Hugo Dixon

Does Europe need a “banking union” to shore up its struggling monetary union? And is it going to get one?

These questions are raised by the increasingly lively debate over how to break the link between troubled states in the euro zone periphery and their equally troubled banks. In some countries, such as Ireland, the lenders have made so many bad loans that they have had to be bailed out – in turn, dragging down their governments. In Greece and Italy, the banks have gorged on so many government bonds that they have been damaged by their state’s deteriorating creditworthiness. And, in Spain, the current focus of the euro crisis, a bit of both has been happening: banks made too many bad loans – and then bought too many government bonds.

One proposed solution to this incestuous relationship, advocated among others by the International Monetary Fund, involves creating a centralised Europe-wide system for regulating banks and, if necessary, closing them down and paying off their depositors. The idea is that the region’s lenders would be viewed as European banks rather than Spanish, Greek or Italian ones. If they got into trouble, they wouldn’t infect their governments; and vice versa. That would make the whole euro crisis easier to manage.

While the idea carries much theoretical appeal, such a fully-fledged banking union isn’t realistic. The incestuous embrace between governments and banks may be unhealthy, but that doesn’t mean politicians entirely dislike it. National oversight of lenders gives politicians all sorts of ways of meddling in their economies. And this is not just in the troubled countries. Relatively healthy states such as Germany and France would be loath to surrender the power to boss around banks to some supra-national authority.

Citizens in rich states wouldn’t like the idea of having to bail out banks that had gone on a binge in a completely different part of Europe either. What’s more, even if a centralised banking body was created, would it really have the clout to tell the big boys what to do?

A further difficulty concerns whether such a banking union should stretch across the euro zone or the entire European Union, which includes the United Kingdom, home to the region’s largest financial centre. Britain would argue that it shouldn’t be roped into a system that is designed to shore up the single currency it is not a part of. On the other hand, if the euro countries went ahead on their own, the single market in financial services would fragment.

Quite apart from the politics, a banking union wouldn’t actually solve all the problems. In particular, it would do nothing to stop banks owning too much government debt. Indeed, in the last few months, Spanish and Italian lenders have bought even more of this debt – using cheap money from the European Central Bank. This has helped finance their governments through a rough patch but at the cost of tying the banks’ fate even more closely to that of their countries. Over time, governments ought to be weaned off reliance on their local banks. But, realistically, this isn’t going to happen fast.

Does this mean that a European banking union is a totally dead idea? Not quite. It may be possible to cherry-pick bits of it. The most important part would be to create a Europe-wide “resolution” regime. The basic idea is that such a regime would allow insolvent banks to go bust in a controlled fashion. If shareholders haven’t put in enough capital, bondholders have to be “bailed in”. Only if bondholders also haven’t put in enough capital do deposit guarantee schemes – and possibly taxpayers – have to be activated to make sure savers are repaid. With such a framework, governments such as Ireland’s wouldn’t in future be infected by their lenders’ problems.

At present, many European countries lack such a resolution regime and those that do exist don’t collaborate effectively with one another. What’s more, until recently the European Central Bank has been hostile to the idea that bank bondholders should suffer any losses. It prevented Dublin from bailing in bondholders, fearing that this would trigger contagion.

The mood, though, is changing. The European Commission is planning to publish plans for an EU-wide resolution regime in June. Even the ECB has started lending its support to such a scheme. The devil, of course, will be in the detail. But there finally seems to be momentum behind this proposal.

A second idea that could be cherry-picked is to reinforce Europe’s deposit guarantee schemes. At the moment, every country has its own. The problem is that depositors in weak countries, especially Greece, don’t have confidence that their national schemes have enough money to pay out. So savers have been taking their cash abroad.

It is too much to expect that Germany, Europe’s paymaster, would agree to a euro-wide deposit insurance scheme. But what about some sort of reinsurance scheme? Nicolas Veron from the Bruegel think tank argues that the European Stability Mechanism, the euro zone’s soon-to-be-created bailout fund, could provide national schemes with a backstop.

Europe is not ready for banking union any more than it is ready for political union. But such ideas show there are practical ways of limiting the unhealthy nexus between lenders and their governments. Europe should grasp them.