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The recent banking and sovereign crisis in the Euro area has exposed critical gaps in the architecture of Europe’s financial system that make it vulnerable to future crises. Prior to the recent crisis, low interest rates led to an excessive build up of credit in the banking system of a number of smaller Euro-area countries. At the same time, persistent fiscal deficits in those countries led to an excessive amount of sovereign debt. The 2008-09 financial crisis forced some of the European governments to bail out their banking systems, thus taking on additional public debt and leading to Europe’s sovereign debt crisis. In order to break this vicious circle of banking and sovereign crises from happening again, a European-wide banking regulator is needed that can reduce the risk of future banking crises and, if they occur, provide the necessary funding to bailout banks without affecting national sovereign debt. According to QNB Group, such a European-wide regulator is essential for Europe’s financial architecture to withstand a future crisis.

A banking union in a common currency area is important for two key reasons. First, it strengthens the health of the banking system through a centralized banking regulator across the region that is not subject to national political pressures. Second, it helps to weaken the link between troubled banks and government debt, so that banking crises do not end up into sovereign ones.

The establishment of a European banking union requires three key pillars. First, there should a single regulator to enforce common rules uniformly. Second, the regulator ought to have the financial means to intervene in illiquid banks and liquidate insolvent ones. Finally, there should be a credible Euro–wide deposit guarantee scheme to reassure depositors that a Euro in one bank is just as safe as in another one. Currently, national guarantee schemes offer limited reassurance to depositors and the level of guarantees is variable across the region (see chart).

European Deposit Guarantee Schemes

(Customer Deposits at end-2012, % of GDP)

EU Banking Union

Source: IMF, Bloomberg

European governments have made some progress in establishing a banking union. In December 2012, they committed in principle to moving toward a banking union, in which bank regulation and supervision, deposit guarantees, and the handling of troubled banks will be harmonized across the European Union. The European Central Bank (ECB) was given the authority to directly regulate 150 of the euro zone's biggest banks and intervene in smaller banks in the event of financial distress. In addition, the Eurozone already has a €500bn bailout fund, the European Stability Mechanism (ESM), of which up to €60bn will be available to recapitalize banks from late 2014. Now the European Commission is proposing a bank resolution fund for the eurozone in which bank levies totaling 1 percent of insured deposits would be used to provide additional funding to intervene in troubled banks.

In June 2013, European finance ministers agreed that shareholders and some creditors must accept losses before taxpayer funds could be used to prop up troubled banks, thus establishing a framework for intervening in troubled banks. The agreement, however, still needs approval from the European Parliament and would not go into effect until 2018. Further progress is, therefore, needed to give the ECB sole authority on the regulation of all European banks and to provide it with the financial means to intervene in troubled banks.

Indeed, it is much easier to endorse the concept of a banking union than it is to implement one. European banks are central to the financial system, supplying about three quarters of all credit to the economy, and are thus critical to the functioning of the wider economy. Their supervision is not just a technical issue; it also requires subjective judgments that have serious implications for credit provision, economic growth and thus jobs. Choices about how much credit banks provide, and to whom, strongly affect the relative performance of national economies and businesses. Hence, designing integrated banking supervision will require agreement on how power will be divided among various European institutions and national authorities.

While there are many issues to tackle, it is critical that a strong regulator is implemented swiftly – not least because the cost of dwindling confidence is already accumulating in the large imbalances brought on by the flight of deposits and capital from smaller European countries to the larger ones. These potential costs can be reversed and minimized by early and credible action to establish the banking union.

Overall, the recent financial crisis has forced a rethink of the underlying institutions needed to sustain the Euro as a common currency. The European banking union can be pivotal in preventing another crisis by breaking the vicious circle between banking bailouts and sovereign debt crises. According to QNB Group, a banking union with a single regulator, empowered with the financial means to intervene in trouble banks, and a regional deposit guarantee scheme would lay the foundation for long-term financial stability in Europe. 

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