Last Call for a Banking Union in the Euro Area

Abstract

At the heart of the eurozone crisis lies the inability of the current monetary policy framework to avert the on-going financial disintegration and to break the vicious circle that ties up banks and governments in a death grip (liquidity ring-fencing), which does not allow policies to deal effectively with moral hazard and adverse selection problems in the banking system. As a result, cross-border interbank lending, as well as merger and acquisition activities, have dried up in the Eurozone, leaving a significant funding gap for Southern European banks. To break this circle and re-establish a healthy flow of funds within the euro area, this paper discusses the set of measures that would promote a 'real' banking union and re-establish a healthy flow of funds among banks. These measures can be split in two complementary interventions: a monetary policy intervention to be made available in case of short-term market instability, coupled with an institutional set-up that would apply common recovery and liquidation procedures. The monetary policy operations, whether through unconventional direct operations or indirect funding of an ad hoc vehicles (such as the ESM), would need to stabilise the sovereign debt market in the short-term to break the link between counterparty and country risk, which has increased adverse selection in the interbank market and impaired transmission channels of monetary policies. The common recovery and liquidation, on the other hand, would promote further banks’ business integration and international diversification. It would require common EU rules implemented by an independent authority with access to a resolution fund or a common deposit guarantee scheme. This is perhaps the last call for a banking union, as ECB’s prolonged inability to repair the monetary policy channel could hamper its ‘credibility’ and therefore the ability to stick to its important commitments.