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Dec 27, 2017 | 19:53 GMT

8 mins read

Dim Chances for a European Banking Union Breakthrough

When Mario Dragui, seen through the lens of a television camera, steps down as the head of the European Central Bank in 2019, the odds-on favorite to replace him will be Germany's Jens Weidmann.
(Thomas Lohnes/Getty Images)
  • Negotiations over the future of the European Union in 2018 will include talks on completing a banking union, which would first require the creation of a blocwide deposit insurance system.
  • The deposit insurance scheme faces strong German and Dutch opposition based on their reluctance to share risk with Southern European banks, which they view as too fragile.
  • Proposals to address the issues of nonperforming loans and sovereign debt exposure may not be enough assuage the Northern European concerns.

Since the start of this decade, Europe has contended with financial crisis, a migrant influx and a wave of political insurgency. Now, with elections in the major EU economies complete, the bloc's leaders are looking forward and will undertake difficult negotiations in 2018 with the potential to shape the future of the European Union. The talks will help answer a fundamental question that has long loomed over the bloc: Does its future lie in deeper integration or in looser ties among its members, or will the status quo prevail? Of all the topics under discussion, the most difficult — and arguably most important — negotiations will focus on the vexed subject of a European banking union. If Europe is indeed to integrate further, the next major step would be to complete the unfinished banking union. To do so would require all states in the eurozone to participate in a mutual deposit insurance scheme. But strong opposition to that idea by Germany and the Netherlands could stall progress on the banking union in 2018.

The banking union was launched off the back of Europe's sovereign debt crisis at the start of the decade. One of Europe's largest problems during the crisis had been the amount of sovereign debt that European banks held on their books, which set up the specter of a so-called "doom loop." This refers to the danger that if financial or economic crisis hit a country whose banks owned large amounts of sovereign debt, solvency problems would be transmitted from the banks to the government and back, leading to an insoluble self-reinforcing death spiral. To head off that possibility, it was suggested that instead of national governments being the sole guarantor of the solvency of their own banks, the risk instead should be spread out. This involved the creation of new rules providing that a bank's own investors would take the first hit in a crisis by being "bailed in" (as opposed to being "bailed out" by the national government/taxpayer) if extra funds were needed. Furthermore, the new rules provided, eurozone banks would all pay into a common deposit insurance pool that would spread the risks of a bank failure across all the banks in the currency union, instead of putting the onus on each national government alone.

European Banks and Their Exposure to National Government Debt

The first part of the banking union was established fairly smoothly. A supervisory institution (now under the authority of the European Central Bank) was set up to oversee the union, and the bail-in rules were phased in over the past few years, coming into full force at the start of 2017. The bail-in provisions have proved controversial — in fact, they were bent somewhat when political exigencies made bailing in Italy's banks impossible — but nevertheless, the Banking Recovery Resolution Directive, however shaky, remains in place. A modest Single Resolution Fund to be used to help faltering eurozone banks after bailed-in investors are tapped is also in the process of being accumulated, though with a final target size of 55 billion euros (roughly $65.4 billion) in 2023, this will never be a substantial tool. (By way of comparison, the 2012 bailout of Spain's banking system alone required 54 billion euros.)

The next piece of the banking union puzzle, then, would be the creation of a European deposit insurance scheme, in which eurozone banks share risk by pooling their national deposit insurance schemes internationally. But establishing the overarching fund has been easier said than done.

Problems With No Easy Solutions

Germany and the Netherlands have led a staunch resistance to the idea of pooling financial risks with banks in the Mediterranean bloc that they view as too fragile. The issue has been under discussion since 2015, but almost no progress has been made. The Germans and Dutch maintain that risks among eurozone banks are too great and that they must be reduced before Northern European countries would be willing to share them. Specifically, those countries have raised two main objections to participating in common deposit insurance: That the levels of nonperforming loans held by banks in Southern Europe are too high and that those banks are still too exposed to their governments' debts. But given the complexity of those issues, they will take a long time to solve — a problem for those eager to establish the common deposit insurance pool.

The experiences of Ireland and Portugal illustrate the difficulty of tackling the issue of nonperforming loans (defined as loans in which scheduled payments are at least 90 days overdue, putting the loan in default or near default). Both countries were at the center of the sovereign debt crisis, and both received bailouts from the European Union near the height of the crisis that were intended to fix their banking systems. Since then, both economies have experienced several years of strong growth, and while neither banking system appears to be in trouble, the underlying loan issues haven't gone away. Portuguese and Irish banks remain saddled with high rates of nonperforming loans, ranking among the top in Europe. Italy, meanwhile, which neither received a bailout nor has enjoyed the same strong economic growth, is further back along the same curve. And with its much larger economy, all the numbers involved are also larger.

Eurozone Debt Crisis: Hardest-Hit Member States

Italy is also at the center of the second issue, which concerns banks holding their government's sovereign debts. The Italian government is the most indebted in the eurozone, with current debt levels equaling 132.6 percent of its economy's annual gross domestic product. Such indebtedness can present problems via high interest repayments, but Italy has been spared these thus far, partly thanks to the European Central Bank's bond-buying campaign. But the central bank has already begun tapering such purchases, a trend that it's likely to accelerate next year. Italy may soon see its interest repayments climb. Against this backdrop, any suggestion from Northern Europe that Italian banks should sell off the Italian government bonds they hold, driving down prices and further driving up government interest rates, is a nonstarter.

Ideas for Overcoming the Problems

Attempts have been made to solve both of these dilemmas. In July, the European Council made new proposals around reducing the volume of nonperforming loans held on banks' books, including streamlining the processes for their disposal and creating rules that would discourage banks from accumulating them. Then in early December, a surprising proposal by Finland, which had historically sided with its Northern European peers in resisting sharing banking risk with the free-spending south, offered a possible roadmap to establishing the deposit insurance scheme. Its proposal demonstrates that it has shifted camps, and for a specific reason.

The Scandinavian bank Nordea decided in September to shift its headquarters from Sweden to Finland to position itself to be within the banking union (Sweden is a member of the European Union but not of the eurozone). This has changed the approach taken by Finland, which would now have to shoulder a substantial amount of new financial risk should Nordea run into trouble. Finland is motivated to share that risk with its European peers, whereas before it resisted. In the resulting proposal, Finland crafted terms for a risk-sharing pool that shifted the argument toward a deal its Northern European peers might one day be able to accept. The idea would be to lump bank and country solvency together when considering risks presented by a particular national banking system, allowing more flexibility than the strict focus on bank-government linkages in the approach that is currently being debated.

But neither of those proposals look likely to quickly change the minds of those countries worried about sharing risks throughout the eurozone. The European Council's drive to reduce nonperforming loans, while welcome, is unlikely to achieve significant short-term results — and certainly not within the timeframe of 2018 negotiations. Finland's proposal, meanwhile, provides an opening should Germany and the Netherlands choose to soften their position, but there are few signs that a change of heart is imminent. In October, the Netherlands managed to form a coalition government, one of the pillars of which rests on the agreement that it would resist attempts to turn Europe into a "transfer union," a banner under which deposit insurance would fall. In Germany where coalition negotiations are ongoing, much remains unknown. Nevertheless, the largest party in the parliament and the likely leader of any new government, the Christian Democratic Union, has regularly made clear its reluctance to embrace eurozone deposit insurance before overall risk has been reduced. On an apolitical basis, meanwhile, Jens Weidmann, Germany's central banker and favorite to replace Mario Draghi as the president of the European Central Bank in 2019, has also focused on the size of the bad debt pile as a reason why eurozone deposit insurance — and, by extension, the banking union — cannot go ahead.

While the banking union discussion is critical to EU integration ambitions, there are major obstacles to any progress being made on it in 2018. Resistance remains strong within Germany and the Netherlands, and the progress these countries require toward reducing risk won't come fast enough to play into upcoming discussions.

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