Europe needs a single banking system to ward off dangers of sovereign debt

ANALYSIS:A unified and shared fiscal backdrop would be of great benefit to euro zone members in cutting risk of contagion

LAST WEEK’S IMF annual meetings provided an opportunity for the world’s finance ministers and central bankers to discuss the euro crisis. At this point, there are concerns that the European crisis threatens global financial stability and global growth performance. The deep financial linkages between Europe and the rest of the world mean that no region is safe from the negative spillovers from the euro crisis.

There are obvious parallels between the present crisis and the US financial crisis in autumn 2008, especially in terms of the fragility of the funding situation facing some major European banks. To many, this suggests that the same type of policy response is required to restore stability.

First, as has been flagged since the time of the July summit, the capacity of the European Financial Stability Facility (EFSF) needs to be greatly enlarged if it is to play a stabilising role.

Second, a bank recapitalisation initiative is required for major European banks.

The analytical underpinning for these policy recommendations is that a diabolic loop binds together European governments and European banks. Here in Ireland, large prospective losses in the banking system have greatly damaged the Irish sovereign position, even if alternative policy choices might have mitigated the fiscal costs of fixing the banking system. Elsewhere, poor sovereign positions threaten banks, which are major holders of government bonds.

These two forces generate a negative feedback loop, with a weak banking system adversely affecting the public finances and a deteriorating fiscal position further damaging the profitability of banks. If these forces become sufficiently strong, a crisis is generated, since investors rush for safety and the illiquid nature of bank balance sheets and fiscal positions mean that funding can dry up very quickly.

These crisis dynamics are amplified by imperfections in the design of the European monetary union. In particular, demand for the national sovereign bonds of weaker member states is quite shallow, since investors can turn to higher-rated alternatives without any currency risk. During the crisis, the demand for German bunds, in particular, has soared, as many investors have opted to switch out of peripheral bonds.

In similar fashion, the deposit base for national banking systems is fragile, since depositors can switch to banks from stronger member countries without facing currency risk. (Switching into sterling or Swiss franc accounts is riskier, in view of the potential for significant currency swings.)

Moreover, national banking systems across the euro zone are bound together through a web of cross-border loans and deposits. As a result, there is tremendous scope for contagion.

That said, there are two important asymmetries in the European banking system. First, there is a split across countries, since the domestic banking system is most vulnerable to sovereign default risk, as domestic banks tend to disproportionately hold domestic government bonds. They are also most exposed to the consequences of national fiscal distress, both directly through increased taxation of the banking system and indirectly through higher loan losses if fiscal austerity drives down local income levels. Second, there is a split between creditor and debtor countries, since there are direct cross-border losses for creditors in the event of a restructuring by a debtor country.

This interplay between banking systems and sovereign debt markets requires both short-term and medium-term policy changes. In the short term, the combination of a leveraged EFSF, a bank recapitalisation programme and the orderly restructuring of Greek debt can provide a bridge to a stronger European financial system.

However, in the medium term, the euro zone needs to move to a unified European banking system with an area-wide deposit insurance scheme, area-wide regulation and an area-wide approach to banking crises.

Such a unified banking system would be far less vulnerable to national sovereign distress and national property bubbles.

A unified European banking system does require enhanced fiscal integration but in a limited form in terms of providing a shared fiscal backstop in the event of systemic European-wide banking distress. Moreover, the joint fiscal exposures can be limited by designing bank resolution mechanisms that ensure there is a sufficient capital buffer to absorb losses and that can shut down insolvent banks.

An important element in creating a unified European banking system is to limit the vulnerability of banks to national sovereign fiscal default risk. It is vital that banks have access to safe and liquid pan-European bonds, rather than being overexposed to individual national sovereign bonds.

While the much-touted eurobonds have the potential to play this role, the required “joint and several” backing for such bonds requires a degree of fiscal union that does not look politically feasible. Moreover, there are clear moral hazard problems with joint bonds, since ill-behaved national governments may be tempted to borrow too much under such a scheme.

Rather, as is advocated by a new international academic working group (www.euro-nomics.com), it is possible to create a European safe bond (or ESBie, for short) through a combination of financial engineering and regulatory reform. A European debt agency could purchase national sovereign bonds (up to a fixed limit) and issue a mix of low-risk senior bonds (ESBies) and higher-risk junior bonds. Through diversification, the tranching of risk between senior and junior bonds and the provision of credit enhancements (by the EFSF, for example), the ESBies would constitute super-safe bonds and provide stability for bank balance sheets.

Importantly, this proposal does not require any cross-guarantees of national sovereign bonds, so it does not require the degree of fiscal integration that is barrier to eurobonds. Since the ESBies would be super safe, these should be treated by the ECB as superior collateral for its operations relative to most national sovereign bonds. In turn, if European banks were less exposed to national sovereign bonds, the orderly restructuring of excessive sovereign debt levels would be less problematic, in view of the dilution of its impact.

Finally, the restoration of financial stability is only one element in the reconstruction of the euro system. Over the medium term, the maintenance of fiscal sustainability requires strong national fiscal frameworks that can ensure that sufficient fiscal surpluses are achieved during good times to provide a buffer against downturns. Fiscal dynamics would also be improved by structural reforms that can boost long-run growth.

Since such policies are only effective over a long horizon, short-term economic recovery also requires supportive aggregate-demand policies from the ECB and from those national governments with the space to attain the ideal combination of short-term fiscal support and medium-term fiscal consolidation.

Philip Lane is professor of international macroeconomics at Trinity College Dublin. He is a member of an international academic working group on the future of the euro (www.euro-nomics.com). This article draws on the group’s work. Its proposal for European Safe Bonds (ESBies) is on its website