This time was different: When a group of American banks failed in early 2023, European Union investors braced for a financial crisis that never came. Higher capital requirements and rigorous central supervision sheltered the euro area from another round of contagion, a clear sign that the monetary union did, in fact, strengthen its foundations after the devastating crisis years of 2010 to 2015.
In the absence of crisis, however, EU member states are failing to learn the lessons that the United States could be teaching: that mid-sized banks can be as much of a threat to the economy as their larger peers, and that systemic importance is best handled with swift and collective action. Instead, EU member states are resisting even small improvements to the banking union, and continue to want to keep medium-sized lenders out of the same risk-prevention framework that has just proved its mettle.
As a result, the EU’s banking union is stagnating at a time when Europe needs every bit of momentum it can get. This, in turn, hurts the international role of the euro and the EU’s ability to fund and keep the innovators it needs for the green transition and a hoped-for new era of economic security. To move ahead, the eurozone ideally should move faster toward true joint deposit insurance, and also enact the bank-failure system improvements proposed by the European Commission this April.
Supervision, Resolution, Deposit Insurance
A banking union has three main elements: common supervision, common resolution, and common deposit insurance. The EU realized it needed to move in that direction after its previous fiscal and financial fragmentation forced five different countries to require economic rescue packages during the euro crisis years. The meltdown showed the destructive potential of the so-called bank-sovereign doom loop. In some eurozone member states, like Ireland and Spain, failing banks threatened their home country’s national finances. In others, like Greece, disastrous sovereign finances took down the banks. Cyprus suffered coming and going—Cypriot banks suffered from the historic write-downs on Greek debt, and then the Cypriot government needed help when its overstretched banks toppled and took the economy with them.
As part of their way out of this cycle, EU leaders came to a historic agreement in 2012 to bring oversight of big banks throughout the eurozone under the central oversight of the European Central Bank. The Single Supervisory Mechanism was soon established and, through its inaugural stress tests and subsequent actions, was able to push weak banks to raise fresh capital throughout the monetary union. Working together with national governments, the ECB helped oversee repairs of the major Greek banks, Italy’s Monte dei Paschi di Siena, and Germany’s HSH Nordbank and Nord LB.
Supervision, therefore, is the strongest and best-developed pillar of the banking union, and it is broadly considered a success. Resolution is more of a mixed bag. The EU did create the Single Resolution Mechanism and its accompanying bank rescue fund. But it has not yet agreed on the backstop to this fund, which is feared to be too small if a major bank got into trouble.
A further hurdle is that so far EU “resolution” proceedings have only been used twice, once for Spain’s Banco Popular and once for managing the EU subsidiaries of Russia’s Sberbank after Moscow’s full-scale invasion of Ukraine. To become as credible as the US authorities, who have a long track record of shutting down failing banks while safeguarding the broader economy, the EU needs its bank-failure system to be better funded and more accessible when needed.
Nonetheless, the Single Resolution Board is up and running and does provide tools for the EU authorities should a big bank get into trouble. In contrast, deposit insurance remains largely national, even if there are EU standards on the minimum level of coverage each country has to provide.
Because deposit insurance is provided at the national level, and therefore linked to national finances, investors won’t have consistent levels of confidence across the euro area. That means a euro saved in one country is not as safe as one in another, which in turn undermines the whole monetary union. “In a crisis, we run the risk of deposit outflows toward other member states and non-banks, thereby exacerbating systemic liquidity stress,” ECB Vice President Luis de Guindos said. “An incomplete banking union is a key vulnerability for the EU banking sector and hampers progress toward greater financial system integration.”
The Way Forward
One way of reducing vulnerabilities will be to shore up the EU’s fledging safe asset, the jointly issued debt that became a major market player in the aftermath of the COVID-19 pandemic. While the European Commission has a long history of borrowing safely on financial markets, it did not issue debt at scale until the need for a continent-wide recovery fund prompted member states to set aside their reservations and band together in capital markets.
So far the program has been a success—the EU is on track to become the largest global issuer of green bonds and enjoys a credit rating similar to that of France—but has been hampered by its temporary nature. If a steady supply of EU bonds became permanent, borrowing costs would be likely to go down because of more fluid trading and, from a banking perspective, financial institutions could hold EU debt instead of their local sovereign on their balance sheets. This would address the core issue of the “doom loop” concerns.
Proper deposit insurance is the other way to move forward. Yet, led by Germany and its fiscally conservative allies such as Austria and the Netherlands, a faction strongly opposed to creating a US-style European Deposit Insurance Scheme has consistently blocked progress on a proposal dating back to 2015. To try to move ahead incrementally, the European Commission put out a more modest crisis management and deposit insurance plan that would adjust the current system to bring more medium-sized banks into the resolution scheme.
As it stands, these mid-sized banks are often not eligible for resolution because they do not have 8 percent of total liabilities in instruments that can be bailed in, which is to say take losses, as required to take advantage of taxpayer-supported backstops. The commission wants the EU to emulate the US in allowing regulators to, if necessary, allow national deposit guarantee schemes to stand in line with other unsecured creditors to reach the limit. Right now, these national schemes have a super-seniority that exempts them from being counted, meaning banks cannot reach the 8 percent, cannot take advantage of EU resolution, and instead must fall back on national liquidation procedures.
No Protection for Taxpayers
The current system seems like it would protect taxpayers best, but in real life it does not, for two reasons. First, once a failing bank is handed off to national procedures, local authorities have more scope to provide taxpayer assistance if they want to. Second, if a bank is fully liquidated, losses are likely to be higher than if the institution can pass through resolution and be handed off to a buyer. After all, if a troubled bank can find a suitable buyer, it may not have to lock in losses at all, and its customers will certainly benefit if their business transfers to a healthier firm.
The US recognizes that allowing deposit insurance to stand pari passu, or on equal footing, with other senior creditors, is often the way to deal with a failing bank at least cost. Taxpayers are further protected because any funds that a deposit insurance scheme does lose are, over time, fully paid for by bank contributions. “We are not using taxpayers money. The idea is to avoid using taxpayers’ money. This is the banks’ safety net,” said John Berrigan, the European Commission’s director general for financial services.
Nonetheless the proposal is blocked. Representatives of smaller banks in Austria, Germany, Italy, Poland, and Spain say it would undermine the “institutional protection schemes” that they have set up, and thus destabilize an engine of their respective local economies. In particular, they criticize the plan for threatening the right of these local authorities to step in before resolution authorities are consulted.
A Worthy Goal
Indeed, removing local loopholes and creating a more standardized and credible local regime is the goal, and a worthy one. Bank runs can move faster than ever before with the advent of instant payments and real-time communications. Investors around the world deserve to be certain that the eurozone will act responsibly and predictably when problems arise, rather than be subject to local preferences.
It's up to Germany, which benefits the most from a strong EU and eurozone because of its role as a global export leader, to convince its fellows that a move toward a common cause is a move toward common prosperity. “If you want to make progress on even a small thing like this, you need someone in Berlin to put up political capital and say, ‘Look, this is worth it and this is really the next step we need to do,’” German Council on Foreign Relations (DGAP) director Guntram Wolff said on June 7.
The EU wants the euro to be a reserve currency on par with the dollar. To get there, it needs to elevate its banking system to the next level.
Rebecca Christie is a non-resident fellow at Bruegel, the Brussels-based economic think tank, and the Brussels columnist for Reuters Breakingviews.