March 26, 2014

One Europe, One Banking System

Could it happen? What are the benefits and obstacles? Two prominent Euro economists go head-to-head.

Sharon Kahn

It’s a premise that could change the European Union forever — and largely for the better, agreed two speakers at a recent panel discussion cosponsored by the Chazen Institute titled “Banking Union in Europe: Prospects and Challenges.” But that’s where their accord ended.

“At this point, banking union is on track,” said Vítor Gaspar, special advisor at Banco de Portugal, and former finance minister of Portugal. “I am the optimist in the debate.”

Athanasios Orphanides, professor at the MIT Sloan School of Management and former governor of the Central Bank of Cyprus, was the somewhat reluctant pessimist. After an EU council meeting in 2012 agreed in principal to create a banking union (as well as an economic and financial union), a recession slammed Europe. “We’ve seen great animosity between the member states,” he said. “In the past, every time a crisis or challenge appeared, governments worked together for a solution that improved Europe overall. Since 2009, each country has been pushed to tackle its own problems.” With such polarization operating as the new norm, Orphanides said, “I am concerned about the Union as a whole and I am pessimistic that banking union will ever happen.”

Why Banking Union?

Although 17 states within the European Union share a single currency, each country operates within its own financial context, which means borrowing costs and prices of goods differ across borders, and each country supervises its own financial institutions. In theory, a central banking system would allow individuals and large and small businesses the same access to money, at the same rates, in Greece as in Germany. Outflows of cash, such as the flight of capital from Spain during the recent recessionary panic, would be less likely since deposits would be insured in the weaker countries just as they are in France.

A banking system does not operate in a vacuum. Financial markets must be integrated and linkages created to assure smooth flows of money. A backstop must be created to insure deposits and remove any correlation between country and banking risks.

The European Central Bank already exists as the supervisory mechanism. In December, eurozone finance ministers laid the groundwork for banking union by agreeing to shut down sickly banks within member states that use the euro. How that will be accomplished is still fuzzy, though, since the ECB lacks the equivalent of the US Federal Deposit Insurance Corp., which has the authority to shutter American banks.

Orphanides argued that strong states such as Germany have little incentive to make banks within their borders give up their advantages. “The mechanism that created the [eurozone] 20 years ago leverages stronger countries at a cost to weaker ones,” he said. “It’s a government’s job to protect its economy and some countries don’t want to give away their competitive advantages.”

Gaspar argued that the EU — like all democratic institutions — is a work in progress, and the current strife is temporary. Citing various financial and currency crisis in the 1980s and 1990s — not to mention the most recent recession — he said, “We’re impatient, but we forget that Europe has always progressed from crisis to crisis, coming to consensus after the general view was that all was lost.” Gaspar also pointed out that the Federal Reserve and FDIC weren’t created until 1933, 140 years after the US launched its financial system. “I think we are progressing much faster than the United States,” he said.

Overcoming National Challenges

To be sure, differences of opinion often split along national borders. Gaspar pointed out that Germany, with its long memory of how rising prices can wreak havoc, is more concerned about inflation than other member states. Also, as the eurozone’s healthiest member, Germany can focus on how low interest rates impact pension funds and other bund investors, and how excessive debt could cripple future generations. Elsewhere in Europe, the more important driver seems to be unemployment. “The differences in viewpoints are remarkable,” Gaspar observed.

Still, Germany remains committed to monetary union, he said — as do even the weaker member states that have suffered through painful austerity programs. “The reaction has been more benign than might first appear, given the lively debates and protests,” he said. Although the next round of elections later this year could see some new faces in power, “largely the same national politicians are in place in 2014 as in 2011.”

Even if banking and broader financial union is achieved, don’t look for political union across Europe, the speakers agreed. “That’s just not going to happen in my lifetime,” said Orphanides.

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