Tectonic Shifts

• Author: Nicolas Véron
• Position: a Senior Fellow at Brussels-based think tank Bruegel and a Visiting Fellow at the Peterson Institute for International Economics in Washington, D.C.

On June 29, 2012, the leaders of euro area countries set in motion what is now universally known as European banking union, or the transfer of banking policy from the national to the European level. The first step, the empowerment of the European Central Bank as the new supervisor of most of Europe’s banking system, has a fair prospect of meeting—by late 2014 or early 2015—its stated aim of addressing the long-standing fragility of Europe’s banking system. But banking union will not stop there, and its structural implications will unfold well beyond the transition to centralized supervision.Â

Europe’s banking problem

Banking union was initiated to resolve a pressing problem. The euro area crisis highlighted the damaging vicious cycle of either weak government balance sheets, which undermined banks’ soundness, as in Greece, or banks’ weaknesses, which damaged government credit, as in Ireland. This linkage became a threat to the entire euro area and its financial system in mid-2011 and forced policy action in 2012. But the underlying problem of European banking system fragility long predates the outbreak of the euro area sovereign debt crisis in 2009–10.Â

This problem was generally denied throughout the first five years of the crisis. Many policymakers first claimed that banking weaknesses could be blamed on the U.S. subprime mortgage market, and then argued that fiscal mismanagement in countries such as Greece was to blame. This narrative was the conventional wisdom until 2012, especially in Germany and France, where policymakers used it to excuse homegrown sources of financial weakness.Â

However, the roots of Europe’s banking problem went much deeper. The core of the problem was a misalignment of incentives of Europe’s banking supervisors. EU countries and institutions, in the wake of monetary union in the 1990s, set themselves ambitious aims to remove cross-border barriers to entry in European finance. In reaction, national authorities tended to champion the protection and promotion of their countries’ banks to give them an advantage in an increasingly competitive environment, even when this entailed additional risk taking.Â

This form of “banking nationalism” effectively downgraded prudential concerns about risk accumulation. A striking example was officials’ assent to the ill-fated takeover and breakup of the Dutch bank ABN AMRO in 2007, which contributed to the subsequent difficulties of other banks, including Fortis, Royal Bank of Scotland, and Banca Monte dei Paschi di Siena. More generally, banking nationalism goes a long way toward explaining the massive buildup of leverage and risk in many European banks’ balance sheets in the decade preceding the global financial crisis.Â

The mismatch between the national scope of supervision and the European dimension of the financial system also explains the failure to address the fragile...