Banking union not sufficient for monetary group’s survival

The line of credit to Spain from fellow eurozone governments may help to stabilise a fragile banking system, at least in the short term, but it is a missed opportunity. Spain’s banking crisis provides a perfect opening to move towards a European banking union.

In the medium term, help to Spain will merely reinforce the link between the sovereign and the banks’ problems, causing even greater fragmentation in the European banking market and pushing Spain closer to potential insolvency by increasing its debt burden.

By contrast, a direct equity stake in Spanish banks taken by an appropriate eurozone investment vehicle would decouple bank and sovereign risk.

Such a move would also contribute to banking integration if the equity stakes were eventually sold in an open EU-wide auction. The issue is whether such a vehicle, and the appropriate control mechanisms for assisted banks, can be established in a short time frame.

Centralised bank

A banking union is a necessary condition for survival of a monetary union that is unable to implement a strict no-bailout policy for member countries.

Such a union should be understood as a centralised bank supervisor, resolution authority (RA), and deposit insurance fund (DIF), at least for systemically important and cross-border institutions.

There are, however, four major issues that must be confronted in order to move ahead with such a banking union. First, a significant degree of fiscal integration is required, since an effective European RA requires a burden-sharing agreement among countries.

The second issue that must be resolved is the design of the DIF and RA. A case can be made that both functions should be integrated within a single agency, which should have three main characteristics:

The third issue concerns whether the scope of a banking union should be the European Union or the eurozone. A banking union is not strictly necessary for a high degree of financial-market integration.

Countries that want to participate in the banking union but not in the eurozone face a dilemma, because they will have to move toward fiscal union even if they do not wish to join the euro.

Finally, a banking union is not sufficient for the monetary union to survive. Indeed, there is no European deposit insurance fund that could sustain a run on deposits in Italy. To cope with this type of sovereign risk, a high degree of political and fiscal integration is needed.

Mr Vives is Professor of Economics and Finance at IESE Business School.