Banking union or bust

The EU can only survive by fully integrating its banks into a common system

August 3, 2015 2:00AM ET

Earlier this month, Greece and its Eurozone creditors reached a controversial cash-for-reform deal that avoided a complete collapse of the Greek economy and a disorderly ‘Grexit’ from the common currency.

However, the ink on the deal had barely dried before a chorus of critics predicted it would fail. Some said the deal was economically doomed because it continued the austerity policies that drove Greece into a deep recession, or simply because it did not significantly write down Greece’s unsustainable debt. Others predicted a political failure, arguing that the government of Greek Prime Minister Alexis Tsipras would prove itself unwilling or unable to implement reforms faithfully in the face of intense public opposition to austerity policies.

Whatever the fate of the bargain reached between Greece and its creditors, one thing is certain: It does nothing to resolve the root causes of the Eurozone mess. It is now obvious that the Eurozone is an incomplete monetary union, lacking key attributes of successful currencies, and that this incompleteness makes the Eurozone prone to crisis. And the current crisis in Greece — along with previous iterations of the crisis in Ireland, Spain and Cyprus — demonstrates that Europe can’t have a stable currency union until it has a true banking union.

Until a stronger banking union is achieved, it will just be a matter of time until Greece — or another Eurozone member — faces another crisis that pushes the Union back to the brink and again call into question the ‘irreversibility’ of Eurozone membership.

The key to stabilizing the Eurozone is to sever the “doom loop” that links weak banks and governments and leads them to drag one another down. Only a completed banking union can do that. A true banking union must combine common supervision of banks, a common mechanism for the resolution of failed banks and common deposit insurance.

Why is a banking union so crucial for stabilizing the Eurozone? Consider the following chains of events. First, if savers in one member state of the currency union (say Greece) lose confidence in their nation’s banking system and its deposit insurance system, they are free to move their deposits to banks in other member states. If too many of them do this, a run on the banks could destroy the country’s banking system, and also spread to other member states. 

Until EU leaders create an adequate backstop for insolvent banks and a system of common deposit insurance, the common currency will remain prone to crisis.

Since a modern economy cannot function without a banking system, the state in question will feel compelled to intervene to save the banks. If the state has sufficient resources, it may ‘socialize the losses’ of insolvent banks by passing them on to taxpayers, as Ireland did beginning in 2008. If not, the state may intervene by imposing capital controls — thus cutting off its banking system from the single market, which happened in Cyprus and Greece. In the last instance, the state may intervene by printing its own currency to recapitalize banks and effectively exiting the single currency, as the Greek government likely would have done, had the European Central Bank cut off funding to Greek banks.

The destructive relationship between governments and banks can operate in the opposite direction as well. If a sovereign state defaults on its debt, banks holding significant quantities of that debt may quickly go bust. The Eurozone’s monetary union is unusual in that it lacks a common ‘risk free’ asset (compare Treasury bonds in the U.S. system), so banks in each member state have been encouraged by regulators to retain large holdings of the sovereign debt of their own government. As a result, a default by any member state threatens to bring down its country’s banking system and drive the state out of the common currency.

The Eurozone has taken important initial steps toward banking union, but they don’t go nearly far enough. In November 2014, the European Union put the ECB in charge of a common system of supervision — the Single Supervisory Mechanism — in reaction to previous episodes of the unfolding Eurozone crisis. The EU also agreed to put in place a common system for winding down insolvent banks by January 2016, but the fund to back that mechanism will only be built up gradually over the coming eight years. Finally, a number of wealthier ‘core’ member states — led by Germany — have resisted calls for establishing common deposit insurance.

Other reforms — including moves toward greater fiscal union and most importantly the creation of ‘Eurobonds’ as a common debt instrument — may eventually be necessary to strengthen the Eurozone. But these reforms aren’t urgent. A banking union, on the other hand, can’t wait. Until EU leaders agree to create an adequately funded backstop for the resolution of insolvent banks and a system of common deposit insurance, the common currency will remain unstable and prone to crisis.

German Chancellor Angela Merkel and other leaders of stable Eurozone countries have long opposed a stronger banking union that would include features such as common deposit insurance; they fear will put their taxpayers on the hook to bail out failed banks on the Eurozone’s periphery. But the latest chapter in the Greek crisis should serve as a reminder that the costs of the absence of a banking union are likely far higher than the costs of constructing one.

R. Daniel Kelemen is a Professor of Political Science at Rutgers University.

The views expressed in this article are the author's own and do not necessarily reflect Al Jazeera America's editorial policy.

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