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Dec 14, 2012 | 01:14 GMT

5 mins read

Europe's Plan for a Banking Union

It can be difficult to separate the important from unimportant on any given day. Reflections mean to do exactly that — by thinking about what happened today, we can consider what might happen tomorrow.

With great optimism, the European Union announced Thursday its newest plan to address the financial crisis in the Continent. After extensive negotiations, the finance ministers of the eurozone agreed to give the European Central Bank supervisory powers over the largest banks in the region. The Single Supervisory Mechanism, as the plan is known, applies in principle to the 17 members of the eurozone, but the other EU countries can join if they wish.

What is a Geopolitical Diary? George Friedman explains.

French President Francois Hollande described this mechanism as a "major agreement." German Chancellor Angela Merkel said that the agreement "cannot be valued highly enough." The head of the European Banking Federation, Guido Ravoet, said he considered it a "historic decision." The reality, however, is more complex.

Considering the number of players involved and the diversity of national interests at stake, the mere fact that a consensus has been reached is important for Europe, considering the political fragmentation that has been taking place in the bloc since the beginning of the crisis. The Europeans can say today that the process of regional integration continues to deepen, even if the bureaucratic machinery in Brussels has become extremely cumbersome.

However, this is a compromise agreement and reflects the fact that Europe has decided to move forward on the elements where consensus can be found while putting off the other issues that may be more divisive. Paris favored a supervision of all banks in the eurozone (about 6,000 banks) while Berlin believed that only large and "systemic" banks should be covered by the European Central Bank, largely to avoid scrutiny on Germany's smaller banks.

In the end, Germany got what it wanted. Only the 150 to 200 banks with assets above 30 billion euros (about $39 billion) will be part of the new oversight mechanism. France was given the promise that smaller banks could be controlled by the European Central Bank if necessary, but no specifics were given on how or when exactly this would happen.

The United Kingdom also achieved its objectives. Britain was worried about the future of the European Banking Authority, a regulatory body based in London. The banking sector is a key component of Britain's economy, and the eurozone ministers decided not to alienate London at a time when the country is debating its role (and even its membership) in the European Union. It was thus decided that the European Banking Authority would continue to be in charge of establishing common rules for all the countries among the 27 EU member states, for example, defining the capital reserves that banks can use as buffers. Moreover, countries that are not members of the eurozone will also have a say in the new banking regulatory mechanism, a compromise agreement that could substantially slow down the decision-making process.

Even more important than what was announced today is what was postponed. One of the central elements of the original plan for a banking union was the creation of a common guarantee fund for eurozone banks, which would enable deposit guarantees in healthy banks to be used to assist troubled banks in other countries. Another was authorizing the European Central Bank to close troubled banks, which would give it strong enforcement power. These issues are highly controversial in Germany, and Berlin has expressed its concerns about them. Tellingly, European leaders decided to leave these issues to be resolved later, which suits Berlin's needs; Germany will hold elections in late 2013, and Merkel wants to avoid those subjects, since they could cause domestic political problems for her.

The European Union's goal is to have the banking union go into effect by March 2014, but this schedule could be delayed since the technical aspects of implementation must be worked out. The European Union has yet to announce what real enforcement powers the European Central Bank will have under the new supervision scheme. Most important, Brussels has yet to outline the legal recourse for any disputes that may arise. The situation of the banks that were left outside the control mechanism also remains an open question, which is a critical issue to address because the regional savings banks in Spain and Germany are significant players in the financial crisis.

The creation of a banking union is part of the European strategy to address the financial aspect of the crisis. The creation of the European Stability Mechanism — a permanent European bailout fund — and the announcement that the European Central Bank is ready to buy troubled countries' bonds are part of that strategy. The promotion of fiscal discipline in member countries is also a key element of Brussels' approach. According to the European Union, all these measures will contain the crisis in the short term and create a healthy financial environment in the long term. In this new financial environment, banks would provide cheap credit and countries would be able to borrow at reasonable costs, something that would eventually lead to economic growth.

Europe's problem is that it is running a race against time. It is not clear that these strategies lead to growth, and if they do, the benefits would only come in the long term. In the short term, most European countries will probably see their economies shrink and their unemployment grow, especially in the periphery of the eurozone. This situation is already leading to growing social unrest and a deepening of the crisis of political representation in Europe, with Greece being the most advanced example. This year, European leaders have made ​​progress in containing the financial side of the crisis; the political and social side of crisis, by contrast, remains largely unaddressed.

Europe's Plan for a Banking Union
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