Europe's Banking Union in the Global Financial System: Constructing Open and Inclusive Institutions

Abstract

The global reach of Europe’s banks is extensive and their foreign operations have supported financial development in European host countries, as has the profitability of bank groups headquartered in Europe. However, financial fragmentation threatens to reverse these gains and is evident in terms of a withdrawal of global liquidity (external deleveraging), and in the segmentation of capital and liquidity pools within the foreign subsidiaries of European cross-border banks (“decentralised banking”). In light of this we examine the external ramifications of Europe’s banking union constituted by a common supervision and bank resolution regime. We show that institutions, as presently designed, may stem global deleveraging but that they are likely to accelerate a move towards a more decentralised banking model. This second trend will be re-enforced by prudential ring-fencing on the side of the host country authorities, which is costly at both the host country and global level. Ring-fencing and banking decentralisation will therefore undermine the benefits of financial integration – both within Europe’s single market and in non-EU emerging markets that have so far enjoyed full capital mobility intermediated within bank groups. However, where foreign host countries have no prospect of further institutional integration with the banking union, decentralised banking and certain prudential safeguards will be inevitable. In such a second-best setting these safeguards may be desirable from the perspective of the host country and the European Central Bank (ECB) in its new role as single supervisor.