Euro Collapse or European Banking Union

By Professor Jeffery Atik

The implementation of the Basel III banking reforms in Europe has spanned two financial crises. And the European legislation is haunted by two specters: a possible collapse of the Euro; and -- in the alternative -- a blind leap into a European banking union.

The first crisis of course was the 2007 global financial meltdown that led to significant bank failures and costly bank bailouts. The Basel III reforms were designed to prevent a re-occurrence of this kind of banking crisis through various new mandates and disciplines. The Basel III response was negotiated within the Group of 20, where Europe had a substantial presence and an important influence. Based on the past record of enthusiastic adoption of Basel norms by Europe, one might have expected the passage of Europe's CRD IV legislative package to be largely a technical exercise. It has not proven to be one.

This is due in part to the timing. The complex European legislative process -- extending well over a year -- coincided with the outbreak of the second severe crisis, one more specifically centered on Europe. This second -- and ongoing -- crisis is the sovereign debt crisis (or the Euro crisis). Initially involving Greece, the sovereign debt crisis has spread to Italy and Spain, sharply raising borrowing costs of these seriously indebted countries and miring their respective populations into social misery.

The European sovereign debt crisis is in large part also a banking crisis, though different in many aspects from the 2007 global financial crisis. The Euro crisis reveals the inherent weakness of the current arrangement: Eurozone countries share a common currency and somewhat coordinate monetary policies, but borrow Euro-denominated funds in their respective sovereign capacities. Moreover, they bear primary oversight responsibilities for the banks headquartered within their respective territories.

The residual sovereign control Eurozone states maintain over their banks means that a bank in crisis will look toward its national authority (and its national authority alone) for deposit insurance coverage, bailouts and eventual resolution procedures. Which works well enough for those healthy Eurozone countries with large economies and small banks.

Things are more challenging for those Eurozone countries with smallish economies and large banks; for these countries, the prospect of undertaking additional bank rescues may drive national accounts deeply in the red and precipitate a decline in the sovereign credit scores.

A pernicious feedback loop has formed between the failing banks and the troubled countries charged with their supervision. As the banks sink deeper, their shrinkage reduces their ability to make available credit, thus starving the real economies where they are active (usually their home countries). As the creditworthiness of the banks decline, the prospect for further bailouts draws on national financial capacities, driving the home state creditworthiness downward (reflected in the increase in its Euro-denominated borrowing costs). Spain's current Euro-denominated borrowing cost on a 10-year bond is approaching seven percent; compare this with Germany's 10-year bond yields of less than two percent.

The widening gap between Spanish and German Euro-denominated sovereign debt, to give an example, does not necessarily suggest that the market is projecting a high risk of Spanish sovereign default. Rather, the concern lies with the possible collapse of the Euro. An end to the Euro would likely cause outstanding sovereign obligations of Spain and Germany to be restated in restored pesetas and restored Deutschmarks respectively, with the value of those obligations reflecting an implicit devaluation of the peseta against the Deutschmark.

A collapse of the Euro is one specter haunting European bank reform. If the Euro is saved, the price of its salvation may be the establishment of a European banking union. A banking union would likely involve (1) a unitary European-level regulator, (2) a common deposit insurance scheme and (3) a unitary European-level resolution mechanism. The consolidated Eurozone economy would stand behind all the banks within, thus eliminating the peculiar challenges faced by the smallish state with largish (and failing) banks.

A fundamental political question remains: is Europe ready for a banking union? For some Member States, this is going too far. There remains the fear that profligacy in Europe's margins (Greece, Spain) should not cost the more prudent core. Member States may also fear losing the convenience (and lending focus) of truly national banks, serving the credit needs of their respective national economies.

The other side of the banking union debate has been forcefully voiced by Germany: banking union cannot be achieved without greater fiscal integration. This prospect truly frightens the Euro-skeptics. At this point, national leaders would lose much control of national budgets. In other words, every European Member States would find itself in the position of Greece or Spain, whose central economic destinies are now in the hands of Brussels.

The author, who may be followed on Twitter @jefferyatik, thanks Jack Cooper for his research assistance.