The aim of the prospective banking union is to foster financial stability in Europe. The euro sovereign debt crisis has shown that financial stability cannot be managed effectively at the national level, because of the diabolic loop between national governments and banks (Alter and Schüler 2012). A truly integrated European-level banking system can do much to stabilise the Eurozone by breaking this diabolic loop. Beyond this immediate concern, the broader case for the banking union is that national governments concentrate on the domestic effects of bank failures and ignore cross-border externalities (Schoenmaker 2013).
While the banking union is scheduled to start with the Single Supervisory Mechanism, the real benefit from the banking union would come from the resolution of ailing banks at the European level. What are the incentives for countries to join the banking union? While all Eurozone countries are required to join the banking union, the non-Eurozone countries (the ‘outs’) have the choice to opt in. So far, politics is dominating the debate on participation. The UK and Sweden have declared that they want to stay out. But what are the economic benefits and costs of joining?
The starting point of resolution of an ailing bank is that only the systemically relevant parts of that bank may be recapitalised, after writing down the shareholders and certain classes of debtholders (see debate on bail-in of debt). Next, the authorities check whether the benefits of a bailout exceed the costs. Among other things, the benefits of a recapitalisation may include those derived from maintaining financial stability and avoiding contagion (Allen and Gale 2000). An example is the Lehman collapse, which caused widespread contagion. A recapitalisation of Lehman may have prevented this outburst of financial instability. By contrast, a minor, idiosyncratic, bank failure (e.g. Barings) would pose no systemic problem. In such cases, an ailing bank should be closed.
We develop a model for the resolution of ailing banks (Schoenmaker and Siegmann 2013). The decision rule that a bank is only recapitalised if and when the benefits exceed the costs. Otherwise the bank will be closed. The model is based on game theory. The rescue of an ailing bank is a non-repeated game with high financial stakes. Countries have to cooperate for the resolution a cross-border bank. Each country will try to minimise its contribution. In equilibrium, all countries would contribute close to nothing to the rescue. Cooperation will thus not emerge, as witnessed with the collapse of Lehman and Fortis. As most benefits accrue to the home country, the ultimate decision is with the home authorities, which only takes into account the domestic (‘home’) benefits.
In the banking union, a new European Resolution Authority would incorporate all benefits within the banking union. For banks with activities in the rest of Europe (outside their home country), the efficiency of resolution increases. The benefits in the rest of Europe are now incorporated.
To analyse countries’ costs and benefits of participation in the banking union, we simulate the resolution of the top 25 European banks. These banks count for the vast majority of cross-border banking in the EU, as small and medium-sized banks are largely domestically oriented.
Bailout benefits can be thought of as preventing a temporary reduction of credit availability (credit crunch) through shortening of balance sheets by a forced liquidation of the loan book in a particular country. Another source of benefits is the safeguarding of financial stability of the total banking system, which might be jeopardised by a fire sale of assets or other externalities. This is in accordance with the ‘credit view’ on the impact of bank failures on the economy (see Bernanke 1983). Thus, we take size and distribution of bank assets to represent the bailout benefits. We calculate the geographic segmentation of the top 25 banks’ assets over the home country, the rest of Europe and the rest of the world (see Schoenmaker and Siegmann 2013). It appears that on average 55% of the assets are in the home country and 22% are in the rest of Europe. There are some large variations among the top 25. An international bank like Santander has only 27% in its home country and 41% in the rest of Europe. Banking union would considerably improve the efficiency of the resolution process. By contrast, a national bank like Lloyds has 90% at home and 7% in the rest of Europe. In the latter case, the UK could do the resolution on its own. Banking union would not add very much.
The costs of the rescue are shared among the participating countries (Goodhart and Schoenmaker 2009). Strategic behaviour by countries will be prevented by adopting a fixed burden-sharing key. Once the decision is taken, countries cannot escape and must pay their share.
Distribution over countries
All countries benefit from the enhanced stability of a supranational approach under the banking union. Host countries benefit as the resolution of the parent bank becomes more efficient. The viability of the host country branch and/or subsidiary is dependent on the performance of the parent bank (De Haas and Van Lelyveld 2013). Home countries also benefit from the improved efficiency of the resolution of their banks. Furthermore, the diabolic loop in which the solvency of countries and banks are intertwined (Alter and Schüler 2012) is broken by the supranational approach.
The improvement, resulting from the move from the home to the banking union resolution mechanism, is collectively paid by the participating countries in the banking union. Although financial stability is a public good, we can calculate the benefits and costs for each participating country. The home country has a direct benefit from the enhanced resolution of its (cross-border) banks, while it must pay only a part of the costs under burden sharing. To measure these benefits, we sum the efficiency improvements of the resolution process of all banks in each home country (see Schoenmaker and Siegmann 2013, for the bank by bank results and the country results). Only ten of the 27 EU countries have banks among the top 25. This reflects the fact that some countries are home to large banks that serve the domestic economy as well as foreign economies, while other countries rely on banking services from these countries (a few countries, like the central and eastern European countries and Luxembourg, rely almost completely on foreign banks). Next, the cost share for each country is calculated. Following the European Stability Mechanism Treaty, this cost share is based on the ECB capital key, which is an average of the relative GDP and relative population share of each country. The cost share is more evenly divided in proportion to a country’s size.
Finally, we report the net effect (benefits minus costs). Figure 1 for the Eurozone shows that Spain (with two large banks in the top 25) and the Netherlands (with three banks) are the net benefiters with 11% and 3%. Germany, France and Italy are net contributors with 7%, 3% and 4%. Although these three countries have large banks, these banks are smaller than the economic weight of these large countries would suggest. From the non-Eurozone countries, Figure 2 indicates the UK (five banks in the top 25) and Sweden (one large regional bank, Nordea) are the key recipients with 13% and 9%. While all CEE countries are contributing, Poland is the main contributor from the non-Eurozone side with 5% due to its size.
Figure 1. Net effect (benefits minus costs) for Eurozone countries of joining banking union
Figure 2. Net effect (benefits minus costs) for non-Eurozone countries of joining banking union
A truly integrated European banking system with supervision and resolution at the European level fosters the stability of the Economic and Monetary Union. Our analysis suggests that the non-Eurozone countries can also benefit from the stability of the banking union. It is interesting to note that the main non-Eurozone countries that do not wish to join the banking union for political reasons (i.e. the UK and Sweden) would be the largest beneficiaries from the banking union. Not joining is very costly on the budgetary front. It would be very demanding for the Swedish government to bear the full cost of a possible recapitalisation of Nordea outside the banking union, while only 20% of the benefits accrue to Sweden. Similarly, the recapitalisation of some of the large UK banks during the great financial crisis put a severe strain on the UK government budget. The UK and Sweden thus preserve the expensive right to do potential rescues of their banks on their own. Political calculus dominates economic calculus.
Within the Eurozone, Spain (with two large banks) and the Netherlands (with three large banks) are the winners of the banking union. To reap these benefits, the second stage of resolution needs to be completed as well. So far, heads of state have focused on the first stage of supervision.
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