21 October 2017

Financial Times: European banking union needs its final leg

A widespread view is that no advance can be made on the EDIS until the issues related to banks’ legacy assets are addressed. In particular, banks in peripheral eurozone countries would need to reduce the large amount of non-performing loans and government bonds that they still hold. Otherwise, the argument goes, the scheme would mean that depositors and taxpayers in the northern countries would have to share the risks accumulated by southern banks before the crisis.

Furthermore, premature introduction of the scheme could create moral hazard and reduce the pressure on banks and their national regulators to dispose of these assets and clean up their balance sheets.

Finally, in the event of sovereign debt restructuring, banks’ high holding of government bonds remains a key source of concern, as it fuels the perverse loop between sovereign and bank risk, which was at the heart of the crisis. It is feared that the EDIS would give countries with high public debt an incentive to put pressure on their domestic banks to buy government bonds.

Progress has been achieved recently in reducing banks’ holdings of NPLs, especially through new rules introduced by the Single Supervisory Mechanism.

However, holdings of government bonds are more complex. European authorities can hardly set limits for their banks independently of international regulatory standards. But since no country outside the eurozone is considering such a measure, there is deadlock. The inability to agree on binding constraints for banks on sovereign debt is blocking progress towards the completion of banking union. The most recent proposals from the European Commission show a lack of any ambition.

This is highly disappointing. There are no good reasons for establishing a strict parallelism between deposit insurance and banks’ sovereign risk. Indeed, in the event of a sovereign debt crisis a country’s whole banking system would be affected, regardless of whether the banks held government bonds.

But the solution in such a case would not be to liquidate all the nation’s banks and use the deposit guarantee fund. Rather the system should be recapitalised, eventually through the European Stability Mechanism — as happened with Ireland, Spain and Greece. Such insurance schemes should not address systemic crises but specific cases, where (small) banks are put in resolution, while avoiding contagion.

The main problem with the EDIS proposal is semantic: “insurance” might suggest it is an instrument of risk sharing, and thus trigger fears of moral hazard and burden sharing. But this is not an automatic mechanism to be drawn by depositors in case of negative events. It can be used only at the discretion of the supervisory authorities, which must decide whether to put a bank in resolution.

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