Banking Union or Bust in Europe?

source: http://www.flickr.com/photos/alfmelin/

source: http://www.flickr.com/photos/alfmelin/

The economic recovery in the euro area has been nothing but fragile. Economic catastrophe struck the region in 2008, as the world stumbled through recession and the systemic financial stress that accumulated during this period came to a head in 2011, culminating in various sovereign debt crises that brought several major economies in the European Union to a screeching halt. After a brief period of positive aggregate economic growth, euro area GDP growth turned negative in 2011 and only began recovering in the second half of 2013.

But on Tuesday, the European Central Bank — which has been tasked with managing much of the tenuous recovery — had some good news to report. Financial conditions remain fragile, but overall systemic stress has moderated over the past few months. Indicators of default risk are now at their pre-2011 levels, and a composite indicator measuring systemic financial market risk has fallen to pre-crisis levels.

“This resilience partly reflects the improvement of euro area fundamentals since the height of the euro area crisis in 2011,” the ECB said in its latest financial stability review. “Fiscal consolidation and structural reforms have continued in the euro area, though at an uneven pace across countries. At the same time, higher capital and liquidity buffers are being built up in the banking sector, strengthening shock-absorption capacity, which should improve bank performance over time. Complementing national policy measures, tangible progress has been made towards building a banking union.”

As policymakers work to stabilize the eurozone after years of economic turmoil, it has become clear that the region’s crisis is rooted in financial distress.

“In the years preceding the crisis, this union began to divide countries with positive trade balances and sound budgets from those with growing budget deficits and external deficits financed by private credit flows,” ECB President Mario Draghi said in May. “No one ever imagined that the monetary uUnion could become a union divided between permanent creditors and permanent debtors, where the former would perpetually lend money and credibility to the latter.”

No one may have imagined it — although there are some pessimists who claim to have seen it coming — but an unsatisfactory creditor-debtor network of relationships has settled over the European Union. Government deficits and non-performing loans have undermined national economies and forced them to accept bailout packages loaded with strict austerity conditions that fall under the umbrella of “policy measures” mentioned by the ECB.

While the effectiveness of austerity has been questioned, it is clear that European authorities were not properly equipped to deal with the crisis. Conditions are improving — again, slowly — and in its financial stability report, the ECB highlighted four key risks to euro area financial stability that remain and underscore the need for the development of a “genuine banking union” that could help fight future crises.

The first risk highlighted, perhaps unsurprisingly, is partially an issue of confidence. Part of the cocktail that makes financial crises so brutal is an evaporation of trust and an abundance of skepticism regarding the financial stability of any given institution.

If depositors don’t trust the stability of their bank, they will pull their money from it, effectively destabilizing the institution. If banks do not trust each another, they may not do business together, or will only lend at exorbitant rates. At the moment, confidence appears to be returning, but the ECB expressed concern that any additional financial shocks could undermine the recovery.

The second risk is what the ECB calls “reform fatigue.” Sovereign debt markets in Greece, Spain, and Italy, among others, were put under enormous strain during the financial crisis, and part of the healing process has been to implement tough fiscal reforms. “Amid a fragile return of market confidence, policy progress needs to continue,” notes the ECB.

The third risk is global financial turbulence. The ECB calls for the need for “stable and predictable macroeconomic policies, including notably forward guidance.” This refers both to the ECB itself, which recently made a surprise cut to its benchmark interest rate, and to the U.S. Federal Reserve, which is currently grappling with the forward guidance issue.

The fourth major risk the ECB highlighted is this: “bank funding challenges in stressed countries that force banks to deleverage excessively.” This is pretty much a direct call for continued progress toward a banking union. Draghi has repeatedly expressed his support for such a union, and he is not alone.

At a meeting between top financial officials held in Lithuania in September, many European Union executives argued for the formation of the first step toward a potential banking union for the eurozone. The measure would create a single supervisory mechanism that would have oversight responsibilities and capabilities for all of the major banks in the region. Proponents claim that it would be an effective way to ensure that banks do not take on bad debts, thereby limiting the need for bailouts as well as bringing national government and banks closer to privately held enterprises.

Critics of the plan, who include German Finance Minister Wolfgang Schaeuble and Swedish and Finnish representatives, question the efficacy of the ECB to fulfill its supervisory role. They instead argue for banks to be overseen on a country-by-country basis, with a central oversight authority in existence only to provide second opinions or to resolve disputes. Critics also have raised concerns over possible conflicts of interest between a central authority that provides loans and other banking services, as well as oversees different banking operations.

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