Europe's Small Steps Toward a Banking Union

7 MINS READSep 16, 2013 | 15:36 GMT
Europe's Small Steps Toward a Banking Union
EU Commission President Jose Manuel Barroso speaks at a May 7 conference on integration.

The European Union has increased supervision of banks in an effort to strengthen the troubled banking sector, but it still must deal with contentious issues such as the centralization of power to identify and fund struggling banks.

The European Parliament on Sept. 12 approved legislation necessary to implement the first stage of a banking union. The legislation involves the European Central Bank taking over as the single supervisor of large eurozone banks in late 2014. (Countries that are not in the currency union are free to join but are not required to.) Central oversight of eurozone banks' balance sheets is expected to make the identification of problems in the banking sector easier. Compromises on centralization are likely after Germany's elections on Sept. 22, but political agreements on the next steps of the banking union will be slow and implementation arduous.

As the European unemployment crisis continues to undermine the ability of households and companies to repay their loans, the chances of banks failing increase. The establishment of a banking union would do little to mitigate that threat. In addition, the implementation of bank restructurings, just like the implementation of deficit and debt rules, will be troublesome for the European Union due to the conflicting interests of members states.

In June 2012, when financial markets seriously feared a breakup of the eurozone, EU leaders agreed to take steps to strengthen the currency union and to create a European banking union in order to contain the banking sector's fragmentation. Although the European Central Bank has made liquidity for banks readily available, interest rates on loans in crisis countries are considerably higher than in Germany, for example, limiting households' and companies' access to credit. 

The political agreement on establishing a banking union is not what saved the euro; all the bailouts and intervention by the European Central Bank were more important. But the agreement signaled to financial markets at the height of the speculation about a breakup that there was still a political will to integrate further to overcome the crisis. Now, as more concrete steps necessary to establish a banking union are being debated, the limits of this integration process are clearer.

Necessary Parts for an EU Banking Union

There are three components necessary for the creation of a European banking union.

The first component is the Single Supervisory Mechanism, which involves delegating supervision of the largest banks in the eurozone — some 130 to 150 banks that account for about 85 percent of total bank assets in the currency union — to the European Central Bank. The central bank gets oversight of the banks' balance sheets and takes over tasks that belonged to the national authorities before, such as evaluating the viability of their business model and ordering banks to increase reserves.

By centralizing supervision, the eurozone countries hope to help restore financial markets' confidence in banks in the periphery. The expectation is that investors will have more faith in troubled countries' banking sectors once they are under the supervision of the European Central Bank because banks will no longer be exposed to national pressure to hide negative news and because there will be a common set of rules by which the banks' health will be evaluated. The European Central Bank is expected to take over its duties as the single supervisor in late 2014.

The second component of a banking union is common regulation to deal with banks that are struggling and to define who should order and carry the burden of restructuring. In June, the EU finance ministers agreed to a set of rules that clarified how each country should divide the burden among shareholders, depositors and eventually the government when a bank is in trouble. This agreement, the so-called Bank Recovery and Resolution Directive, must still be approved by the European Parliament and likely will not take effect until 2015 at the earliest. The complete set of rules is not even expected to apply until 2018.

The rules do not fully address the second component. The June proposal leaves the decision of when restructuring or dissolution is necessary up to national governments, but the European Commission in July suggested that it should have that power after consulting with member states. However, Germany opposes the idea, arguing that delegating such decisions would require changes to EU treaties. In light of the German population's skepticism toward bailouts, Berlin prefers the decision-making power to remain with the member states and for each country to commit its own resources before asking others for help, as has been the case with regular bailouts, something that highlights the tension between supranational integration and national sovereignty in the European Union.

Eurozone and Non-Eurozone Countries

Eurozone and Non-Eurozone Countries

After the German elections, there will probably be a political agreement to establish an intergovernmental body that involves the EU Commission but leaves the final decision up to member states. This would allow leaders to show that progress on the banking union is being made while countries have the longer and more fundamental debate about the legal and institutional framework necessary for more centralized decision-making.

The third component of a European banking union would be the creation of a central fund to help troubled banks. Eurozone countries have agreed to set aside 60 billion euros ($80 billion) in the European Stability Mechanism, Europe's permanent bailout fund, to aid banks once the second component is in place. This is not a large sum considering that aid to banks in Spain, Greece and Cyprus amounted to about 100 billion euros. In addition, bank bailouts through the European Stability Mechanism would still be linked to conditions on governments and would not go directly to banks.  

The commission's idea is to go further and set up a central fund that would be financed through levies raised on banks. Germany, again putting forward legal reservations, prefers for each country to set up its own fund based on bank levies to deal with faltering banks. In June, the eurozone countries agreed to this idea, an additional burden for troubled financial sectors in Spain, Portugal and Greece, for example, as these national funds are set up over the next 10 years.

A Tough Road Ahead

Pressured by financial markets and fearing the dissolution of the eurozone, EU leaders took steps over the past year to establish a banking union. The fear has subsided as the financial aspects of the European crisis moved somewhat into the background in response to promises made by the European Central Bank to preserve the currency union. However, there is a significant risk that instability in the financial sector will return and that the European Union will struggle to implement the agreements regarding the banking union.

As a result of the extended unemployment crisis, a growing number of households and companies are unable to honor their mortgages and loans. Banks are largely still able to hide the problem on their balance sheets by, for example, extending loan payment periods, enabling them to delay the recognition of a loss as they operate under the assumption that the loan will still be paid back at a later date.

In light of the extended period of unemployment, it is likely that the financial crisis will return to the forefront at some point. It is difficult to say what will trigger the crisis, but the chances are high since the problem can continue to mount as long as the European Central Bank provides cheap money to banks and regulators look the other way.

Before the European Central Bank takes over as supervisor, it will assess the balance sheets of the eurozone banks. This process is supposed to be completed in the first quarter of 2014 and is likely to reveal shortcomings in several banks. The central bank will face a dilemma between making these shortcomings public, putting pressure on banks and the government to recapitalize certain institutions to maintain credibility, while at the same time not triggering a renewed financial crisis.

Even if the European Central Bank points out deficiencies once it takes over as supervisor, the bank's effectiveness will still be severely complicated by the possibility of member states' objecting to its advice through several channels, such as the European Banking Authority or by pointing out national prerogatives, and by the politicized decision-making at the EU level. 

The effectiveness of Europe's banking union is likely to remain limited because of the European Union's perennial enforcement deficiency. Instead, it will probably be another EU construct that reflects the union's permanent tension between integration and national sovereignty.

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