Europe Needs Banking Union for Safe, Stable Financial System

Banking union can help enhance stability of Europe’s financial system

Banking union should eventually comprise single supervision, resolution, and safety nets

Current plans are important step, implementation will be key

According to a new paper from International Monetary Fund staff, a successful banking union should eventually include three key elements: a single supervisory mechanism to oversee the rules and contain the buildup of risks; a single resolution authority to deal with weak or failing banks; and common safety nets to sustain depositor confidence in the event of shocks.

More integrated markets need more integrated oversight

Prior to the crisis, banks and financial institutions operated with ease across countries, but the framework underpinning the safety of the system stopped at each border. The mechanisms to ensure financial stability—supervision, resolution, and safety nets—were nationally based.

During the crisis, governments in many countries could not provide timely or cost effective solutions, and the framework proved inadequate to deal with the risks across Europe’s financial system.

As a result, trouble in some parts of Europe has amplified and rippled across the euro area. Banks have been unwilling, and often unable, to deploy funds across borders to places where funding is scarce. Also, lending and deposit rates vary widely across Europe; private borrowing costs rise with the government’s; and the European Central Bank’s rate cuts have only limited effects in economies under stress.

“A banking union can reverse this fragmentation of European financial markets and break the adverse spiral of private and sovereign borrowing costs witnessed across the monetary union,” said Mahmood Pradhan, Deputy Director in the IMF’s European Department.

“Single supervision should reduce national distortions, bring a uniformly high standard of oversight, and mitigate the buildup of concentrated risk that compromises stability for all,” said Rishi Goyal, one of the lead authors of the study. “And moving responsibility for potential financial support to the supranational level would de couple banks’ prospects from that of sovereigns with weak finances, protect individual sovereigns from banking sector weaknesses, and thus enhance confidence.”

Key elements for success

The single supervisory mechanism, agreed by the European Union Council in December 2012, is an important step toward integrated oversight of the region’s financial...