can play this role. A stronger Europe-wide deposit insurance system can also contribute to the long run stability of the banking system.

Only a European banking supervisory authority with sweeping intervention powers can break the linkage between the financing of governments and of banks. It would represent an important step towards solving the problems presently faced by the Eurozone. In contrast, it is much more difficult to intervene directly in the fiscal affairs of Eurozone states – this would require a process with democratic legitimacy, which remains a very remote option at the present. A banking union is thus only part of a complete solution. The mechanisms and budgetary controls that would be implemented in the framework of a European Fiscal Pact are also needed to restore public budgets to sustainable paths.

A banking union can help decisively to secure the financial integrity and stability of the European monetary union. For this reason, the signatories of this manifesto support the creation of a durable, unified framework at the European level which can serve to break the link between the funding of private banks and the public purse.

Editor’s note: This is the English translation of the manifesto that has more than 100 signatories. The original, German-language version can be found here.

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2 Comments

  1. David Lazarus says:

    Yes ending the sovereign duty to act as lender of last resort is essential if the crisis is to be solved. The problem I see is that the sovereigns should not be impaled on the new bail out hook via a euro bond. The banks need to have substantial capital injections and reductions of loans issued to become solvent again. Most banks will not survive. There needs to be a reset of the entire banking system. Even Italy was more prudent than many banks.

    If banks were then broken up so that no bank had more than 500 branches that would create competition, ends too big to fail problems. If big companies need big banks then they are also too big. Investment banking should be done by partnerships and as such they would never had taken such stupid risks. We also need to look at the problems of capital flows. They enable deficit nations to go on for too long and stops both creditor and debtor nations alike from structural reforms.

    As far as I can see the current plans are only extend and pretend on a continental wide basis, dragging in every other sovereign. That cannot last and will destroy European peace. There will be recriminations over this and I suspect open hostilities will follow. The only question is how long can they hold this bubble up?