Banking Union, now!

At the end of June, European leaders undertook to create a banking union and facilitate bail-out funds to directly recapitalize banks, should they need it. The European Commission will soon present its proposal regarding a European supervisory mechanism as part of the development of a route map to strengthen monetary union, which must be urgently studied by the Council of the European Union before the end of 2012.

The aim of this integrated financial framework is to put right one of the greatest structural deficiencies in the institutional system for European financial stability. Will Europe’s actions meet the expectations raised?

The European Central Bank defines financial integration as a situation whereby there are no frictions that discriminate between economic agents in their access to capital and their investment opportunities, particularly on the basis of their location. Under this conception, financial integration has a peculiar effect in the case of the euro area as bank intermediation on a national basis predominates in this financial market.

Over the two decades prior to the start of the crisis, the focus adopted prioritized efficiency over stability, trusting that market mechanisms would function properly. The main two elements of the institutional framework were free trade and establishment and the creation of the euro (eliminating exchange risk and simplifying transactions); always in line with the notion that bank control and supervision and deposit guarantees would be based on the bank’s country of origin.

European bank integration gradually gained ground, in terms of financial flows between countries and even in supranational mergers and acquisitions.

Particularly of note was the fast integration of equity and bond markets but this was also notable in areas of banking, especially wholesale financing markets (interbank, securitisation, etc.) and, to a lesser extent, in retail markets for loans and deposits. The serious, persistent crisis erupted within a climate that was complacent regarding this strategy, starting in the United States in 2008 and getting worse since 2009 with the problems of Greece and then other peripheral countries. The dynamics of financial integration came to an abrupt halt and have subsequently gone backwards.

The shortfalls and dysfunctions of the existing institutional system suddenly came to light. Authorities’ responses, given as they went along, often merely accentuated this fragmentation. The epicentre of these problems lies in the core of Europe’s financial system: banks.

The fact that the framework of supervision, recovery and resolution on which banking operates is national in scope rather than European has been a decisive factor in the withdrawal of banks to within their own borders.

The current crisis has made this system unviable. Bank control and supervision by the country of origin is of no use when a large bank encounters difficulties, due to its effects on other banking systems. Many countries lack the resources to bail out their main banks. The perverse link generated between bank risk and sovereign risk ultimately complicates any resolution to the crisis.

Financial support for Spain in recapitalising its banks reflects some of these problems and its implementation is closely related to the regulations on banking union that are being forged. The proposals of the EU Presidency, Commission, Eurogroup and the European Central Bank must set a course that helps to restore financial stability and relieves the pressure on European monetary union.