fiscal union, banking union: two opposite paths for europe

7/28/2019 Fiscal Union, Banking Union: Two Opposite Paths for Europe

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Summary: The problems that

the eurozone is facing are all

of its own making. Not only did

the common currency deprive

European nations of the ability

to adjust to economic shocks,

the euro was itself the shock

to which it could not respond.

Countries on the periphery

had access to cheaper credit

than they had experienced in

living memory, contributing to

scal imbalances and growing

public debt. The current crisis

has shown the impracticability

of an economic and monetary

union in Europe without the

essential institutions of a

banking or nancial union.

As the recent cases of Spain

and Cyprus already indicate, a

banking union will draw on the

widespread political reluctance

to support euro area bailoutsfor banks. Electorates in Europe

will nd it even more difcult to

bail out a foreign bank, so we

may well expect that a common

resolution regime will rest on the

bailing in of bank creditors.

The feedback loop linking

banks and states is not broken

from above, but from below, by

imposing losses on investors

and unsecured bank creditors.

Fiscal Union, Banking Union:

Two Opposite Paths for Europe

by Bruno Macaes

1744 R Street NWWashington, DC 20009 1 202 683 2650F 1 202 265 1662E [email protected]

May 2013

Paper SeriesE TheEuroFutureProjectF

Problems of its own Making

As Paul Krugman has noted, one o

the bitterest ironies in the crisis othe eurozone is that the problems itis acing were all o its own making.Not only did the common currencydeprive European nations o theability to adjust to economic shocks,the euro was itsel the shock to whichit could not respond.1 Suddenly, coun-tries on the periphery had access tocheaper credit than they had experi-enced in living memory. Governancestructures are badly prepared to deal

with radically new conditions, so weshould not be surprised that easieraccess to nancing greatly contrib-uted to scal imbalances and growingpublic debt. But the problem wasnot limited to public debt. In somecountries, it was even on the wholemuch more serious in the privatesector, uelling housing bubbles andlax lending standards.

Under the euro, banks remained

under national supervision and tookincreasing risks with their balancesheets. Investors were very muchwilling to turn a blind eye in the aceo growing imbalances because theold exchange risk had disappearedand the new risks created by the

1 Paul Krugman, Revenge of the Optimum Currency

Area. NBER Macroeconomics Annual 2012, Volume 27

(Chicago: University of Chicago Press, 2012).

single currency were, or the moment,dicult to athom. In the absence

o a productivity boom, moneygrowth will maniest itsel as ina-tion: rising wages, prices, and realexchange rate misalignments. Tis inturn lowered real interest rates evenmore, so the process ed on itsel.Currency depreciation would haveworked as an adjustment mechanismaer the shock, but it could havealmost certainly worked even beore,as currency and ination risk wouldhave put a break on these huge, desta-

bilizing capital ows.

As or the new risks, it seems thatalmost no one was ully consciousthat countries belonging to a currencyarea are no longer ully sovereignin economic matters. Tey have nocontrol over their currency, so therisk o sovereign deault stops beingan abstract possibility. As a result,their ability to ully stand behindtheir national banking systems should

also be regarded with resh skepti-cism. Beore the crisis erupted, noone seemed interested in pricing risksaccording to the new political situ-ation, but to be air, this new situa-tion was never made clear the way itshould have been with new rules,new institutions, and new principles.


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E TheEuroFutureProjectFIt is important to point out that optimum currency areatheory sees two main ways in which a currency area might

be able to survive without the exibility ofered by diferentnational currencies. o speak very broadly, a currencyarea needs to be able to adequately respond to asymmetricshocks and correct imbalances beore ragmentation isallowed to set in. Te theory stipulates two main responsemechanisms: the market and the state. While one does notalways look at it in these terms, it helps to understand howthe problems posed by the introduction o the euro leave uswith two opposing solutions. Tey correspond more or lessexactly to the ideas o a banking and a scal union.

Tus, it may be argued that an essential ingredient o a

common currency is a high degree o actor mobility. Itmay be added that the crucial actor or the eurozone iscapital rather than labor, since we know that labor mobilityin Europe aces a number o cultural, linguistic, and even,to some extent, administrative or regulatory limits. Teavailable empirical studies seem to support the claim thatin successul currency areas, like the United States, shocksto gross national product are mostly smoothed by creditand capital markets, with only a small percentage beingaddressed by ederal government spending. Te sum ocapital market and credit market smoothing constitutes theraction o shocks smoothed through the market mecha-nism. Te two difer in that capital markets are able to dealwith asymmetric shocks through ex ante arrangements. Byholding claims to output in other states, citizens are able tosmooth shocks to their home gross product, while residentsin other states are orced to share in the downside.2

Te third channel is, o course, the ederal budget. Here,we have an alternative that is conceptually distinct rom,and even opposed to, the market mechanism. It relies onthe notion o economic sovereignty, the combination oa single monetary policy with the instruments o scalpolicy: scal and monetary policies must go hand-in-hand.For the deenders o a scal union, there should always be atreasury, opposite to each central bank, that is empoweredto tax and spend and capable o compensating or regionaldiferences using both sides o the budget.3

2 See Pierfederico Asdrubal, Bent E. Srensen, and Oved Yosha, Channels of interstate

risk sharing: United States 19631990, The Quarterly Journal of Economics (1996):

1081-1110.

3 See Peter Kenen, The theory of optimum currency areas: an eclectic view, reprinted in

Exchange Rates and the Monetary System: Selected Essays of Peter B. Kenen (Aldershot:

Elgar, 1994), 3-22.

Tere is a common diagnosis o the ongoing crisis inthe eurozone that essentially views it as the result o the

weakness and contradiction o having a monetary unionthat is not also a scal union. In a sense this is true: theeuro was ounded on the understanding that a numbero independent states could share the same currency, thesame monetary policy, and build ully integrated nan-cial markets, without having to share their tax bases andbudget decisions. Te problem o having a monetary unionwithout a scal union is that states lose the ability to soenasymmetric choices by allowing the value o their currencyto adjust, while not being able to use a ederal budget orthat same purpose.

Let us clariy at the outset that scal union reers to thesharing o revenue and expenditures among regions ormember states. Tis may take diferent orms: a ederalunemployment insurance program, or example, but alsocommon debt issuance or even common debt guarantees.In all cases, a scal union would be marked by two signi-cant developments. First, the commitment to share revenueand transers would dramatically recongure nationalbudgets. Until now, the European budget has remained theobject o periodic negotiation and kept at a very modestsize. Second, once revenue and transers are even partiallyshared among member states, scal sovereignty thepower to allocate revenue will have to be moved romthe states to the center. Control at the center is obviouslynecessary in order to avoid ree riding by member statesthat stand to benet rom access to a common pool o taxesand transers.

Tus, it is perhaps to be expected that any progress towardsa genuine scal union would have to include establishinga European treasury with the power to raise taxes, thepower to decide on how to spend these monies, and thepower to issue joint and several guaranteed euro bonds.A ederal scal union with a central authority havingdiscretionary spending, taxing, and borrowing powerswould decisively move the European Union towards agenuine political union a supranational state, callingor the corresponding democratic mechanisms necessaryto ensure its political legitimacy. On the other hand, whenrecalling that the original sin o the euro was the unlimitedaccess to cheap credit across the periphery, it is hard notto conclude that what is ofered as a solution to the crisis,an explicit joint liability or public debt, was in act, albeit


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E TheEuroFutureProjectFimplicitly, the real source o the crisis. Now, the answerto this problem might be a renewed efort to bring about

real convergence at a higher level. Perhaps member statescould agree that what was lacking beore was convergencein economic structures and institutions. Lucas Papademosliked to argue that this is the most proound meaning oreal convergence.4 o ensure that the process would notbe resisted or postponed, national states would have tosurrender part o their sovereignty to a ederal authoritycapable o bringing about this institutional or structuralconvergence.

Needless to say, this would be pure olly. It would exac-erbate tensions between member states and commit the

economic ortunes o the continent to a process o politicaltransormation or which it lacks both the instruments andthe will. As a general idea, it has already been tried. In act,the rst ten years o the euro were a conscious bet on thereal convergence between member states. Wagering everychip they had on this outcome, politicians and marketparticipants rushed headlong into a disastrous nancialcrisis rom which we have yet to recover.

The Age of Credit Equality

Once the process o monetary integration eliminated

currency and ination risks, it might have been thoughtthat any lack o convergence on scal policy would neces-sarily imply that highly indebted countries would be payinghigher interest rates. Fiscal discipline would be imposedby high market borrowing costs.5 But even at the time,there were serious doubts about this. First, one shouldnot assume that lenders will react quickly to the risk oscal collapse or outright deault, which most marketparticipants will consider an extreme case, and one thatpolicymakers will in any case want to prevent. Sovereigndeault in a developed economy is an almost unthinkablepossibility, not least because public debt is owned in such

signicant amounts by domestic nancial institutions.Second, it is not clear whether higher borrowing costs havesucient dissuasive power to break a spiral o excessiveborrowing. It is only in the long run that higher borrowing

4 See, for instance, On the Road to the Euro: Progress and Prospects of the New Member

States, speech by Lucas Papademos, vice president of the European Central Bank, in-

tervention at a panel discussion at the conference The ECB and its Watchers, Frankfurt

am Main, May 5, 2006.

5 Alberto Alesina, Mark De Broeck, Alessando Prati, and Guido Tabellini, Default risk on

government debt in OECD countries, Economic Policy(1992): 429.

costs become punitive or a government, especially in theorm o resistance to new or higher taxes. As Otmar Issing

put it, a small rise in interest rates is unlikely to have anysignicant disciplinary impact on the scal policy o thedecit country.6

Faced with doubts about the efectiveness o market disci-pline, the choice was to establish a regulatory rameworkto impose limits on scal policy in the member states.Tere was, perhaps, a touch o incoherence in this choice.Aer all, i market discipline was deemed too weak in theabsence o a regulatory ramework, then it might disappearaltogether i such a ramework were put in place, commit-ting the monetary union to a collective zero-risk goal or

sovereign debt. Unsurprisingly, this was precisely whathappened. It is disingenuous to blame market participantsor excessive complacency in the decade up to the crisiswhen market discipline was explicitly ruled out as thepolitical and nancial architecture or the monetary unionwas being put in place. Alexandre Lamalussy pointedout that closer economic and solidarity ties, implied bymembership o the union, could generate market expecta-tions that the member state would be bailed out, entirelywrecking the market mechanism.7 But i it was not possibleto rely on market orces to diferentiate the cost o unds,then such diferentiation would have to be abandoned. Itcertainly could not be imposed politically.

Te choice was incoherent in a second respect. We mustremember that this scal ramework was designed not tointerere extensively with domestic economic and scalpolicies, which were still thought to belong to the irreduc-ible core o national sovereignty. National autonomy shouldbe inringed upon as little as possible, in accordance withthe limited degree o political integration and democraticlegitimacy at the union level. Zero risk was to be a blanketassurance extended to member states, even i scal andeconomic conditions still varied widely among them. Inact, the European capital requirements directive allowsbanks to apply a granular approach to corporate, mortgage,and retail exposures, while applying a uniorm zero riskweight to the sovereign debt o member states.

6 Otmar Issing, The birth of the euro (Cambridge: Cambridge University Press, 2008)

195.

7 See Alexandre Lamfalussy, Macro-coordination of scal policies in an economic and

monetary union in Europe. Paper annexed to the Report on Economic and Monetary

Union in the European Community (commonly called the Delors Report), Committee fo

the Study of Economic and Monetary Union (1989).


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E TheEuroFutureProjectF

The whole nancial architecture

of the monetary union rested onwishful thinking.

o determine sovereign deault risk, a number o vari-ables must be considered: degree o indebtedness, revenue

sources, the diversity o these sources, implicit and explicitexternal backing, and, last but not least, political risk. Howcould it be assumed that countries with very diferentinstitutional arrangements and political and scal systemswould benet rom essentially the same risk assessment?

It is always sound method not to proclaim a certain law asuniversally valid, as valid under all possible conditions. Itis the only way to avoid seeing it reuted. In the case o thezero risk status o sovereign debt in the monetary union,it was clear that no test had yet been perormed. Te test,which alone could justiy such a pronouncement, would

come much later. Te whole nancial architecture o themonetary union rested on wishul thinking. It rested, asa matter o act, in a single proposition which, by itsel,implies the denial o risk analysis: the proposition thatsovereign debt has zero risk no matter what the underlyingnational economic and political conditions turn out to be.Tis proposition was quickly and duly reuted.

Heterogeneity and its Causes

One might argue that the diferentiation in sovereign bondyields was no more than a return to sanity and a neces-sary incentive or countries to put their own houses inorder. But things are not that simple. Such diferentiation,once adopted and anchored, would permeate all the waydown to the domestic banking sector and its links to the

real economy. It is a measure o how ingrained the inter-dependence between banks and sovereigns has become incontinental Europe that, until very recently, it was repeat-edly assumed that a greater amount o economic andnancial integration between member states has to take theorm o a scal union. In act, integration can be pursuedat a diferent level by disconnecting states rom the banksoperating in their jurisdictions.

It turns out that the persistence o diferent domesticbanking systems was only compatible with a zero risk

assessment. Once this has been corrected, the increasein sovereign risk is concentrated in some o the memberstates and acquires a number o reinorcing eedback loops,since every correction in risk assessment is both a reec-tion o the underlying undamentals and a actor shapingtheir uture development. From this standpoint, the eurocrisis appears as a result o rapidly increasing ragmenta-tion along national lines. It is sometimes said that the crisismay lead to a reversal o the integration process in Europe.It is much more correct to say that it already reects thisreversal.

On one hand, we nd a clear channel o risk transmissionrom banks to sovereigns. Te anticipation by nancialmarkets o the likely costs o a bank rescue translates intodoubts about the sustainability and credit worthiness opublic debt. As long as the cost o recapitalizing ailingbanks remains with the individual sovereign, the implieddebt burden will respond to weaknesses in its own nan-cial sector. On the other hand, banks tend to have sizeableexposures to the home sovereign and nancial marketshave quickly reacted to this act by orcing risk premia obanks exposed to troubled sovereigns to rise accordingly,which in turn will increase the odds o a costly bank rescue

In addition to the direct impact on balance sheets,increases in sovereign risk make it more dicult or banksto use government securities as collateral. In act, i thesecurity is already posted with a central bank or a privaterepo market, a downgrade or a drop in price could trigger amargin call. Another channel o transmission rom sover-eigns to banks takes place through the ratings mechanism:it is very rare, as we know, or a bank to exceed the rating othe sovereign or to avoid a downgrade within a ew monthsollowing a sovereign downgrade. Finally, the worseningo sovereign credit positions will reduce the value o theexplicit and implicit guarantees given to banks, whichraises their unding costs.

As noted, these channels work in both directions at once.A correction in the assessment o sovereign risk will beamplied by the impact it has on bank risk and the reversetransmission mechanism rom the banks back to the sover-eign. Te same is true when assessing bank risk. When theIrish government announced that it would guarantee allbank liabilities, nancial risk was transerred to the govern-


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E TheEuroFutureProjectF

The current crisis has decisively

shown the impracticability of an

economic and monetary union

in Europe without the essential

institutions of a banking or

nancial union.

ment balance sheet, while at the same time creating newsources o risk or banks resulting directly rom increased

sovereign weakness. One cannot ignore either the taxpayercost o signicant bailout packages or the indirect cost orthe banking sector itsel.

Te process gets more complicated i we consider macro-economic channels. Banking crises have an obvious impacton economic activity and thereore on negative trends intax revenues. Sovereign credit weaknesses will afect thecost and availability o unding or banks, orcing themto deleverage and rebuild capital ratios. Tis in turn willimpact the real economy, increasing the pressure on taxrevenues and casting urther doubts on the sovereign.

Conversely, the need or scal consolidation ollowing asovereign crisis may weaken economic activity, afectingcredit quality and protability in the banking sector.

Outright Monetary Transactions

Financial market ragmentation is clearly incompatiblewith a monetary union. I banks resident in distressedcountries ace unding pressures, while banks resident inother countries benet rom unding surpluses, mone-tary policy will not be equally transmitted to the wholecurrency area. It may even be eared that some countries or

regions will efectively be excluded rom the currency areain the sense that nancial and economic conditions therebecome entirely impervious to monetary policy decisions,as the unding constraints on banks in the periphery signi-icantly reduce the amount o loans they are able to supplyto households and rms. Also, as banks try to counter theadverse impact o unding pressures on their earnings,lending margins tend to increase, having a very powerulnegative impact on economic activity.

As Banque de France Governor Christian Noyer hasconvincingly argued, there is no logic in a situation in

which some banks are heavily penalized in their undingand activities solely because the governments o the coun-tries where they happen to be located have been scallyirresponsible in the past.8 Tis in turn will afect economicconditions or companies and amilies, adding to unem-ployment pressures. It is clear that the problem is not justabout banks, which is why nancial union may be abetter term than the more common banking union. Te

8 See, for instance, The Next Step for Europe Is Financial Union, Wall Street Journal,

June 11, 2012.

current crisis has decisively shown the impracticability oan economic and monetary union in Europe without the

essential institutions o a banking or nancial union. Howshould one address this problem? Notice that there are twomain possibilities. Assume that, through various channels,diferent sovereign risk proles in vulnerable countrieshave an impact on the unding conditions or domesticbanks. Should we try to reintegrate nancial markets bytrying to break these links or by reducing sovereign risk, sothat it is no longer transmitted to the banking sector? Onceagain the choice is between, as we said, two mechanisms ointegration: the market and the state.

In order to saeguard the transmission mechanism o

monetary policy in all euro area countries, the ECBdecided in September 2012 to launch a program oOutright Monetary ransactions (OM) or sovereignbonds. A number o conditions were specied. Strict andefective conditionality in the orm o an adjustment orprecautionary program has to be in place and compliedwith in order to ensure scal discipline in countries eligibleor OM. Purchases would be limited to the shorter parto the yield curve and conducted in the secondary marketonly.

Te announcement had a powerul impact on investor

sentiment. Sovereign yields in the vulnerable memberstates started to decline almost immediately and have nowreached levels not very diferent rom what these countriescould obtain beore the crisis. What is most extraordinaryis that no purchase has yet been made under the program.Te market seems satised to know that the possibilityis there i and when tensions were to resurace. By this


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E TheEuroFutureProjectFIn a sense, the idea behind OMT

is the very negation of a banking

union.

standard, it should be considered a notable success, butone should not orget that its declared goal was a diferent

one: to bring about a better alignment o unding condi-tions or the real economy with the key ECB interest rates.It is perhaps too early to have a nal opinion on this score,but the program has so ar been incapable o repairing thetransmission mechanism o monetary policy. On one hand,the spread in sovereign yields is still signicant and, as longas it remains in place, it is dicult to expect that nancingconditions or households and rms can start to converge.On the other hand, the banking systems in periphery coun-tries remain considerably impaired and monetary policycan do nothing to address this question. It is not the role o

a central bank to recapitalize weak nancial institutions orto do away with bad assets.

Te undamental aw in the program is its indirectness.In a sense, the idea behind OM is the very negation oa banking union, since it is based on the conviction thatcredit conditions in nancial markets can be made similaronly i the position o the diferent sovereigns is also madeto converge. Tis intermediary presence is a source otwo distinct problems. First, the impact o the measureis considerably soened beore it can develop its desiredefects. Te measure does not act directly on undingconditions or banks and the real economy. Second, it canonly reach its goal by having considerable consequencesor the scal position o member states. In act, althoughOM were presented as trying to address the uneven orimpaired distribution o the monetary policy stance, itis in act sovereigns that stand to directly gain rom thepurchases program, while banks and rms must wait orthese benets to cascade down to them. Tis cannot butraise serious concerns about moral hazard, scal compla-cency, and even, as Bundesbank President Jens Weidmannput it, the redistribution o solvency risks between euroarea countries.9 It should be noted that one o the conse-

quences o introducing policy conditionality or central

9 Q: From the outset, you were consistently opposed to ECB purchases of bonds from

crisis countries. Since the announcement by ECB president Mario Draghi in the summer

to buy, if necessary, an unlimited quantity of bonds, the bond and equity markets have

been humming along nicely. Are you now a convert? A: The fact that, as you say, the mar-

kets are humming along quite nicely at the moment cannot be the sole determinant. What

the ECB ultimately announced is that it is quite willing, if need be, to redistribute solvency

risks between euro-area countries without limit. However, a clean dividing line between

monetary and scal policy is important. In addition, the announcement is a sort of insur -

ance policy backed by the central bank but the insurance is not making the system any

more stable. I fear that eagerness to reform will ag if monetary policymakers come to the

rescue time and again. Interview with Jens Weidmann, Frankfurter AllgemeineSonntag-

szeitung, December 30, 2012.

bank purchases o sovereign debt is to project thesepurchases into the uture. Tus, while previous governmentbond purchasing programs allowed eurozone banks to sellthose securities to the ECB, the current program allowsthem to buy bonds with the expectation o selling them inthe uture at a higher price. Tis may have a sizable impact

on yields, but it is also building up important risks in thesystem.

A Banking Union

One could draw the conclusion that the powerul posi-tive eedback loop linking banks and sovereigns shows thenecessity o maintaining sound public nances, as stressin the sovereign credit markets will easily afect undingor banks and, as a result, credit conditions in the realeconomy. Santander is a case in point. Despite being themost protable bank in Europe or a number o years, theSpanish bank was quickly orced to pay more to borrow inthe private markets than some o its weaker counterparts inGermany.

Te problem may be put in this way: i the strong linkagesbetween banks and sovereigns are to remain, economicand nancial convergence in the eurozone would seemto depend on a similar convergence in sovereign risk andscal standards. One size must t all, or the creeping difer-entiation in sovereign credit quality will oster increasingnancial and economic segmentation.

I sovereign risk is to be allowed to diverge, the policy

implications are naturally quite diverse. Te interdepen-dence between banks and sovereigns must be broken up inorder to isolate the nancial sector rom emerging difer-ences in sovereign credit quality. Stresses in the sovereigndebt market could then have a disciplining efect, while thedanger o having a whole economy held hostage to a longand dicult process o scal consolidation would be muchabated, perhaps even eliminated. Diferent sovereignsmight take their turn being the ocus o investor doubt, but


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E TheEuroFutureProjectFnext to them, a large and ully integrated common marketwould go about its business with healthy indiference.

Te obvious way to bring about a ully integrated bankingsector is to set up a common resolution authority, accom-panied by a joint supervisory regime. Banks would nolonger be dependent on the creditor guarantees providedby their sovereign. Tese guarantees, or the lack thereo,would be part o a common resolution regime at the euroarea level. Other sources o nancial ragility, such asthe home bias in the holdings o government debt by thenancial sector, would also be reduced. Aer all, i a bankis directly afected by any deterioration in the credit qualityo its sovereign, it is economically rational or it to hold a

disproportionate amount o domestic debt. A bank will beseverely afected i the sovereign loses market condencewhether or not it holds its debt, so it might as well capturea higher yield. Another explanation o home bias is thesubtle or less subtle practice by which banks are incentiv-ized, encouraged, or orced to support the nancing needso their sovereigns. A deadly embrace tends to develop,since banks themselves acquire considerable leverage overpolitical authorities by increasing their domestic debt pile;they will be a position to wreak havoc in the secondarymarket or public securities i and when they decide tounload it. Since the start o the euro, the share o euro-zone government bonds held domestically decreased romaround three-quarters to just over one-third. Tis processwas then reversed, especially in Spain and Italy, and thequestion is how to resume nancial integration even in theace o persistent bond yield divergence.

Te solution to this problem must surely include theestablishment o a single supervision authority, able to actindependently rom the demands o national scal policy.In addition, the current system o separate supervisorstends to encourage national authorities to underestimaterisks to the solvency o their banking sectors, relying onunding rom the central bank, and postponing the dicultmoment when they might be held responsible or capitalinjections or deposit insurance. National supervisors maytreat their national champions with avor. In trying topreserve international competitiveness or to avoid reputa-tional costs, they may delay addressing existing problems,which as a result will tend to grow worse. Also, in times onancial stress, national supervisors typically encouragehome banks with subsidiaries abroad to repatriate as much

capital as possible. A single supervisory mechanism wouldoperate very diferently, because it would have access to

inormation about banks in diferent countries and wouldbe specically mandated to protect the interests o the euroarea as a whole.

Te second step is a common crisis management rame-work, including clear rules or bank resolution. It is, ina sense, the crucial step, eliminating the shadow that abanking crisis throws over the integration o nancialmarkets in Europe. European banks are European in lie,but national in death. It is enough, then, or a bankingcrisis to emerge as a possibility and or nancial marketsto start acquiring a distinctly national shape. Besides, as is

well known, the endgame o resolution will always drivethe incentives or supervision, so the two processes must gotogether.

o efectively address the root causes o nancial ragmen-tation in the eurozone, the crisis management rameworkwould have to extend to all member states and all systemi-

cally important banks. Given that nancial ragmentationis ultimately rooted in unaddressed banking ragility, weneed a transparent and energetic mechanism to make thetriage o strong and weak institutions, impose the recogni-tion o losses, recapitalize viable institutions, and removebad assets rom the system.

In all these respects, a common resolution regime wouldll an obvious void, but there are two main interpreta-tions o how it could operate. A banking union couldsimply transer to the European level most o the practicesthat were adopted during the crisis by national resolution

authorities. Tis would be enough to break the direct linkbetween sovereigns and their own banking systems, butit would not break the more general risk channels linkingbanks and sovereigns. Alternatively, a banking union couldrepresent a new way o thinking about the managementand nancing o ailing bank resolution, one that wouldat least start to sever the umbilical chord connecting euroarea banks and political authorities. Tere are our diferentreasons why the costs o resolving a ailing bank should beshied rom taxpayers to the banks and their creditors:

European banks are European in

life, but national in death.


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E TheEuroFutureProjectF When bank risk is capped by sovereign guarantees, we

are much more likely to experience destabilizing capital

ows o the kind that brought about very high levelso private debt in the rst place, as investors will eelencouraged to take excessive risks. Consider what themessage to eurozone banks would have been i banksin Cyprus had been bailed out by a European recapital-ization und.

o rely on government loans does not reduce theburden o debt, but merely shis it somewhere else.

I we want to break the eedback loop linking sover-eign risk and bank risk, we should avoid rebuilding it

at the European level. It is not sucient to argue thatrisks will be much smaller i shared by all countries.Bank assets are several orders o magnitude larger thanexisting sovereign debt.

Government-unded rescues would not coincide withtransers between states, since troubled banks can beound in every country. Nonetheless, i bank resolutionis to be nanced by a shared pool o taxpayer money,the distinction between a nancial and a scal unionbecomes less clear. A banking union would be intro-ducing a scal union through the back door, raising

intractable political problems.

As the cases o Spain and Cyprus already indicate, abanking union will draw on the widespread political reluc-tance to support euro area bailouts or banks and add anextra layer to it. Electorates in Europe will nd it even moredicult to bail out a oreign bank, so we may well expectthat a common resolution regime will, in act, rest on thebailing in o bank creditors. Te eedback loop linkingbanks and states is not broken rom above, but rom below.Tat means not through the inusion o shared Europeanunds, but by imposing losses on investors and unsecured

bank creditors.

Conceptually, the goal o a resolution regime should be tominimize disruption and even ensure that a ailing bankcan continue to operate as a going concern by makingshareholders and creditors absorb the losses that led to theneed or intervention. Ex ante rules replace the politicaldecision to bail out nancial institutions, or to abruptlyunplug them rom public support. From this perspective,a common regime is the result o a collective retreat rom

About the Author

Bruno Macaes teaches politics in Berlin, Germany. For the past two

years, he was a senior political advisor to Portugals prime minister,

Pedro Passos Coelho. His recent publications concentrate on eco-

nomic policy and the uture o the European Union.

About The EuroFuture Project

Te German Marshall Fund o the United Statesunderstands the twin

crises in Europe and the United States to be a dening moment that

will shape the transatlantic partnership and its interactions with the

wider world or the long term. GMFs EuroFuture Project thereore

aims to understand and explore the economic, governance, and geo-

strategic dimensions o the EuroCrisis rom a transatlantic perspec-

tive. Te Project addresses the impact, implications, and ripple efects

o the crisis in Europe, or the United States, and the world.

GMF does this through a combination o initiatives on both sides o

the Atlantic, including large and small convening, regional seminars,

study tours, paper series, polling, briengs, and media interviews.

Te Project also integrates its work on the EuroCrisis into several

o GMFs existing programs. Te Project is led by Tomas Kleine-

Brockhof, Senior ransatlantic Fellow and Senior Director or

Strategy. Te group o GMF experts involved in the project consists o

several ransatlantic Fellows as well as program staf on both sides o

the Atlantic.

state intervention and, in act, an extension o existingrules on state aid to the crucial case o banks and nancial

institutions.10 Te goal is to re-establish a level playing eldmarket participants in diferent countries will no longerbenet rom the implicit guarantees o a more solid sover-eign. A level playing eld can be viable only i asymmetriesin state power become less important.

It is important to remember the classic distinction betweenpositive and negative integration. Te latter is obtained byremoving the obstacles to integration put in place by themember states without erecting a new state at the center.A banking or nancial union is a orm o negative integra-tion.

10 See Willem Buiter, Three unanticipated consequences of banking union, Citi

Research, Economics, Europe, Global Economics View, August 2, 2012.
http://www.gmfus.org/programs-projects/policy-programs/foreign-policy-civil-society/eurofuture-projecthttp://www.gmfus.org/http://www.gmfus.org/http://www.gmfus.org/programs-projects/policy-programs/foreign-policy-civil-society/eurofuture-project

fiscal union, banking union: two opposite paths for europe

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