Can we bank on the euro?

Central to the eurozone crisis has been the link between lenders (the banks) and sovereigns (individual governments). As the banks’ debts have dwarfed their domestic economies, this has seen the two drag each other down – for example, the liabilities of Ireland’s banks are more than 700 per cent of the country’s gross domestic product (GDP). This has been exacerbated by local politicians providing patronage over banks – which are often ‘national champion’ firms.

Furthermore, national regulators have been tempted to hide the real truth about the health of their banks to avoid investigations from the European Commission’s (EC) competition watchdog, which is committed to restricting banks if they receive state aid.

There have been significant calls for a Europe-wide banking union with the following two features: a depositor protection scheme, and a common approach to supervision and crisis resolution.

Through existing legislation and regulation, the EU already forces sovereign governments to cover customer deposits at any one bank of up to ¤100,000 (£78,352) through 40 schemes across the bloc’s 27 member states.

But crisis resolution has proven a thornier issue to tackle. The US’s troubled asset relief programme (Tarp), first proposed in 2008, was a feasible model for the US as its banks’ liabilities equated to 100 per cent of US GDP. However, European banks’ liabilities represent between three and four times the GDP of their home countries. Therefore an EU Tarp is neither economically feasible nor acceptable to the eurozone’s strongest economy, Germany.

There is increasing calls for further mutualisation of risk on this front so that, in addition to the sovereign state-backed deposit insurance, there is a eurozone bank-resolution fund as well as a joint deposit insurance scheme. Although the banks would initially pay for this, it would require support from taxpayers, which would not go down well in Germany.

Regulation, regulation, regulation

Europe’s 19th crisis summit held in Brussels on June 28-29 2012 took a key decision. Europe’s leaders decided the eurozone’s most recent bailout fund, the European Stability Mechanism (ESM), could be used to recapitalise banks, although only after the creation of a Europe-wide bank supervisor (involving the European Central Bank) before the end of the year.

The European Banking Authority (EBA), which currently oversees the banking sector, is one of three European Supervisory Authorities created in 2011 with the aim to create a single EU rule book. The authorities draft technical standards that will then be adopted by the EC as EU law. They issue guidance and recommendations with which national supervisors and firms must strive to comply with.

The EBA is able to prevent attempts to play one set of regulators off against another and should allow banks to compete fairly throughout the EU. The EBA will prevent a race to the bottom because banks established in jurisdictions with less regulation will no longer be at a competitive advantage compared to ones based in jurisdictions with more regulations, since all banks will now have to comply with the higher pan-European standard.