Banking union, properly structured: the concurrence of crisis management and regulatory policy.

• Author: Weidmann, Jens

In the third year of the sovereign debt crisis, policymakers in Europe still face two challenges. First, they have to solve the current crisis. And second, they must make the structure of European monetary union more stable. Of course, these two challenges are interconnected, since the short-term measures taken to solve the crisis must not clash with what is important for the stability of monetary union in the long term. This means that what we need is indeed a meaningful "concurrence of crisis management and regulatory policy."

The Bundesbank has pointed to two paths towards stable monetary union. One leads via an improved Maastricht framework in which national ownership is increased--meaning countries are to decide for themselves, but must themselves also bear the consequences of their decisions. The second way leads via a fiscal union under which substantial national sovereignty would be transferred to the European level.

However, it does not look at present as if policymakers will be taking either of these paths with any great commitment. In the wake of the crisis, joint liability has expanded considerably, representing a move away from the Maastricht framework. At the same time, however, little willingness is being shown to cede national core powers. Thus, monetary union is not moving much closer to fiscal union, either. If we are to achieve a coherent structure, therefore, the main foundations still have to be laid.

Although the future architecture of monetary union remains unclear, work on a new financial market architecture is making progress--in the shape, above all, of the European banking union. This activity is well justified for, whichever of the two paths monetary union will take, a considerably more stable financial system will be needed with rules that will strengthen above all investors' individual responsibility. But thoughts differ on the purpose and design of the banking union project, too. In my view, at least, the banking union can play a central role in a stable monetary union. Let us examine this idea more closely, and begin by asking what the fundamental concept behind a banking union is.

CONNECTION BETWEEN SOVEREIGN DEBT CRISIS AND PRIVATE DEBT CRISIS

For monetary union, the financial system is an open flank. The crisis has made that quite clear. The financial system played an important part in creating the economic imbalances in the crisis-stricken countries and in the massive rise in private debt and government debt that accompanied it.

Prior to the crisis, the economic prospects of several countries were drastically overestimated. When these expectations had to be revised, doubts increasingly arose as to the sustainability of their debts and their ability to repay the loans they had been granted. And although these doubts initially centered on the creditworthiness of households, enterprises, and in some cases governments, the banks, too, quickly attracted attention given their role as financial intermediaries. After all, banks' balance sheets are always a reflection of their respective economies. Another factor was that not all national banking systems were prepared for a crisis to begin with. And because of the systemic dangers involved, the risks of the banking system became the risks of the government that had to come to the rescue. Ireland, for example, had a balanced budget before the financial crisis. During the crisis, the deficit then grew to stand for a time at more than 30 percent of economic output. At the same time, however, problems in public finances also impose a strain on the banking sector. For instance, the Greek haircut for private investors tore gaping holes in the balance sheets of Greece's banks.

When this...