The euro area was originally set up as a ‘decentralized’ regime where countries would share a common currency but where they would remain responsible for their public finances and their banking systems. While fiscal and debt limits were put in place (Maastricht criteria, Stability and Growth Act), it turned out to be difficult to enforce them. Financial ‘decentralisation’ was legally enshrined in the famous no-bail-out clause. However, with the onset of the euro area debt crisis, the creditors came to realise that they could not ignore economic and financial instability in other member-countries, if only because instability in even a small economy risked setting off a euro area wide financial crisis. The debtor countries, faced with a choice between a disorderly default and euro exit, also came to see the wisdom of making the euro area more resilient. While both debtors and creditors agree that further institutional reform is necessary to prevent future crises, they have been at loggerheads over the details of the various reform proposals and, more specifically, the distribution of its potential economic and financial costs and risk attaching to them.
Institutional reforms in the wake of the euro area crisis focused on stricter government fiscal and debt limits, the establishment of a bail-out mechanism and the setting-up of a bank resolution regime to limit the risks of future systemic financial crises. Weaknesses in the institutional armour remain: limits on national fiscal policies are difficult to enforce; the financial rescue fund is too small to deal with a sovereign crisis in a larger euro area member-state; the lack of a common-deposit insurance scheme does not allow the euro area to address the risk of euro wide banking sector instability and so on.
Three basic risk-sharing regimes can be distinguished. First, conditional lending allows for financial resources to be made available in exchange for macroeconomic adjustment and policy reform. The lenders will get repaid in full, unless the borrower defaults or requires debt relief. Second, an insurance scheme requires all member-states (or banks) to pay into a fund and the fund then distributes financial resources based on a pre-determined rule or criterion. In this regime, it is possible for some countries (or banks) to emerge as consistent net contributors and others as consistent net recipients of funds. Limiting access to the fund would limit the financial liabilities of the net contributors, of course, but unless some sort of ex-post conditionality is attached to the use of fund resources, there is indeed a risk of the scheme turning into what Germans call a ‘Transferunion’. Third, there are debt mutualisation and financial guarantee schemes, where member-states jointly and/ or severally guarantee other member-states' liabilities or the liabilities of its banking sector. Of course, guarantees can be limited size-wise. However, all other things equal, the risk of moral hazard is greatest in this scheme.
In all three risk-sharing schemes, the size of financial liabilities can be limited ex-ante. The problem with limiting the available financial resources is that it might make a crisis response less credible. In other words, creditors’ concerns about limiting their financial liabilities due to moral hazard limit the ultimate effectiveness of all the respective schemes. Financially virtuous countries prefer ex-ante control of economic and banking sector policies in order to rein in risk-taking and moral hazard and to limit the size of future contingent liabilities. By contrast, financially less virtuous countries will prefer regimes that offer financial support that is less limited size-wise and comprises greater risk-sharing, including transfers. While both creditors and debtors have similar objectives, that is, the prevention of future financial crises, they not surprisingly disagree over the distribution of the financial risks and economic costs required to realise this objective. Similarly, the political conflict over the present banking union reform is about the potential distribution of risks in pursuit of preventing or ring-fencing future crises.
On the sovereign risk side, the euro area system today provides for a combination of constraints on national fiscal policy and public finances, on the one hand, and conditional lending to prevent or deal with sovereign crises, on the other hand. By comparison, national banking sectors continue to be backstopped by their governments, government’s access to the bail-out fund - as well as the single (common) resolution mechanism and fund in case banks need to be wound down. Institutionally, an euro area wide deposit insurance is an important piece of the institutional architecture that is missing to make the euro area more resilient in the face of national sovereign or banking crises. A common deposit insurance mechanism (second approach) may lead to debt mutualisation through the proverbial backdoor. So does the single resolution fund, of course. If a country is prone to banking crises or banking failures, it will tend to receive net financial resource transfers, even if the transfer is funded by banks (and especially banks in located in creditor countries) rather than taxpayers. Given the size of the potential liabilities involved in guaranteeing the deposits, the question becomes who backstops the backstop? Until the deposit insurance fund is large enough, it will necessarily have to be supported by government in order for it to serve as a credible instrument of crisis prevention.
Severing the so-called sovereign-bank nexus by way of a deposit insurance scheme would be helpful in terms of reducing the risks of runs on national banking systems, which subsequently may cause a sovereign crisis. It would also help reduce the risk of a sovereign crisis causing a banking crisis. A common deposit insurance scheme would also make it easier to allow sovereign defaults, easier but not easy! The direct ‘balance sheet’ effect of a sovereign default would be more manageable and the spill-over effect between member-states' banking systems would be less severe, even though financial market volatility, declining asset valuations and economic weakness would negatively affect banks. But they would be less likely to have to deal with a destabilising run of their deposits on top of all this. Most importantly, with a deposit insurance in place, a liquidity-driven banking sector crisis would become less likely and it would go some way in terms of mitigating the negative consequences of a sovereign default on the national banking system – and therefore on the rest of the euro area.
In designing financial risk-sharing regimes, creditors seek to minimise potential liabilities, while maximising crisis-fighting capabilities. In order for the creditors to sign up to a scheme that effectively guarantees other member-states’ banking sector deposit liabilities, they will demand greater ex-ante control of financial risk-taking (Single Supervisory Mechanism) and the reduction of banking sector risks (‘legacy assets’) in order to limit future contingent liabilities. Following the establishment of single supervisory mechanism and the fiscal compact, creditors now insist that banks value their holdings of government debt on a risk-adjusted basis. But this would effectively force the banks in countries with low credit ratings to raise large amounts of capital. From the creditors’ point of view, this would help limit their potential future liabilities in terms of deposit guarantees. It would also help limit moral hazard, that is, governments' ability to pursue irresponsible fiscal policies by leaning on domestic banks to buy their debt. From the debtors’ point of view, a banking sector backstop is welcome, but eliminating the what is effectively the lender-of-last-resort function of the national banking system is unacceptable. From a creditor perspective, limiting the ability of banks to absorb government debt is to be welcomed, as it may help impose market discipline on debtor governments. From a debtor perspective, it sharply diminishes the lender-of-last-resort function of the national banking system and will increase the risk of a banking and/ or sovereign crisis. This issue is at the centre of the disagreement between creditors and debtor countries in their negotiations about a common deposit insurance scheme.
Creditors have an interest in making the euro area more robust and in ‘completing’ banking union through a common deposit insurance scheme. So do debtor countries, if only to avoid national financial crises. What creditors and debtors disagree on is who is to shoulder what share of the potential financial (and economic) risks. Creditors will want to minimise their financial risks by transferring as much as risk as possible onto debtor countries, while retaining the ability to safeguard systemic stability. Debtors fear that such a move would be self-defeating in terms of limiting the degree of necessary risk-sharing during a crisis. The trick is to find a solution that allows to safeguard systemic financial stability, while making the arrangement politically acceptable to both creditors and debtors. It is clear that finding an agreement will be a lengthy process in spite of the recent proposals put forward by German Finance Minister Scholz. It requires technical agreement on the level of resources available to counter system crises and it requires agreement on the distribution of financial and economic costs and risks between creditors and debtors. Therefore, the strengthening of the European banking union will take time and a deposit insurance scheme will be phased in over many years (like the Single Resolution Fund).
It will also take a long time to complete banking union because neither creditors nor debtors are under significant pressure at the moment to sign up to what they perceive as potentially costly reforms. The need to advance banking union deepening is generally recognised, but the absence of instability does not make it politically urgent. During the next crisis, firefighting will be the primary concern, not how to make the building more fire-proof. One more reason why completing banking union will be a marathon, not a sprint.
It will also take a long time to complete banking union because neither creditors nor debtors are under significant pressure at the moment to sign up to what they perceive as potentially costly reforms. The need to advance banking union deepening is generally recognised, but the absence of instability does not make it politically urgent. During the next crisis, firefighting will be the primary concern, not how to make the building more fire-proof. One more reason why completing banking union will be a marathon, not a sprint.