Twelve years after its initiation, it is time to complete the banking union

In the early hours of 29 June 2012, boldness and clarity came together. After a long night of negotiations, European leaders laid the foundations for the banking union project. They found strong and clear words on its purpose, stating it is imperative to break the vicious circle between banks and sovereigns.

The decision was taken in the aftermath of a twin crisis that had shaken the euro area – a sovereign debt crisis coupled with a banking crisis. The close links between sovereigns and banks had created a “doom loop”: sovereigns bailed out teetering banks, straining public finances, and rising sovereign yields put pressure on banks’ home-biased sovereign exposures. Such loops emerged as a particular vulnerability of the euro area, with its unique institutional setup as a monetary union of otherwise sovereign states, increasing the pressure on the Eurosystem to save the day. The banking union was conceived as the sword that would sever the doom loop.

Today’s banking union is primarily the result of intensive legislative efforts between 2012 and 2014. They established a complete framework for supervising European banks, and an incomplete one for dealing with banking crises. This helped to mitigate the vicious circle, in particular by creating the Single Supervisory Mechanism under the European Central Bank and the national supervisory authorities. That has proven its effectiveness, but the vicious circle has not yet been broken.

Before the lessons of 2012 are forgotten, the new EU term offers an opportunity to finish the task and break the vicious circle between banks and sovereigns for good. Action must go both ways. First, block the direct contagion channel from banks to sovereigns. Taxpayers should not have to suffer when banks run into problems. Second, close the contagion channel from sovereigns to banks. A sovereign credit event cannot and should not be ruled out in a monetary union with sovereign fiscal policies at the national level. At the same time, it must not be permitted to drag down banks with it and thus further jeopardise financial stability.

The first aim calls for strengthening the crisis intervention framework. Valuable progress has been made with the establishment of the Single Resolution Board and the Single Resolution Fund. The latter reached its target level, currently at €78 billion, after a decade of build-up. However, a more streamlined and predictable framework is needed. Specifically, resolution should be a credible and feasible option to manage more, if not all, failing banks under EU law, instead of the current confusing mix of European and national procedures that leaves too much scope for national state aid and moral hazard.

The reform of the framework for crisis management is closely linked to deposit insurance. A common European deposit insurance mechanism would strengthen confidence in depositor protection and thus reduce the risk of bank runs. It is intended to weaken the link between banks and their national sovereigns and thus to contribute to making the euro area as a whole more resilient. The two of us have different views on how it should be structured, whether fully centralised or a hybrid involving national authorities. However, we share the firm conviction that deposit protection needs a European level. All banks in the euro area should participate in it. Its funding can and should be risk-based, taking into account arrangements such as the institutional protection schemes that play a significant role in Austria and Germany.

Under that mechanism, certain risks would be shouldered jointly within the EU. Conversely, risks that are within the remit of the individual Member States must be appropriately limited. To reduce negative spillovers from sovereigns to banks – the second aim – it is crucial to avoid large and undiversified exposures of bank balance sheets to a single sovereign. Concentration limits and capital charges can serve as effective tools here. With adequate calibration and a transition phase, these tools could incentivise banks to diversify their sovereign exposures, thereby gradually overcoming home bias.

As it turns out, the issues of crisis management, deposit insurance and banks’ sovereign exposures are intertwined. Attempts to make progress have so far failed, not least because they were not comprehensive enough. Part of why the European Commission’s 2015 legislative proposal on deposit insurance was shelved is because banks’ concentrated sovereign exposures were not tackled at the same time. It seems that Member States are unwilling to make concessions if the outcome is merely a halfway house. A comprehensive approach that addresses the interlinked issues holistically is worth considering. It could complete the work that began with a promise twelve years ago – to break the vicious circle between banks and sovereigns.