Financial crisis exposes EU’s credibility gap

Two months after the Cyprus bailout, capital controls are still in place on the Mediterranean island. The phrase is one of the many muted, understated terms used by the European Union to describe something that is in fact extremely serious.

People in Cyprus continue to face restrictions on the amount of money they are permitted to withdraw from bank accounts as European authorities assiduously work on implementing the island’s colossal bank restructuring and the terms of its EU-IMF bailout.

The fact that the euro zone is stemming the flow of money in and out of one of its 17 member countries seriously undermines the concept of a currency union. Cyprus, located just 200 miles from Damascus, may lie at the furthermost edges of the European Union, but the chaotic handling of the bailout, in which depositors were put directly in the line of fire, was deeply unsettling for European citizens and savers.

The continuation of capital controls in Cyprus is a persistent reminder of the deep challenges that face European monetary and fiscal union. Having owned up to its shambolic handling of the Cypriot bailout, EU officials have busied themselves with advancing banking union – the EU's grand plan to deal with the economic crisis. The proposal envisages not only a radical reform of the way European-based banks are governed, but also a realignment of the relationship between states and their banking sectors, and a move towards a greater centralisation of powers with the Frankfurt-based European Central Bank.

Troubled banks
Central to this is a plan to introduce EU-wide rules to govern how troubled banks are wound-down. Officials argue that the ad-hoc approach to bank collapses in countries such as Cyprus, and Ireland, illustrates the need for a common set of bank resolution rules.

The plan is to shift the burden of future bank collapses away from the taxpayer and on to the private sector, in other words, to move from a state-funded “bailout” model to a “bail-in” approach, where a bank’s own creditors absorb the losses if it runs into difficulty.

Discussion this week in Brussels focused on what class of creditors should be hit in the event of a bank collapse. Depositors under €100,000 will be safe, we are assured, but deposits of over €100,000, various ranks of bondholders, and shareholders would all be liable. Who gets hit first is still under discussion.

Though Europe insists that clarity is key, the reality that large deposits could be liable for losses in the event of future bank collapses would have been unthinkable a decade ago. The probability that bondholders will also be hit is particularly maddening for Ireland, which was forbidden to burn senior bondholders in the former Anglo Irish Bank for fear of financial contagion.

Integration dilemma
The move towards a more integrated European banking union reflects in microcosm what countries, including Germany, argue is the logical next step for Europe more generally – greater integration. But the discussions around banking union also show up the difficulties involved in that process.

Britain, for example, asked whether it made sense for bank bonds, many of which are held by pension funds, to be exposed to bigger losses than large deposits. Other countries argued that member states outside the euro should be given greater flexibility, reflecting the broader political question of whether Europe is heading towards a two-tier Europe split between those within the euro zone and those outside.

Similarly, Germany has queried the wisdom of transferring supervisory powers to the European Central Bank, suggesting that full banking union may need a change to Europe’s existing treaties.

The difficulty in achieving consensus on a common set of rules on banking encapsulates the problems facing the European Union as a whole as it tries to encourage the need for greater integration at a time when public appetite for a stronger European Union has never been lower.

This week a study by an influential Washington-based think-tank, the Pew Research Centre, showed confidence in the EU is flagging, with more citizens than ever opposing the transfer of more power to EU institutions. Only in Germany is more than half the public in support of giving more power to Brussels to deal with the economic crisis.

The logic of greater integration may be persuasive, particularly in terms of greater fiscal co-operation in the euro zone, but bringing Europe’s citizens on board may be another matter.