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Op-ed

Banking Federalism Key to Euro Area Survival

by Nicolas Veron, Peterson Institute for International Economics

Op-ed in Emerging Markets
November 3, 2011

© Emerging Markets


Banking system dysfunction has been at the core of the euro area crisis. There are two main issues.

First, trust has remained elusive since before the Lehman shock of 2008, as policymakers have refused to identify the weak spots in Europe's banking system in spite of annual half-hearted stress tests since 2009. Dexia, which passed last July's test with flying colors (10.4 percent core equity ratio under adverse scenario assumptions) before collapsing last month, is the latest symbol of this complacency.

Second, banking weaknesses and sovereign credit dynamics have been connected in a perverse country-by-country feedback loop. This involves excessive implicit and explicit government guarantees on banks, as in Ireland and Spain, and inexplicably high home biases in banks' portfolios of EU sovereign debt, as in Greece (94 percent), Spain (90 percent), Portugal (79 percent), or Italy (78 percent). The result is national fiscal and banking problems feeding each other. This is incompatible with sustainable currency union.

On this basis, it is unclear how much progress, if any, was made with the plan announced by EU leaders in Brussels on October 26. The recapitalization plan fails the Dexia test: The “well-capitalized” Franco-Belgian bank would apparently not have been asked to raise new equity.

Because it rests on unreliable capital assessments, the plan risks delivering the full economic cost of deleveraging and shareholder distress without the benefit of instilling confidence that the weak links have been properly addressed.

Meanwhile, because new capital and guarantees are to be provided primarily by national governments, the fiscal/banking connection will be further reinforced. This may worsen both the debt dynamics of peripheral euro area countries, and the market distrust of their domestic banks. In addition, it will create a sense of unfairness, as well-run banks from weaker countries will have to shrink, while poorly run ones from stronger countries can merrily expand their international balance sheet.

Europe's policymakers need to accept the lessons of the past three years. An honest application of the subsidiarity principle should lead them not to insist on action at the national level but to create a truly federal euro area banking policy framework.

They should immediately place all national deposit insurance systems in the euro area under the explicit guarantee of the European Financial Stability Facility (EFSF) to prevent retail bank runs in troubled countries. Then, they should ask the European Banking Authority (EBA) to conduct a new assessment of the most important banks' capital position. The EBA should ruthlessly bypass national supervisors that failed to produce reliable results in previous stress tests. It could rely partly on private-sector help, as Ireland's central bank did this year with an audit of its banks' assets by BlackRock.

Leaders should then create a temporary, high-powered European team to negotiate the restructuring of those banks which, on the basis of this fresh assessment, cannot repair their capital position on their own. One option is to create and empower a euro area–wide Resolution Trust Corporation that would take over failed banks on behalf of the relevant member states, sell back their viable operations to fit and proper investors, and temporarily manage the rump assets.

Over the long term, the EBA should be granted full supervision and resolution authority over large banks, at least in the euro area, and work with national supervisors in a similar manner as the European Commission does with national authorities to enforce competition policy.

From a political standpoint, it may be the case that banking federalism is even more difficult to implement than fiscal federalism, against which national resistances have started to erode. But measures such as the ones suggested above are an indispensable component of any credible crisis-resolution plan.

The euro area cannot thrive without an integrated banking system, and this cannot exist without an integrated banking policy framework. Better to start now.


RELATED LINKS

Policy Brief 13-23: How to Form a More Perfect European Banking Union October 2013

Policy Brief 13-17: A Realistic Bridge Towards European Banking Union June 2013

Op-ed: Five Myths about the Euro Crisis September 7, 2012

Article: Why the Euro Will Survive: Completing the Continent's Half-Built House August 22, 2012

Testimony: Challenges of Europe's Fourfold Union August 1, 2012

Policy Brief 12-18: The Coming Resolution of the European Crisis: An Update June 2012

Book: Transatlantic Economic Challenges in an Era of Growing Multipolarity July 2012

Book: Resolving the European Debt Crisis March 2012

Working Paper 12-12: Sovereign Debt Sustainability in Italy and Spain: A Probabilistic Approach August 2012

Policy Brief 12-20: Why a Breakup of the Euro Area Must Be Avoided: Lessons from Previous Breakups August 2012

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Speech: Italy's Effect on the Global Economy February 9, 2012

Policy Brief 12-4: The European Crisis Deepens January 2012

Policy Brief 11-21: What Can and Cannot Be Done about Rating Agencies November 2011

Policy Brief 11-13: Europe on the Brink July 2011

Working Paper 11-2: Too Big to Fail: The Transatlantic Debate January 2011

Policy Brief 10-27: How Europe Can Muddle Through Its Crisis December 2010

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Book: Transforming the European Economy September 2004