Banking union for Europe – where do we stand?

Thorsten Beck 23 October 2013



In a few days, pending some last-minute diplomatic conflict between the UK and the European Commission, the ECB will begin an asset-quality review of European banks. This is supposed to be the entry point to the supervisory role of the ECB in the context of the Single Supervisory Mechanism (SSM), the first of three pillars of the planned banking union. Little political progress has been made on the other two pillars, bank resolution and deposit insurance, in spite of proposals by the EU Commission.

A year ago, in the early days of the public discussion of the banking union, it seemed possible that the banking union would go the way of so many other initiatives to address the Eurozone crisis. There was brief but heavy political emphasis on, for example, the fiscal and growth compacts, and different monetary policy initiatives of the ECB – most of which were relegated to the backburner shortly thereafter. The new kid on the block has stayed with us and has grown into a teenager, marred by puberty and not quite sure of its direction.

What have we learned from the still unfolding Eurozone crisis (including the Cyprus crisis resolution) for the design of the Eurozone banking union? In the following, I will pick up on a few themes highlighted in last year’s eBook which have taken on new urgency given recent events.

Plus ça change, plus c'est la même chose

European authorities and many observers have pointed to the special character of each of the patients of the Eurozone crisis and their unique circumstances. But there has been a common thread across all crisis countries – close ties between government and bank solvency. In Ireland, this tie was established when the ECB pushed the Irish authorities to assume the liabilities of several failed Irish banks. In the case of Greece it was the other way around, with Greek banks having to be recapitalised once sovereign debt was restructured. In all crisis countries, this link is deepened as their economies fall into recession, worsening the government’s fiscal balance and increasing sovereign risk, which in turn puts pressure on balance sheets of banks that hold government bonds but also depend on the same government for possible recapitalisation. Recent statistics indicate that banks in the European periphery invest more heavily than before in domestic government bonds, further strengthening the deadly embrace. Unless this tie is broken, neither will the crisis resolved nor the currency union put on a more sustainable footing. None of the crisis resolution initiatives so far, including the SSM, addresses this issue.

A deposit-insurance scheme is only as good as the sovereign backing it

One of the main objectives of deposit insurance is to prevent bank runs. That was the idea behind the increase of deposit insurance limits across the Eurozone to 100,000 euro following the Global Financial Crisis. However, deposit insurance is typically designed for idiosyncratic bank failures – not for systemic crises where a public back stop funding is necessary. Obviously, the credibility of the latter depends on a solvent sovereign. The case of Cyprus has shown that when the solvency of the sovereign is itself in question, savers lose faith in a deposit insurance scheme. A banking system without the necessary confidence will be hard pressed to fulfil its basic functions of facilitating payment services and intermediating savings. Ultimately, this lack of confidence can only be overcome by a Eurozone wide deposit insurance scheme with public back-stop funding by ESM and a regulatory and supervisory framework that depositors can trust.

A currency union with capital controls?

The protracted resolution process of the Cypriot banking crisis has increased the likelihood of a systemic bank run in Cyprus once the banks open. As in other crises (those in Argentina and Iceland) that perspective has led authorities to impose capital controls, an unprecedented step within the Eurozone. Effectively this implies that a Cypriot euro is not the same as a German or Dutch Euro, as they cannot be freely exchanged via the banking system – a contradiction to the idea of a common currency (Wolff 2013). However, these controls only formalise and legalise what has been developing over the past few years: a rapidly disintegrating Eurozone capital market. National supervisors increasingly focus on safeguarding their home financial system, trying to keep capital and liquidity within their home country (Gros 2012). Anecdotal evidence suggests that this does not only affect the inter-bank market but even intra-group transaction between, let’s say, Italian parent banks and their Austrian and German subsidiaries. Again, without Eurozone-level supervision and resolution authorities that internalise the costs of this disintegration for the Eurozone, this problem will not be tackled.

If you kick the can down the road, you will run out of road

The multiple rounds of support packages for Greece by Troika, built on assumptions and data often outdated by the time agreements were signed, has clearly shown that you can delay the day of reckoning only so long. By kicking the can down the road you risk deteriorating the situation even further. In the case of Greece, that led eventually to restructuring of sovereign debt. Delaying crisis resolution of Cyprus for months (if not years) has most likely also increased losses in the banking system. On a first look, the Troika seemed eager to avoid this mistake in the case of Cyprus, forcing recognition and allocation of losses in the banking system early on without overburdening the sovereign debt position. However, the recession that is sure to follow will certainly increase the already high debt-to-GDP ratio and might ultimately necessitate sovereign debt restructuring. A scenario that might repeat in other countries – as well as the Eurozone – only delays the day of reckoning with respect to bank and sovereign fragility.

The Eurozone crisis – a tragedy of commons

The protracted resolution process of Cyprus has shown yet again that in addition to a banking, sovereign, macroeconomic and currency crisis, the Eurozone faces a governance crisis. Decisions are taken jointly by national authorities who each represent the interest of their respective country (and taxpayers), without taking into account the externalities of national decisions on the Eurozone. It is in the interest of every member government with fragile banks to “share the burden” with the other members, be it through the ECB’s liquidity support or the Target 2 payment system. Rather than coming up with crisis resolution on the political level, the ECB and the Eurosystem are being used to apply short-term (liquidity) palliatives that deepen distributional problems and make the crisis resolution more difficult. The currently envisioned structure of the SSM does not alleviate concerns that this will continue even in a joint regulatory entity. And the piecemeal approach, where supervision but not resolution is transferred on the supra-national level, does not overcome this challenge either.

Banking union with just supervision does not work

The move towards a Single Supervisory Mechanism has been hailed as major progress towards a banking union and stronger currency union. As the case of Cyprus shows, this is not enough. The holes in the balance sheets of Cypriot banks became obvious in 2011 when Greek sovereign debt was restructured, but given political circumstances, the absence of a bank resolution framework in Cyprus and – most importantly – the absence of resources to undertake such a restructuring, the problems were not addressed until it was too late. Even once the ECB has supervisory power over the Eurozone banking system, without a Eurozone-wide resolution authority (with the necessary powers and resources) it will find itself forced to inject more and more liquidity and keep the zombies alive, if national authorities are unwilling to resolve a failing bank.

A banking union is needed for the Eurozone, but won’t help for the current crisis!

While the Eurozone will not be a sustainable currency union without a banking union, a banking union cannot solve the current crisis. Building up the necessary structures for a Eurozone or European regulatory and bank resolution framework cannot be done overnight, while the crisis needs immediate attention. There are strong arguments for establishing a resolution authority separate from the SSM housed at the ECB, which might require treaty changes. Second, the current discussion on banking union is overshadowed by distributional discussions – as bank fragility is heavily concentrated in the peripheral countries – and using a Eurozone-wide deposit insurance and supervision mechanism to solve legacy problems is like introducing insurance after the injury has occurred. The current crisis has to be solved before the banking union is in place. Ideally this would be done through the establishment of an asset management company or European Recapitalization Agency, which would sort out fragile banks across Europe, and also be able to take an equity stake in restructured banks to benefit from possible upsides (Beck, Gros and Schoenmaker 2012). This would help disentangle government and bank ties (discussed above), and might make for a more expedient and less politicised resolution process than if done on the national level.

There is no free lunch, neither for savers, nor for banks, nor for taxpayers

At the risk of sounding like a broken record, the Global Financial Crisis and subsequent Eurozone crisis have offered multiple incidences to remind us that you cannot have your cake and eat it too. This applies as much to Dutch savers (attracted by high returns in Icesave and subsequently disappointed by the failure of Iceland to assume the obligations of its banks) as to Cypriot banks piling up on Greek government bonds promising high returns even in 2010 when it had become all but certain that Greece would require sovereign debt restructuring. This argument also applies to the zero risk weights for government bonds on banks’ balance sheet within the EU, which is partly behind the still increasing investment of Eurozone banks in domestic government bonds, especially in the periphery countries with attractive interest rates on their sovereign bonds. While this might be seen as an easy trick to provide a low-risk investment option for weak banks and satisfy immediate government funding needs (combined with cheap ECB liquidity support, previously known as the Sarkozy trade), in the long-term it increases risks and also increases the vicious embrace of banks and sovereigns (Acharya, Drechsler and Schnabl, 2012).

Looking forward

The experience over the past year and the ongoing political struggle over the shape of the banking union provide serious doubts about the effectiveness and consequences of the AQR and SSM.

  • What does the experience so far imply for the asset quality review and the new role of the ECB as supervisor? How will the criteria be set for the asset quality review? Past ‘stress tests’ have lacked credibility vis-à-vis the market. What will be different this time around, aside from the fact that these are not officially stress tests?
  • Even more importantly: what happens if this review reveals undercapitalisation in specific banks?
  • Worse still: what if this undercapitalisation is concentrated in countries with insufficient fiscal resources to resolve these banks and with no Eurozone-level resolution mechanism in place?

If the past year has taught us one thing is that a well designed banking union can be an important part of overcoming the Eurozone crisis. But we are still a long way away from having one.


Acharya, Viral, Itamar Drechsler and Philipp Schnabl (2012), “A tale of two overhangs: the nexus of financial sector and sovereign credit risks”,, 15 April.

Beck. Thorsten (ed.) (2012), Banking Union for Europe – risks and challenges, eBook, 16 October.

Beck, Thorsten, Daniel Gros, Dirk Schoenmaker (2012), “Banking union instead of Eurobonds – disentangling sovereign and banking crises”, 24 June.

Gros. Daniel (2012), “The Single European Market in Banking in decline – ECB to the rescue?”,, 16 October.

Wolff, Guntram (2013), “Capital controls are a grave risk to the Eurozone”, Financial Times, 26 March.



Topics:  EU institutions Global crisis

Tags:  ECB, eurozone, monetary union

Professor of Banking and Finance, Cass Business School; Research Fellow, CEPR