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A new concept has emerged in the discussion on the solutions to the euro crisis: that of a European banking union. It was discussed by the EU leaders at their last meeting and it has been endorsed by the European institutions. True, this is probably the worst possible name from a communication viewpoint, as citizens are angry against banks for having created the crisis and against the European Union for having mismanaged it, but it actually makes considerable sense. Here is why.

The European monetary union was initially created on the basis of two pillars: a monetary one, around the independent and price-stability oriented European Central Bank, and a budgetary one, around the provisions that were meant to ensure fiscal discipline and a certain modicum of coordination. It had no financial component apart from the prohibition of capital controls and the promotion of a single market for financial services, both of which apply to all members of the EU irrespective of participation in the euro area, and in particular it had no banking component, apart from those arising from the operation of monetary policy. The ECB itself had few financial stability competences.

This bare-bones monetary union has shown its limits in the crisis. First, the previously integrated financial market that underpins the common currency and contributes to ensuring homogeneous transmission of monetary policy impulses has started to fragment along national borders. Banks were European in quiet times, but they have become national in crisis times because they depend on the national government that has the capacity to bail them out, if needed. They are increasingly being encouraged by national authorities to cut cross-border lending and retreat within national borders. Indeed, this is understandable from a national viewpoint as taxpayers have little reason to pay for the consequences of imprudent lending to foreigners, but the consequence is to disintegrate the euro area. Capital was supposed to move as freely across countries as across regions within a federation, but the reality is that we have unexpectedly experienced within-euro area balance-of-payment crises.     

Second and no less problematic is the correlation between banking and sovereign solvency crises. In Greece, Ireland, Spain and Italy, as well as in other countries (though to a lesser extent), sovereign solvency concerns have contaminated banks and bank solvency concerns have contaminated sovereigns. The explanations are that banks massively hold government bonds issued by their sovereign and that sovereigns are sole responsible for bailing-out banks headquartered on their territory. This creates a potential for vicious circles and even self-fulfilling crises that the ECB cannot quell because a federal central bank is not, and cannot be mandated to assist particular sovereigns.

Moving to a banking union – that is, assigning to the European level the responsibility for deposit insurance, bank supervision, and crisis resolution – would help on both fronts and therefore contribute to making the monetary union more resilient. It would at the same time strengthen financial integration and reduce the potential for correlation between sovereign and banking crises. Hence, the new interest for the idea.   

However this is not an easy move. First of all, it cannot be done piece by piece. European deposit insurance is of little help if not backed up by fiscal support: it would only help dealing with small crises, not with bigger ones that overwhelm bank-financed deposit insurance funds. Also, as soon as insurance is moved to the European level, supervision has to follow suit, otherwise national supervisors would have a strong incentive to overlook excessive risk-taking by banks in their jurisdiction.

Second, there are limits to what can be insured. European deposit insurance cannot cover the risk of euro exit. This would simply amount to subsidising it massively as bank accounts would keep their euro value even if corresponding bank credits were converted into a new currency. So a European banking union would help cover some risks but not all of them.

Third, the euro area is a subset of the EU and it does not include its main financial centre, London. So there would be a need for creative variable geometry to combine what belongs to the EU and what belongs to the euro area. A positive development is that the UK, whose traditional attitude was to block the initiatives he did not want to take part in, has changed attitude. British PM David Cameron has decided that the national interest was to help the euro area “make-up” rather to “break-up”. However the devil is in the details and negotiations on the exact contours of the banking union and its interaction with the European single market rules promise to be difficult.

Last but not least, any insurance mechanism involves distributional biases. The countries with stronger banking system are naturally reluctant to subsidise those whose banking systems are or are perceived to be weaker. True, it is hard to say ex ante who is stronger and who is weaker, and the series of banking crises throughout the world suggests that rich countries are as prone to them as poorer ones. In the short term however Northern European countries are reluctant to embark on a support to Spain, where the legacy of the real estate crisis is severe. In the end, the survival of the euro may be worth the transfer. But not after much discussion.

Will Europe bite the bullet? Until recently it seemed that it would not. From banking protectionism to fear of transfers and reluctance to assigning new powers to the European level, there were many reasons to think that this sound idea had little chances to see the light. The heightened risks that recent developments represent for the euro area and market perception that the very existence of the euro is at stake may lead the European heads of state and government to change their mind. It would not be the first time they wait until they are on the edge of the cliff to take the decision they should have taken earlier. But it would not be the first time they end up taking the right decision.

Colleagues and I at Bruegel have been promoting the idea for some time. See my paper on the incompleteness of monetary union, on the correlation of sovereign and banking crises, here the contribution by Nicolas Véron on the need for Europe to change course on banks and the paper by André Sapir, Guntram Wolff on the relationship between euro and non-euro area member states.